The Big Debt — A Glimpse at the Current U.S. Debt Situation
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Tick, tock, tick, tock. From 2008, we are now 11 years into the economic cycle. Possibility of a recession is on top of mind for many investors. From the U.S.-China trade war, the Brexit situation, to an inverted rates curve, investors’ nerves are touched again and again. One argument for the trigger of a potential recession is that U.S. corporations have accumulated too much debt.
How much debt are we talking about? Will we be able to pay it back? Can we continue to borrow? In my attempt to answer these questions, I started by looking at what money really is.
01. What is Money?
When referring to money, most of the time we actually mean cash. In the eyes of corporations, however, money means any finance-able assets. This is because one could utilize those assets as collateral in exchange for credits and spend those credits the same way as cash. Credit cards are perfect examples where we utilize potential future incomes in exchange for goods & services today. In fact, the total amount of U.S. currency in circulation is ~$1.7T (per the Fed), but the total amount of credit is estimated to be ~30x higher.
Credit is another term for debt. In the world of finance, debt instruments such as treasury bonds function as money in institutional markets. This is because primary dealers (i.e. banks) can use treasury bonds as collateral in exchange for loans from the Fed in what is called repo markets. A repo agreement is an agreement to pledge a security in exchange of a loan or cash with a pre-agreement to repurchase in a later time. In a very simplified way, primary dealers most typically access the Fed through repo markets by pledging assets (such as treasury bonds). Thus the Fed essentially ‘prints’ money by injecting monetary base into repo markets in the form of credits, and adjusting monetary base by changing the price (i.e. the targeted federal funds rate) of these credits. Therefore, effectively, money is any finance-able asset in the securities market.
From the hands of the Fed to the economy, the effect of a dollar ‘printed’ is much larger than just a dollar. For example, if everyone has a 10% reserve requirement (i.e. for every $100 of deposits one receives, he/she lends out $90 to someone else, who in turn, lends out 90% of that), a dollar printed eventually becomes $10 in circulation. This is called the multiplier effect.
This definition of money and the multiplier effect give rise to the importance of the shadow banking system in the economy. A shadow banking system is a group of financial intermediaries facilitating the creation of credit but are not subject to regulatory oversight. What that means is additional credits are created in the economy by non-regulated financial entities.
Impact of all above is the explosion of the outstanding corporate debt amount. In the U.S., we currently have $72T non-financial sector debt. Comparing non-financial sector debt to private sector saving of $41T, we see the ratio at 1.8x. This means for $1 of savings, we created $1.8 of debt. Notice that this was not the case during the “gold standard period” where the U.S. accumulated equal amount of savings vs. debt (For more information of the gold standard period and a short history of the currency, please refer to my article here). In other words, back in the “gold standard period”, the U.S. economy was fully financed by equity, but it is now partially financed by debt.
02. Can we keep the ball rolling?
As mentioned above, we are now in the 11th year of a financial/business cycle which began in the depths of the 2008 financial crisis. This period is known as the “Late-cycle”.
The cycle functions like this: when the economy is doing well, we have a rise in income. Income increases -> higher borrowings -> increased investments -> soared asset values -> more credits can be extended.
This chain of effects creates elevated asset values. When the cycle overextends and asset values become too high, we call it a bubble. Since credits are supported by asset values and asset values are supported by debt, we can keep the ball rolling as long as both values are not decreasing.
One way to look at this debt crisis is to compare the amount of non-financial sector debt vs. the amount of U.S. net wealth. We define net wealth as the amount of unencumbered assets (i.e. finance-able assets that are not used as collateral in exchange for debts). Currently, the U.S. net wealth stands at $92T, which is higher than non-financial sector debt at $72T. This probably is why the dollar has not collapsed.
03. Not All Debt Are Created Equal
From analyzing all above, here are my takeaways:
- Credit plays a key role in the U.S. economy
- Credits are created by primary dealers & shadows banks and the Fed influences the amount of credits in circulation by adjusting prices of those credits
- Unlike the “gold standard” period when the U.S. economy was backed by equity, a good portion of the economy today is backed by debt/credit
- The U.S. has accumulated a large amount of non-financial sector debt, which is supported by unencumbered assets
In my mind, the big debt situation itself is not the problem. However, if default rates on these corporate debts increase significantly to levels that trigger general asset re-evaluations, values of unencumbered assets will be impacted, which in turn will warrant a re-evaluation of the big debt situation.
How much debt will default? Which debt will default? Well, not all debt are created equal.