Don't Get Caught On The Wrong Side Of A Debt Default

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You never want to be caught on the wrong side of a debt default. In this case, I would define the wrong side as the side where you don't get paid or are paid with a less valuable currency that has seen its value eroded by inflation. When I write about debt default, it is important to understand these defaults can take many forms, but what they have in common is they all can be considered as reneging on financial obligations. Generally, we make a distinction between public and private debt, but even that may become blurred when government in need of funds has to seize or take over assets or institutions. The term financial crisis is applied broadly to a variety of situations in which some financial assets suddenly lose a large part of their nominal value, a default falls into this area. Debt has grown at a tremendous rate across the world in recent years.

Relationship Between Tangibles To Intangibles

Of great concern should be the growth in non-recourse loans as well as unsecured personal loans and such. It is also to make a distinction between public and private debt because many investors are seduced into thinking the backing of government adds tremendous validity to both the explicit and implied warranty that come with government-backed instruments. History has shown public debt can be handled or should we say, mishandled, in several ways. One example from the past was how Henry VIII, in addition to engaging in an epic debasement of the currency, seized all the Catholic church's vast land holdings. While not strictly a bond default, actions such as these accompanied by imprisonment or even executions can still be considered as reneging on financial obligations. It is difficult to argue this doesn't constitute some kind of default.

A debt default is often the result of a collapse or failure of an institution, financial mechanism, or even a financial instrument and can result in a rapid shift in the value of assets. The word "collapse" has a way of conjuring up the image of something falling or crashing in, but it is important to note subtle details of the way this occurs can have a great effect on the damage it creates. Many of the economic crises we might encounter in our complex modern world have the potential to spread from one institution to another, creating contagion and resulting in a destructive domino effect. The massive derivatives market that is touted as one of our modern financial tools is often cited as having the potential to wreck havoc in this way.

Defaults often fuel the collapse of what some people label as Ponzi-type schemes; underfunded pension funds can be considered in this category. Pensions and promises will be broken, so get ready for more pain. This is especially true in the public sector where the 25 largest U.S. public pensions face about $2 trillion in unfunded liabilities. While it could be said that several ways exist to cheat or rob those who paid into pensions for years, it would be an understatement; more ways exist than you could imagine. One reader on another site compared pensions to a Ponzi scheme where benefits are paid out to its investors from new capital paid to the operators by new investors, rather than from profit earned through legitimate sources. I fear the future will prove him mostly right. The financial stress caused by defaults is often the final straw bringing final collapse, causing things to cave in upon themselves.

Note: This Chart Prior To China's Recent Problems!

One thing is clear - we are only beginning to see the tip of the iceberg when it comes to this growing problem and just how many of these schemes are underfunded because this is a problem that exists all over the world. Remember the PBGC, America's safety net for failed pensions has total assets of about $88 billion and liabilities of $164 billion. This is an indication of how dire the situation is. A "bank bail-in" can be viewed as another way to disguise a massive default and it can happen here in America. An example of just how delusional we have become as to the fragility of our financial system is that many people have taken comfort in the efforts to control the banking sector through legislation following the 2008 crisis. The Dodd-Frank Act of over 2,300 pages and still growing allows this under Title II by imposing the losses of insolvent financial companies on their common and preferred stockholders, debt holders, and other unsecured creditors including depositors.

There is also the area of inflation. We should consider the possibility that inflation has been kept in check primarily because we as a society have invested a large percentage of our wealth into intangible products or goods such as stocks, bonds, and even currencies. If faith drops in intangible "promises" and money suddenly flows into tangible goods seeking a safe haven inflation would soar. This would drive interest rates upward and result in massive losses for bond holders. A lot of money has rushed into government bonds in a flight to safety, and this has sent yields lower and lower. To give you a sense of what this may mean to U.S. Treasury Bond investors a 10-year treasury bond issued at a 2.82% interest rate could see a 42% loss in value from a mere 3% rise in interest rates. This means if you'd held $100,000 in these bonds prior to the rise in rates, you would only be able to sell those bonds for $58,000 in the secondary market. Please note the $58,000 you get back would also be affected by a loss of purchasing value lost from inflation.

Many who have read my blog have indicated to me they strongly feel a major reset will take place in the future. Those invested in bonds should not underestimate the power of inflation to strip them of their wealth. Never before do I remember seeing so many predictions of interest rates remaining low forever and a day. Many of us have a problem lending hard earned money out for a long period of time and we should be wary. Rates are based on predictions of future government deficits and events around the world that may or may not unfold as expected. Part of a conundrum we face is that far more freshly printed money has been created and floated into the system than new tangible assets to back it. An issue that merits more attention than it gets is the large role our government plays in the economy. I contend that in the case of a financial crisis brought on by a large number of defaults, it will act as a net under the economy making painful deflation less likely.

Footnote: This is part two of a two-part series. The first part titled, "Thoughts On "This Time If Different"" can be found here.