Death by Leverage
America’s national debt exceeded $15 trillion [with a T] for the first time on November 15, 2011. Deficit spending since then has pushed the total national debt closer to $17 trillion.
An official population of 316,110,225 (6-23-13) means every man, woman and child in America now owes $52,953 plus future interest costs.
It should be noted that the nearly $17T debt does not include the enormous unfunded liabilities for Social Security, Medicaid/Medicare and federal pensions, or the potentially crippling burdens of ObamaCare.
"The U.S. national debt comes out to about $16 trillion today [Nov., 2012]. That's something. But it's nothing compared to the extra $87 trillion in unfunded liabilities to Social Security, Medicare, and federal pensions. Here's how that works. If you add up all of the U.S. government's promises to pay retirement and health care benefits for the next 75 years and subtract the projected tax revenue dedicated to those programs over the next 75 years, there is a gap. A $87 trillion gap -- in addition to a $16 billion hole.
"'Why haven't Americans heard about the titanic $86.8 trillion liability from these programs?' Chris Box and Bill Archer ask in the Wall Street Journal. The authors blame the U.S. government for using shoddy accounting and for misleading the American public on their finances..." (Is Our Debt Burden Really $100 Trillion?, by Derek Thompson, The Atlantic.)
Incremental debt is being added at an unprecedented rate. Including future promises that have not come due yet, the total unfunded liability number is over five times higher.
The Treasury bond auction market reveals nothing about the true state of interest rates (the cost of borrowing) as shill bids from the Fed have sucked up virtually all net government bond issuance this year.
Europe is already in recession and drowning in debt. There are no solutions on the horizon. The idea that the Fed will cut back on money printing/bond buying programs is fantasy. The politically expedient solution is for quantitative easing (QE) to continue or even expand, both in the U.S. and abroad.
The only alternative is the outright confiscation of wealth. That technique was beta-tested just months ago in Cyprus.
Bubble valuations currently reside in the fixed income arena, and bonds appear riskier than stocks. Shares of highly levered companies have benefited from artificially low rates by refinancing old debt. They have also borrowed to pay for massive share buyback programs. Those times may be coming to an end.
Holders of long-term bonds are taking huge risks. A 1% rise at the long end of the yield curve could send 30-year bond prices down 17%. A 2% increase could drop principal values much more. Years of coupon payments could be wiped out on a total return basis.
Long maturity corporate paper issued just weeks ago as part of Apple’s (AAPL) $15 billion debt offering have already been marked down by over 10%.
A credit crunch, or a freeze, may be brewing that could be worse than what we saw in 2008. (A crunch implies credit is available at a high price. A freeze means it's nearly impossible to borrow at any price.) While it's a fool's game to try to predict the timing, we should be preparing.
Preparing for a credit crunch or freeze
Risk in the equity market is substantially lower than risk in fixed income. Especially compared to alternative investment vehicles, stocks are not overpriced (see Think stocks are overpriced? Think again and In Love with TINA).
Avoid bonds. But if you must keep any fixed income vehicles, be sure they have short maturities.
Make sure companies you own have enough predictable cash flow to service both bond interest payments and principal payments coming due within the next few years. 2008 taught us to avoid highly leveraged companies. When credit freezes, even healthier firms with maturing debt can be forced to issue highly dilutive shares or descend rapidly into bankruptcy.
Even top-rated firms can be forced into coercive terms if they need to refinance when money is tight. For instance, in 2008, Berkshire Hathaway extracted 10% interest plus warrants from Goldman Sachs, GE and others. The next cycle could lead to even more punitive terms.
Check balance sheet data by consulting subscription services such as Value Line, S&P or Morningstar. Free sites like Yahoo Finance and MSN MoneyCentral also offer access to up-to-date financial information. A firm that cannot meet its bond obligations is at the mercy of its lenders.
Stick with shares of dominant companies with solid balance sheets. I favor the companies included in our Virtual Value Portfolio, especially those still trading at prices close to where we initially added shares.
Avoid margin. Debt-free portfolios can wait out temporary storms. They allow for the possibility to add to your holdings after major selloffs.
Adapted from this week's Market Shadows' newsletter, The Banker Who Was God (6-23-13).