The Ramifications Of A Massive Debt Collapse

by: Bruce Wilds

In today's low interest rate easy money environment, it has become much easier to hide under-performing assets and the inability to repay debt. Low-interest rates tend to foster an "extend and pretend" attitude that becomes apparent only after rates climb and put stress on the system. Several other bad things also happen in this kind of financial environment such as increased speculation that propels the creation of leverage or carry trades which multiple risks. It also tends to move demand forward and cause an increase in the improper allocation of capital. Both of these activities have a way of causing problems that can linger for decades. Across the globe, since 2008 the central banks and governments of the world have played a giant game of hide the debt, much of it disguised by transferring obligations from the banks and people onto the backs of their populations in the form of public debt which they claim is more benign.

We should not underestimate the impact a massive debt collapse would inflict upon the economy. this type of event also known as a "Minsky Moment" refers to a period of time when a market fails or falls into crisis after an extended bullish period with highly inflated market speculation and unsustainable growth. Clever sounding terms like "transitory" are often used to mask growing problems and to inject a bit of sophistication to this problem while trying to brush reality aside. Sometimes a person presenting the case growing debt is under control will even go so far as to explain that some of it is good debt or boast how we are enjoying the positive effects of the loose lending standards. While it appears much of the financial community is relatively unfazed by the mountains of debt growing throughout the world, we as individuals should be concerned as to the many ways it might spill over and affect our lives.

Danger Ahead - All Types Of Debt Have Surged

Artificially low interest rates tend to skew all markets, especially the credit and debt markets, creating an unsustainable debt explosion that extends into everything including consumer spending and the statistics surrounding their effects on the economy. A great deal of what is being seen as deflation flows from a loop being created from lower interest payments on things like autos and housing; sadly this is a one-off and only goes to mask deeper issues developing under the surface. Even now we are hearing calls by many people to write off and forgive student debt without any real understanding of the implications such a policy would entail. We should remember debt takes many forms and shapes, it is not contained in auto and student loans. Not only have companies borrowed a great deal of money to buy back stock, driving the market ever higher, but debt also accumulates when a person falls behind in their rent because they used their money for other things.

Again, I caution those who think this writing off of debt will be an orderly and even process because not all debt is created equal. One major difference is whether it is backed by assets or collateral. Many other factors affect the strength or impact of defaults. One factor of this is how it matures or becomes payable, some debt is stretched over decades while other obligations are short-term and paid with a balloon payment or all at one time in a lump sum. Also, debt is computed at different interest rates and this can affect its long-term impact but another often forgotten issue is to whom the debt is owed to and the impact default will have on their ability to honor their current and long-term obligations. This is a huge issue for pension funds. I have seen several businesses forced into bankruptcy when a large customer defaults and cannot pay its bills.

The world of bankruptcy and unpaid debt has become a complicated place where protection for one party can leave another totally exposed. We have seen things like "clawbacks" or the government making an exception and changing the rules as in the case of shafting the bondholders of General Motors (NYSE:GM) during the bailout. Yes, writing off debt can be a slippery slope because debt that is written off takes something with it when it leaves this world and that is the wealth of someone else! As stated earlier in this article, today's low-interest rate easy money environment allows us to hide and ignore under-performing assets and the inability to repay debt fostering a dangerous extend and pretend attitude that becomes apparent only after higher rates stress on the system. No matter how we go about justifying the surge in credit and debt the ugly fact is that it hangs above our heads as a Hindenburg in search of a spark.

Footnote: This is the second part of a three-part series exploring unsustainable debt. The next will take on conventional thinking and make the argument that such an event need not be deflationary but can result in a huge bout of inflation. The link to part one of the series can be found below.
A Minsky Moment Is When The Debt Pyramid Collapses