Given the spate of articles in the business press about this country or that country facing a potential debt crisis, I wanted to write a bit about sovereign debt crises.
In my view, economic stimulus has been warranted in order stabilize the financial system and prevent economic collapse. However, the price of that stimulus is unsustainably high increases in government debt — in a world in which private sector debt is already critically high. I see the sovereign debt problem as critical, especially in Europe. The sooner we abandon a debt servicing cost mentality, the more likely we are to face up to this challenge.
The debt service mentality
During the boom and bubble which led up to the financial crisis, many in the financial community looked to debt service costs in the private sector as the only relevant metric to gauge whether debt levels were sustainable – both for individuals and in the aggregate. This was bubble mentality which I must take to task now now that we are seeing it crop up in discussions about public sector debts as well. If not, we will likely see some major sovereign bankruptcies in the not too distant future.
The debt service mentality goes a bit like this: Bob and Shirley are looking for a new house. They make $6,000 per month. So they can legitimately afford to pay $2,000 per month for their mortgage. With a 7% interest rate on a 30-year fixed mortgage, that means they can afford to borrow $300,000 – or just over four times income. So, if Bob and Shirley put 10% down on the purchase of a home, they can afford one that costs $330,000.
The problem is when this is the only constraint on borrowing. What happens to house affordability when Bob and Shirley's 30-year rate drops to 5%? Suddenly, they can ‘afford' a $375,000 loan. What if they get a 4% rate? Now, they can afford $425,000 in debt – a loan more than 40% larger than at 7% and a massive 5.9 times income. Anyone who has a mortgage recognizes this math as integral to the home buying process.
The lower interest rates go, the more affordable any debt load becomes when debt servicing costs are the only constraint. As rates drop toward zero percent, theoretically Bob and Shirley could afford to buy any house no matter how expensive. But, of course, interest rates don't move in one direction. If rates were to move up significantly when Bob and Shirley wanted to move house, they would face a serious problem. In this sense, artificially low interest rates are toxic. And therefore pointing to debt servicing costs as the only metric of affordability and debt constraints is bubble finance plain and simple.
Here I am talking about bubble finance, not Ponzi finance. In the Ponzi finance schemes in the U.S., we saw fixed rates substituted with lower but unsustainable adjustable rates. Eventually affordability became passé as no-doc, zero-percent down, ninja loans became the norm. In the end, the Ponzi debt scheme collapsed in a heap – as it always must. That's what we saw in the blow-off stage of the bubble after Greenspan lowered rates early this decade. But, the debt servicing mentality is what preceded it.
Relative debt constraints
What is needed is a relative debt constraint like debt to income – or in the case of aggregate figures or sovereign debt figures, debt to GDP. For example, before the bubble in the U.K., one might have seen relative debt constraints like three times income. That meant one could borrow up to three times one's annual income – no ifs ands or buts. If you worked in the City and received a bonus, you might have convinced the bank to count half of it toward your income for loan purposes.
As prudence was thrown out, these constraints were relaxed. The Bradford and Bingleys of the world used lower interest rates to justify jacking these constraints up to 3.5 times or four times income. Eventually these constraints hit six times in the UK.
How do you compete against that as a bank? All of the business is going to Bradford and Bingley and you are getting stuffed. I guarantee you shareholders won't like that. As an executive, you better find the holy grail of prudent but profitable lending or follow Bradford and Bingley on the road to easy money. Otherwise, you will be out of a job.
Eventually, even the prudent relax their standards too – that's how risky behaviour drives out good when risk is rewarded.