Another Debt Milestone

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Source: Lisa Benson, Washington Post Writers Group

Switzerland-based Bank for International Settlements recently announced that global debt passed the dubious $100 trillion milestone in mid-2013.  That’s almost twice the mid-2013 $53.8 trillion world equity value.  In the six years since mid-2007, just before the financial crisis, equities declined in value by more than 6.5% while debt levels exploded by 42% from $70 trillion to $100 trillion. The prime causes were governments piling on the debt to rescue economies from recession and corporate treasurers taking advantage of record low interest rates.

With the U.S. and Japan promising to add far more debt to central bank balance sheets this year and Mario Draghi pledging to “do whatever it takes” to lift the Eurozone’s stagnant economy, debt levels will inevitably march higher.  Most major equity markets have risen appreciably since 2009, confirming investor belief that growing debt is certainly no roadblock to higher stock prices.  Those, in fact, who point to debt levels as a danger are frequently ridiculed for repeatedly crying wolf.  True, excessive leverage has been offered as a reason for caution for a decade and a half, yet many equity markets are near all-time highs.  It’s perhaps worth recalling, however, that in 2008 excessive debt levels necessitated an unprecedented central bank bailout to prevent a collapse of the world banking system.  Greece, Portugal, Ireland and Cyprus were essentially bankrupt without restructuring or coordinated rescue efforts.  In this country, Detroit is a recent example of debts having risen to unserviceable levels.

Rising stock prices, declining interest rates in financially stressed countries, and silver-tongued central bankers seem to have eliminated fear in most investors.  It is irrational, however, to ignore centuries of history that testify to the damage done to economies from debt relative to GDP even far lower than that prevalent today throughout most of the developed world.

Central bank efforts to shore up bank capital levels have certainly succeeded to a degree.  Leverage in the U.S. has been roughly cut in half from pre-crisis levels.  That many assets are not yet marked to market, however, argues that our banks are not yet in the clear.  On top of that, many have again begun to issue large amounts of the covenant-lite loans that became all too common leading up to the 2008 crisis.

A recent Morningstar report demonstrates that, despite deleveraging, major European and Japanese banks are just now getting down to leverage levels in the mid-twenties, where U.S. banks were just before the 2008 crisis hit.

Not only is the quantity of debt worrisome, quality is as well.  On April 2, Financial Times reported that Europe’s banks hold more sovereign debt than at any time since the Euro crisis.  Because Basel II rules allow regulators to treat sovereign debt as risk free, banks do not have to hold any capital against it.  When the European Central Bank gave banks the opportunity to borrow at 1%, many invested the loan proceeds in the higher yielding sovereign debt of countries like Spain, Italy and Portugal, all of which had and still have precarious finances.  These countries and their banking systems are dangerously intertwined.

Not having experienced many countries or major banks going unrescued, today’s investors have become overly complacent.  Excessive debt levels are a real danger.  In a recent International Monetary Fund working paper, Carmen Reinhart and Ken Rogoff offered a cautionary historical precedent.  There was a widespread default on World War I debts to the United States by both advanced and emerging nations.  Those debts were never repaid.  In today’s extremely leveraged environment, a similar outcome is not out of the question.