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Brett Buckley
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With nearly 20 years of investment experience, Brett Buckley has, until 2009, spent most of that time as a principal and managing director of Dolphin Limited Partnerships. Mr. Buckley's experience spans analysis, trading and capital commitment in everything from risk arbitrage, special... More
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  • The Final Analysis of the True Household Debt Burden
    In these unusual times we now live in, worrying about if households, sovereignties and everyone in between have too much debt is certainly in vogue. One can understand why as, at least for in the U.S., it is a lynch-pin component to determining whether we have now entered the decline phase from Pax Americana.
    If we are indeed saddled with too much debt, this financial crisis may well have accelerated us into a decline from which we may never truly recover. If not, we’re down presently, but not out. From a stock market point of view, if the former is the case, several years from now the Dow will be 5000 – and every long term investor who has been trained over the past several decades to buy dips will be colossally burned. If the latter is the case, it will be more like 20000 – and this moment in time will come to be regarded as one of the best in a generation to have bought stocks (and real estate, for that matter).
    Right now, I want to focus on the U.S. household (I may address government debt in a subsequent article). In essence, it is the core of it all – households provide labor and revenue for business, as well as the majority of income for governments. So is the household, the core of our society, in too much debt?
    Let’s first analyze the household as if it were an operating company. We may refer then to personal income, less consumption (which is before interest expense, taxes and other transfer payments) as EBITDA (earnings before interest, tax, depreciation and amortization expenses). We might use some common financial analysis metrics such as interest coverage (in this case EBITDA to interest expense), EBITDA margin (household EBITDA as a percent of personal income), debt to EBITDA, debt to equity, etc. These are indeed tools that the ratings agencies (for whatever that’s worth anymore) use when determining credit ratings.
    So using those metrics, what does "U.S HouseCo, Inc." look like? Observe the charts below that I have built (source data, BEA and the Fed):





     
     Reading through Moody’s various credit ratings methodologies, I might characterize each metric determining a rating as follows:
    1)      Prior to the early 1980s, household interest coverage of 11-14 times would have received a Aaa rating. Afterward, it would have slipped to Aa and presently – despite a current uptick due to unusually low interest rates – it might be flirting with an A at 8-10 times.
    2)      Prior to the early 2000s, household EBITDA margins of 19-25% would have received between Aaa to Aa, but lately below 19% might get an A.
    3)      Prior to the mid-1980s, household debt to EBITDA of 2.5-3.5 times had been at the cusp of investment grade at Baa. It might have dropped below investment grade in the 1990s and has presently collapsed to one of the worst junk ratings, Caa, after the mid-2000s at ~6.5 times.
    4)      Prior to the early 1980s, household debt to book capital (or equity) 15% or lower enjoyed a Aaa rating. Presently, having skyrocketed recently to 25-30%, it is now maybe an A.
    Now obviously what I just did there is completely arbitrary on my part.  But I believe that one can start to get a sense from this that the U.S. household has been in a state of decline in creditworthiness for decades - having accelerated in the past couple-few.  I also observe that three of the four metrics possibly suggest that the household is still quite “investment grade”, whereas one indicates total junk status.  One might conclude from this that the U.S. household is still in relatively good shape, but has eroded from sort of a Aa, to somewhere in between A and Baa rating. This is hardly junk status – but it something to keep an eye on for sure.
    Those kinds of metrics have value when analyzing operating companies – entities that are set up to generate profits for its owners as a going concern in perpetuity. But households aren’t quite like that. They have a finite nature to them. Aside from getting the kids through college (and out of the house), as well as some other stuff, household wealth – their saved income accumulated over time – pretty much exist to serve as a source of income for an individual’s retirement years.
    Here is how I look at the true relevancy of household debt; my sort of “final analysis”. Households have assets. The house, the car and all the stuff in the house are tangible assets. But those are generally illiquid and tend to have more of a utility than “investment” value. So I focus on the more liquid financial assets only – cash, stocks, bonds, retirement accounts, life insurance policies, etc. I look at that net of total household debt – after all, that “net financial wealth” is all that we will have, subsidized by Social Security benefits, to get on in our retirement years (presumably still 65 years or older). So how does the total retirement burden of the U.S. compare to the total of household net financial wealth (again, subsidized by SS)?
    Firstly, how do I look at defining the total retirement burden? In 1950, people generally died of old age when they were 68. Today they die on average at 78. That means that, in 1950, on average they pretty much just had to worry about funding three years of retirement. Today it is 13. Back then, there were 12 million people older than 65 (~8% of population). Today there are 40 million (~13% of population). So in 1950, we needed to somehow fund on average 39 million retirement man-years (three years of life expectancy beyond 65, times 12 million people). Today we must fund 520 million retirement man-years.
