The Debt Polemic: A Utopian Solution

The debt market shocks of August 2007 have surely been a wake up call to investors and central bankers all over the world.

The causes were numerous. Among the most at fault were the banks, who packaged risky loans in with staid staples to form structured debt portfolios that sported higher theoretical yields but with added risk and lower credit-quality mixed in. As many of you are undoubtedly aware, these products lost a lot of value after the riskier portions of the debt began to turn into non-performing loans at a rate much higher than the investors expected. This decline in value led many investors to run for the exits, selling their debt at a substantial loss, and then another crisis showed its ugly head: liquidity deficiency. It turns out that, because these loan portfolios were so customized and difficult to value, they werent tradeable commodities who had willing buyers. The buyer’s market for this debt dried up, scared to buy a depreciating asset, and trades grinded to a halt. The people who weren’t able to sell didn’t even know how much their assets were worth because there was little recent comparable trade data. Those who held on to their portfolios found themselves writing down the value of their securities. Goldman Sachs wrote down their debt by some $2 billion, Merrill Lynch and Bear Stearns followed with poorer performances still.

Another whipping boy in the polemic is the debt ratings agencies of Fitch, Moody’s, and S&P, who did not react quickly enough to the change in debt values, and were still rating these bonds highly while credit quality was severely declining. The reason they didn’t act: banks pay the ratings agencies to rate their debt offerings. If the ratings agencies don’t rate the banks’ debt placement with a high-enough grade, the bank will simply take its business elsewhere, to a ratings agency with less scruples and more hunger for doing business. This system needs change, and if we’re to avoid this disconnect between rating grades and actual risk, we need to implement an independent, unbiased ratings system as soon as would be prudent.

To ease investors’ fears, the Federal Reserve lowered its rate one-half of one percent, which gave the debt market a shot in a the arm, a placebo injection of confidence soup. So much for battling inflation.

So what now? What should happen-at least in my imaginary world where central bankers are responsible and the free market determines the correct solution to everything-is as follows:

All debt gets repriced. All rates should slowly rise to reflect the true risks inherent to owning debt in the current environment. This means that debt of low-credit quality might be priced at a higher premium to government bonds, or the two would rise in yield concurrently and significantly. Government bonds should rise in yield (dropping in value) because Treasury bills do not offer significant rewards compared to stocks and haven’t for years. The money taken out of Treasuries should go to funding the equity markets, which not only provide more opportunity for growth than government bonds, but have proved their strong resiliency over the last 3 years. This situation could help the dollar out because, after a long fall, foreign investors would pour money into the dollar-denominated debt if the yields were appealing enough here.

The Fed stops dropping money out of helicopters.

Rate cuts are imprudent when inflation has risen due to higher energy costs. If anything, inflation needs to be kept in check, so that we might avoid stagflation.

The domestic fiscal situation gets righted.

The federal government cuts spending by 10% and finally generates a surplus and slowly begins to pay down the national debt. This will increase the attractiveness of the dollar to foreigners, and all those who’ve made money short-selling the USD (Warren Buffet included) would get out of their positions by buying dollars and restore even more confidence in the dollar as an international currency.

Households start spending responsibly.

Instead of spending more than one’s income (as has been made possible of late by rising home prices/home-equity), households start spending less than their income and put money in savings, money-markets, or investments. Corporations currently have ridiculous amounts of cash on hand from strong earnings and won’t miss the extra cash from irresponsible, unsustainable consumer spending.

The markets set everything straight.

When systems venture out of equilibrium, they sometimes need a shock to get closer to where they need to be, closer to equilibrium. Often they’ll overshoot, but shocks are beneficial if they brings systems closer to their rightful equilibrium. The market naturally provides shocks-they’re unavoidable-and hopefully, one year from now, the market will have worked out a more sustainable set of values that will contain major boom/busts, more accurately price securities of all kinds, and set the stage for sustainable future growth without all the pitfalls of a boom and bust cycle that we currently enjoy.