Thursday, January 29, 2009

Debt Binge--The Perfect Financial Storm

When historians look back they will be writing about the Debt Binge.
A binge is any behavior indulged to excess.
In America, we now have a series of binges coming together to form the perfect financial storm. The components of the perfect storm include:  
  • excessive governement borrowing from foreigners to finance enormous debt in the public sector,
  • excessive borrowing by consumers in the form of mortgages, mortgage refinancings, and credit cards, 
  • and, the enormous borrowing by investment banks and bank banks to leverage up their balance sheets with credit default swaps.

The most recent of the borrowing binges--the stimulus package. Or should I say--packages.

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If you saw the movie the Perfect Storm you might remember at one point in the movie it appeared that the fishermen on the Andrea Gail had ridden out the perfect storm. For a brief moment, a hole appeared in the sky and the sun peaked through. The fishermen in an almost euphoric moment thought they had ridden out the monster storm. But, as quickly as the sky opened it closed. Soon the ship was being battered with a series of monster waves that kept getting bigger and bigger. In spite of efforts of the fisherman the Andrea Gail was consumed by a giant wave that consumed the boat and sent it to the bottom of the sea. This where we are today in the financial markets.

I am a proponent of the stimulus package. It is better than nothing (nothing equals depression). Nevertheless, the stimulus package is a continuation of the same binge pattern--
curing a debt problem with more debt.
Soon we will be calling on the world to lend us enormous amounts of money.  Treasury debt offerings will come to the market in bigger and bigger waves--a key component of the perfect storm.  Corporation will be crowded out of the market and unable to borrow more in an attempt to pay for their past sins.  Consumers, leveraged to the hilt, will begin to default on their debt in greater and greater numbers as unemployment marches higher and higher. Hedge funds will be the next to follow the trend. In case you haven't noticed  investment banks are now extinct. Not only did Bear Stearns and Lehman Brothers implode; but, the venerable Goldman Sachs is now a bank bank. Weak hedge funds now hanging by a thread will join the party during the next downside in the market. As hedge funds near extinction, they will be selling assets as fast as they can--the equivalent of a fire sale. Prices of stocks will get very cheap (a good thing if you were a squirrel during this period).

It seems like much of this is happening unnoticed as history unfolds right before our eyes.

The best way out of this trap is a massive inflation that bastardizes the U.S. currency and lessens the debt burden by cheapening it. Of course, there is the Argentinian solution--default.

We should be looking around and noticing that every major economy in the world is wounded. The situation came about because of excessive debt and leveraging--the World Debt Binge.

The cure to excessive debt is savings. The only good thing I hear out there is talk about wringing out the excesses in our government to bring about costs savings and lessen the need for future borrowing. What is the likelihood of that happening soon? In case you haven't noticed over the last 25 years the quickest way to cut costs is to "fire" people. Instead, we are trying to put more people on the government payroll by creating projects funded with government dollars via the stimulus package.

Something has to give. The massive leveraging of the U.S. economy leaves us in debt to the tune of three and a half times times the output of our economy. The big credit card in the sky is being leveraged to the max. What if the lenders pull the plug? The likely result is higher and higher interest rates to finance the borrowing--or worse.

We have not learned our lesson--excessive leverage via borrowing is not a good thing. There are only two possible solutions to this problem: inflation or default. Both are ugly but the only way out of the trap.

Coming soon: Tsunami.