    In 1950, annual disposable income per capita was ~$1,400. So, in dollar terms, we needed to fund ~$55 billion worth of retirement man-years (~$1,400, times 39 million man-years). Today disposable income is ~$36,300 per capita. So if retirees wish to continue living the lifestyle they are accustomed to at that level of income (irrespective of inflation), we need to fund $18.9 trillion worth of retirement man-years. The latest Federal budget statements say we paid out nearly $700 billion in Social Security benefits last fiscal year. That works out to be ~$17,000 per person older than 65. If we adjusted disposable income for this subsidy, we still need to fund about $10 trillion of retirement burden.
    This is where our nest egg – household net financial wealth – comes in. Presently, households (really inclusive of non-profit organizations) have $45.5 trillion of financial assets. They owe $13.9 trillion (mostly the mortgage). That means their net financial wealth is $31.6 trillion (all source, the Fed’s Flow of Funds report, through March 2010).
    So, the sum of all U.S. household net financial wealth is presently a little over three times the total U.S. retirement burden net of subsidies, as I define it ($31.6 trillion, over $10 trillion). In 1950, it was 12 times the then burden. In other words, in 1950, we had 12 years’ worth of liquidity to fund three years of retirement (net of subsidies). Today, we have three years of liquidity to fund 13 years of retirement. We are completely upside down relative to decades ago.

    And it only looks worse going forward. The Baby Boomers (the first of which born in 1946) are only now getting ready to start retiring months from now. According to Congressional estimates, those older than 65 will plateau in 2030 at 72 million, or ~20% of then population. Life expectancy will be just under 80 then. If they don’t raise the retirement age (and I have my doubts they won’t), we will need to fund one billion retirement man-years in 2030.
    Let’s say we grow disposable income at 5.1%, Social Security at 5.5%, household financial assets at 6.0% and household liabilities at 7.2% - simply because those are the respective average annual growth rates for each in the past 20+ years (but no one is saying that past performance is indicative of future results). The result, using this “final analysis”, is household net financial wealth will only be able to fund 1.5 years of the then 15 required. Again, this is all net of Social Security subsidies, and assuming those are not somehow diminished, or otherwise compromised.
    Therefore in 20 years one-fifth of the U.S. population will almost certainly be in some mode of significant belt tightening. And that cannot portend good things for the business of America – and thus the long-term prospects for U.S. stocks. Now I hate being a “nattering nabob of negativism” - and I do love my country - but someone please tell me how I get comfortable with how to successfully accommodate for this scenario?
    An allegedly resultant higher savings rate improves the analysis, but pushing some numbers around, it seems too little, too late – especially considering the possible negative feedback loop on investor returns resulting from this scenario. Opportunities do exist – ranging from relaxing immigration laws (making the average age younger) to strengthening exports. But I just don’t see policy heading in that direction (at least not presently). And how do you get elected in this country running on a campaign of taking more and more, cutting benefits and telling people to live more modestly and work longer and harder for less?
    All of that isn’t even the worst part of this. Here’s the final killer. Most of that household wealth is not in the hands of most households, whereas debt and the ultimate retirement burden is. The top 1% wealthiest households own one-third of all U.S. wealth. The top 20% own 85% of all wealth.  In other words, 80% of Americans only own 15% of that $45.5 trillion needed to fund their retirement. So unless Bill Gates or Warren Buffet is going to pay off our mortgage and send us a check every month during our golden years (beyond that they already are through their income taxes), we have a problem. In my view, this problem serves to highlight the looming redistribution of wealth pressures coming down the pike.
    So how much is too much or too little household debt? The most truthful answer I believe I, or anyone else for that matter, could give you is – who knows? But it sure feels like we’re a lot closer to too much than too little.


    Disclosure: No positions.
    Sep 08 2:52 PM | Link | Comment!
  • Between Bear and a Hard Place
    Ahhh… 1923. There was a lot going on then, four score and seven years ago. Our President Harding had a heart attack and died, leaving his VP “Silent Cal” in charge. Lenin (not the Beatle, but almost as popular in certain quarters) had a stroke (his third actually), prohibiting him from removing Stalin as a growing power in the USSR’s Communist Party. Some rabble-rousing, upstart named Hitler was causing quite a stir in Bavaria. That got him sent to jail for a bit, which provided some down time for him and his pal Hess to chat about things like die Fräulein, Bier, der Sport, Kampf… ach ja - und Lebensraum.
    Luce and Hadden published America’s first weekly news magazine, “Time”. Disney was just getting started wishing upon a star. Gershwin was all the rage with the kids, challenging conservative rural values with his gritty, urban style of music - Jazz. And upon this world stage... Bear Stearns was founded.
    You remember Bear Stearns, right? It managed to survive the 1929 stock market crash and ensuing Great Depression (the claim being without laying-off a single employee), as well as everything else between there and here. But it just didn’t seem capable of surviving our current financial crisis - and I do mean “current”. By March 2008, its counter-parties had lost all confidence in Bear’s ability to fund itself for just one more day. The concept of matching leveraged investments that pay-off (hopefully) longer than one day, with having to fund each day, came crashing down on them.
