Debt
This is a continuation from Part 1
One of big problems in the financial world today is debt. It would be very foolish not to take note of debt because the havoc it's causing is affecting every country,even now. Because of the "creative" people in financial world, we have come across some "crazy" debt instruments and the failure of people to understand these products has caused a great deal of problems. A brief introduction, how to we take on debt or borrow. We usually borrow money from banks or other financial institutions and that is the most common way. For large institutions like corporations or governments, they are able to borrow by issuing debt. One party borrows, pays it back in the future plus interest. It all seems like an easy equation but what if the borrowing party can't pay it back? And what determines the riskiness of the borrower?
Debt is such big word that occurs at many levels and sometimes people do not see the entire picture. Borrowing and lending occurs at different levels. It can be at an individual level, a business level or a national level. Understanding debt at these levels is crucial.
Before we get there we have to understand what exactly influences the interest rate on debt? If we would like to borrow money, rationally we would like it at the lowest rate, right? But different kinds of debt give you different rates? But why the difference? One big word any borrower and lender needs to know, and that's RISK. From two extremes, the interest on credit cards (18%) and interest on a home loan (6-7%) are different. Why such a big difference, especially to a person who is going to pay the loan back anyway. The answer...risk. One of the simplest explanations is the debt on credit cards are unsecured while a home loan, the (house/asset) is secured by the lender. If a person goes bust with a credit card debt outstanding, if the person has no assets, the lender (or the issuer of the credit card) would probably write off the debt as unrecoverable. If the a person defaults on a home loan, there are safeguards in place as the asset is secured and the lender could take possession of the asset and try to recover the loan amount by selling it. A home loan is probably the lowest interest rate loan known to individuals, because it is least risky to the lender.
There are many other debt instruments available in the market and to keep track on all of them is impossible. So what I suggest is to know the ones that are frequently used.Another important thing to understand to risk and return trade off. Yes, everyone knows you need to take on more risk for a higher return. But what people sometimes overlook is whether they are compensated SUFFICIENTLY. If you've done some finance, you would have come across the efficient frontier which tells you having a portfolio on the frontier would give you an efficient portfolio (maximising returns for a given level of risk). The model is normally used for stock returns but calculations for debt or stocks are alike and it is directly applicable. So when a corporation or financial institution borrows money from you for a higher interest rate than the normal rate, does it include a risk premium and it is sufficient?
One of the best examples of a risk premium is insurance. You pay a couple of a hundred dollars a year of premium but when there's an accident or claims, you get back a lot more than the "premium" you pay. One friend asked me awhile back, how is the insurance company going to make any money in that case. Well, firstly, the insurance business is very profitable business because they have done the math in terms of estimating claims. They charge premiums based on probability calculations. One thing people fail to remember is when we buy insurance on a building, car or health, it just lowers your risk financially. You won't actually HOPE or EXPECT your building to burn down or your car to get into accident right...So the bottom line is the premium an insurance company charges you more than compensates them for the risk they are taking on (repaying claims). So here you go, the insurance company is more than compensated for the risk they are taking, hence they will be profitable. So on the other side (which is us) buying and paying the premium, we are under-compensated right? Technically yes, but it would be extremely foolish not to buy insurance to reduce risk of loss.
There are many types of debt instruments that are available to public. Debt is normally classified by its duration, short term or long term. Just a clue, when there are words like money market, bills or notes, they usually mean short to medium term. When we talk about longer term debt, you should be seeing the word bond.
Just a rule of thumb and referring to the principle of risk and return, when they are instruments that offer higher returns than the risk-free rate, there will be a risk premium, which is the difference in the price of the instrument or the interest rates paid by the instrument.
Good Debt vs Bad Debt
This section is probably the most important in my view. Debt or leverage is probably the most effective way of growing wealth. The general view is that we should reduce the amount of liabilities (debt) we have, but that should only happen in the case of bad debt. Bad debt are debts that do not generate a net benefit while good debt are debts that will generate a positive benefit. Bad debt are things like credit card or personal loans which do not provide any financial returns.I've actually written about this before in my previous posts so I won't go too in detail.
