World economies appear to be in trouble. There’s been a lot of talk lately about debt levels, especially sovereign debt and individual indebtedness. The reason is that Japan’s “lost decade” resulted in part from deleveraging. Governments and households have taken on more debt than in the past as compared to income (or GDP) and ever-increasing debt isn’t sustainable.
When indebtedness increases, the funds must come from somewhere. It requires people to be willing to lend money to governments and other individuals. On the one hand, the supply of excess cash to be lent isn’t endless. On the other hand, as lenders become less willing, interest rates rise. Over time, interest expenses create drag on the productive capacity of the economy or the spending capacity of the individual.
An often overlooked aspect of debt. It’s easy to add quickly, but it’s slow to reduce. Think of buying a house. At the time of purchase, it’s easy to borrow 80% of the value of the house in a single day, but it will take 25 or 30 years to pay back the principal with interest. If a person were able to accelerate their payments, it would still take decades to pay back the debt.
Investment debt has similar characteristics. It’s easy to buy stock on margin. Selling stock to reduce leverage by repaying margin isn’t as straightforward. First, no one wants to sell stocks when they’re down, so it would make sense to wait for an opportune time to sell. Further, not all stocks are equally liquid, so it may take some time to find buyers willing to buy as many shares as an investor wants to sell. Finally, as long as the stock is paying more in dividends than the interest cost of the loan, it makes financial sense to remain leveraged.
The slowness of deleveraging increases the risks associated with borrowing. The economic or investment environment can change very quickly. Interest rates could rise or dividend yields could be cut or stock prices could fall. All of these things would make debt repayment both more important and more difficult.
Any time a person chooses to borrow, it should be for a financial sound purpose and it should be accompanied by a specific plan to reduce indebtedness over time. There should also be a backup plan to be able to repay the debt immediately, should the need arise.