Stop me if you’ve already heard this analogy. There is a pool into which (or out of which) water flows. The bottom of the pool, its floor, is debt. The top, or wavy surface, is value. The water in between is equity. Debt is solid, and fixed; that is to say, it is contractually defined, represents a real obligation, and for these same reasons underpins other economic assets with some degree of substance. The water on top, on the other hand, is high-maintenance and fickle: it requires care, purification, replenishment, justification, and it can’t be stood upon. Value is not contractual, not firm, and its purity is subject to interpretation.
Analogies aside, debt can be of a variety of types: house mortgages, business loans, leveraged buyout financing, securitized products, municipal paper, federal borrowing, these are all obvious. Less obvious, but also debts of sorts, are obligations such as payroll for employees, overhead bills such as rent or utilities, and perhaps there is a place in this somewhere as well for schooling and taxes? Whether at an organizational or personal level, these are items of operating leverage that, like financial leverage, supports value when value can be supported, or represents a detriment in an environment of declining asset valuations.
When values fall, the referenced forms of debt are a hindrance, because these need to be serviced regardless – but now with lesser resources and to lesser advantage. Coming back to our opening analogy, contractual obligations – which are the pool’s solid floor – are unmoved by circumstance. The purity of the water in the pool, its texture, its level, none of these things matter… with one exception: when moisture has completely evaporated, the hard terrain begins to crack, to erode, and the reverse of liquidity – excessive dryness – can, over time and unattended, cause the pool’s structural foundation to collapse.
To prevent such a scenario, those in charge of maintaining the pool do what they can to keep the water level from falling. Beyond the analogy, they work to make structural improvements to the core asset – whether a house, a small business, an international corporation, a municipality or federal government, and largely speaking, even the broad economy – and in addition, they do what they can to “talk it up.” Because beauty is in the eye of the beholder, because value is a matter of perception and is not contractually fixed, the beholder’s eye must be trained and guided.
But there are limits to the “talking up” that can be done, to the training and guiding of beholders’ eyes. If one would sit at the edge of a pool and, dangling one’s legs into air, looking down would see cracks at the dry bottom; if one would see grass and weeds sprouting through, there isn’t any salesmanship to convince this person to jump. This is the risk of excessive leverage: the margin for error, the flexibility of valuation volatility, all diminish to a point where erosion is difficult to overlook, and the level is low at which the pool is prone to turn dry.
I am thinking about macroeconomic issues these days, as many of you are also, and I am thinking that aggregate debt, at a variety of levels in the system, is such that pool of water is very thin. I am thinking that there is a great deal of “talking up” happening, for understandable reasons, in order to add water to the pool, or mirage to the beholder. And I am thinking that on its own this is an insufficient solution.Perhaps the analogy weakens at this point of the discourse, but bear with me: the foundation, the pool’s floor, is cracked and needs fixing. Even if fresh water is poured in – some of which in consequence of the strategy described – it is bound to drain through, it won’t hold, and as time goes on, increasing quantities of replenishment will be needed. Figuratively speaking, for purposes of analogy, water is a limited resource. A firm foundation, on the other hand, one without cracks, can do the pool good for a long time ahead.
Disclosure: No positions