    Today it exists as a wholly-owned subsidiary of JPMorgan Chase. And I believe that they didn’t even want to buy Bear, until the Fed funded a $29 billion separate entity (Maiden Lane I) to warehouse a host of mortgage-related “toxic” assets sitting on Bear’s books at the time. They even had to guarantee that Bear’s brand-new, Midtown Manhattan building was part of the deal. They granted JPMorgan an irrevocable right to acquire the property exercisable if, among other things, the agreement was terminated due to Bear accepting an alternative acquisition proposal. Having read thousands of merger agreements in my time, that is an unusual clause. It basically served as a “poison pill” to any competing proposals – the inference being that the only asset of significant and definable value that Bear owned at that time was 383 Madison Avenue. Chilling other acquisition interest allowed JPMorgan to buy Bear cheaper than otherwise. But the shareholders approved it, so that’s all academic now.
    I digress. So why do I bring up Bear? I’m getting there – just keep walking with me. In 2007, I wasn’t directly focused on credit instruments every day. So when, in June of that year, it became public that Bear Stearns refused to allow Merrill Lynch to withdraw from a mortgage-related hedge fund Bear was managing for Merrill, my antenna went way up for the first time. If I had noticed that in June, mostly as a stock guy at the time, then people in credit markets must have been quite aware of some serious problems in their world – specifically, mortgage derived - at least months before I did (indeed home prices had commenced notable declines across the country about a year earlier).
    By August 2007, most sophisticated operators in finance had become keenly aware of some serious issues in credit and derivative markets, as well as the growing reluctance between financial institutions to lend to each other. By late 2007 / early 2008, that counter-party activity had ground down seriously. And Bear had become the poster-child for this issue.
    The stock markets had begun to erode somewhere in late 2007. The Fed, up to that time acting with utter ambivalence toward financial market asset price concerns, effectively stated that they in no way would ease monetary policy to accommodate - right before they embarked on doing exactly just that by September 2007.
    By March 2008 the S&P 500 had been driven down ~20% from its October 2007 peak as fear and apprehension grew. That is until Monday, March 17, 2008 - the day Bear Stearns’ “rescue” was announced. The poster-child gets tucked away, CNBC talking heads can high-five each other and proclaim “one and done” (or something to that effect – they actually did that when the Fed eased for the first time some months earlier, so I am projecting a bit here).
    Problem solved, right? The S&P begins a ~15% rally back. Through the next several months, the economy wasn’t exactly falling off a cliff. We had started losing jobs, but it wasn’t necessarily anything to freak out about. We might get out of this thing. That is until, six months later over a couple particular weeks in September, Fannie and Freddie were placed in conservatorship, Lehman failed, AIG was nationalized and Treasury and the Fed showed up, hat in hand, suddenly needing 700 “bars” from Congress – and like, yesterday.
    The rest is history. No wait - the rest is now. I believe the story of Bear’s demise should remind us that just because the fix is in, that doesn’t mean that all is fixed. Sovereign authorities around the globe have now pumped $trillions in record stimulus into the system – either through providing record low bank borrowing rates, outright purchases of assets from banks, guarantees to financial institutions or fiscal spending.
    A couple-few years into it now, all of that fix is now winding down – that fix is now in. Much of that, in my view, has effectively served to merely transfer the problem of excessive leverage, without appropriate regard for risk, off of the books of the private sector and onto the books of the public sector. Economies - most notably labor markets - remain eerily softer than one might have expected at this point. At this time, deflation seems to be winning the tug-of-war being played out in government bond markets.
    I think the stock markets, since April, are finally starting to get that all is not well; that it’s not all just about beating earnings estimates. After Bear’s presumed “fix” in 2008 came Lehman’s failure, Merrill Lynch’s “rescue”, AIG and Freddie’s nationalization, Fannie’s re-nationalization, Citigroup’s quasi-nationalization, GM and Chrysler’s nationalized bankruptcies. (What am I forgetting?)
    And now after the world’s governments have this latest “fix” in – now what? I can’t remember where I read it recently, so I am just echoing it – right here right now, the next several months will define the next several years. Right now we are somewhere between Bear’s fix and… who knows?
    Today, Greece might be our Bear; Portugal our Merrill. So who might be our Lehman or AIG or Citi or GM?
    Until we have some clarity on this latest fix, I would remain cautious with stocks – especially after the S&P 500’s 80%+ rally through April, still 60%+ rally through August (off of March 2009). Also, owning government bonds at this point, at these historically low yields, in my view even if I believe that we are in some form of depression, has far more downside than upside. And gold, which I believe is a hedge more against systemic risk than inflation (look at its rally in this clearly non-inflationary period), despite its run, is probably still the best place to put your money right now.
    Have a happy Monday.


    Disclosure: I have no equity stakes, long or short positions, or business interests in any of the companies mentioned this article, nor do I have any positions in gold or business interests with any companies associated with the gold market.
    Aug 23 10:43 AM | Link | Comment!
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