Leverage or taking on debt allows investors increase risk which achieves potentially higher returns. For example if you want to own an investment property, are you going to save up until you have ALL the money required to buy that property? The answer is no, it would take too long and you would lose out on the potential rental income.The most effective way is borrow a portion of the value of the property and start renting it out immediately. If you worked the numbers out correctly financially then you would probably have an investment with a positive net present value which means you have added value to your wealth.Debt is probably the most common tool used to get rich if managed intelligently. Leverage is also used with many other instruments to increase the potential risk/reward. For example in shares, investors may use margin loans or contract for difference (CFDs) to increase risk. Other instruments such as futures contracts involving commodities and foreign exchange can also be levered to increase risk.
The Debt Crisis
If this post didn't mention about the crisis the world is GOING through, it would be ignorant. The global financial crisis (GFC) started from the subprime mortgage market where banks handed out loans recklessly to home buyers who were borrowing more on rising housing prices. The outcome was the housing bubble bursting where people struggled to meet their repayments and flooded the market with their houses. 15 months after the start of the GFC, Dubai went into trouble. Why? They had too much debt. Building artificial islands in different shapes are cool but how did they do it when they were not even producing oil. They were optimistic on becoming a global hub, conditions were wonderful at that time and banks were more than happy to lend. The result, disaster.
In May 2010, the European debt crisis began. And most notably Greece was was in trouble. They were on the verge on default which would have disastrous for the European Union and most notably the euro (currency). The bigger countries in the EU bailed them out but the story won't end there. Spain and Portugal had their credit ratings cut at that time. What are the significance of these events? Well, didn't we learn sovereign (government) debts were riskless in finance. That assumption no longer holds and we have to be extra careful when evaluating debt we are buying. Yields may be 9% or higher, but this includes a very high portion of risk premium which is the risk of default (non-payment).
Credit Ratings
In finance courses we are taught credit ratings allow us to value a company or a country's debt. A company with a high credit rating can borrow money at the lowest rate, vice versa. So with a AAA (highest) rating, we would think the instrument is pretty save. But, an event has changed the complexities in the already extremely complex world. In April 2010, Goldman Sachs were charged for fraud in issuing one of their products. They basically repackaged subprime mortgage backed securities and sold it to the public as a AAA product. These securities were far riskier than an investment grade instrument. How did they do it? Long story short, it's fraud. Investor's lost more than a billion dollars, Goldman got away with a song (not sure it was even a couple of million dollars). To make matters worse, Goldman was trying help an ally offload these securities. Investors were defrauded and they get nothing in return. Goldman Sachs employees? They shared a pie of $14 billion worth in bonuses, how nice of them. Those investors could have been anyone, the lesson for investors is to be extra careful when evaluating securities they buy because when it comes to money, anyone could have an incentive to take advantage.
Debt Crisis in 2011
2011 might not be the year of an economic recession but it is the worst year since the GFC. Debt problems in the America and Europe has caused lots of uncertainty and economic growth has slowed. The debt crisis which surfaced in 2010 has again caused problems to financial markets. Many considered Greece a small country and brushed off the significance of their decline. With the leading countries in the EU combining, there was little fear Greece couldn't be rescued. But today, Greece is very certain to default. The other countries in trouble are Ireland, Hungary, Portugal, Italy and Spain. These countries are not that small and the impact of these countries defaulting could be massive.Italy has the third largest economy in the EU. Compared to the GFC where the US government were bailing out banks and companies, now we're talking about bailing out COUNTRIES!.It's not going to take billions of dollars but trillions of dollars! It's an ongoing issue today which would take a lot of sacrifices to resolve. A lesson to take from this is even government debt which were generally risk free are no longer the case. And the simplest principle of not spending more than you earn is evident in every of these countries.
More recently, America's credit rating of AAA was slashed for the first time. This is because the government has failed to manage its debts properly. They have raised the debt ceiling numerous times and they have not done enough in reducing their spending. America's debt to GDP ratio is heading to 100% and is the world's largest debtor. So how safe is American debt? Can it still be considered a risk free asset? There are also definitely long term implications to the US Dollar as the world's reserve currency.Even the debt of the world's largest economy is getting riskier, it's definitely important to pay close attention.
~deyao~
