Demon Debt and the Dalliance of Denial

Stocks rose 70 points on the Dow yesterday. Gold went up $8. And oil is now selling for more than $85 a barrel.

What are these numbers telling us? That there is a recovery? That inflation is increasing? That things are booming…?

Every body is an optimist.

House flippers are back in business. They’re not buying new houses this time. They’re standing in front of courthouses and buying houses that have been repossessed. Still, they think they can find buyers and make money…

The day traders are back too. Now they’re trading currency! Apparently, trading currencies is a hot thing in Japan…where housewives make a little extra money (or lose some) by betting on the yen/dollar exchange rate…

“Extreme optimism” is what Ned Davis Research calls it. That’s what his measure of investor sentiment registers. And not since 2007 have mutual funds had so little cash.

But are these the real, deep trends? Or these just on the surface, hiding the real movement below?

The states are in trouble. The New York Times reports:

“New Hampshire was recently ordered by its State Supreme Court to put back $110 million that it took from a medical malpractice insurance pool to balance its budget. Colorado tried, so far unsuccessfully, to grab a $500 million surplus from Pinnacol Assurance, a state workers’ compensation insurer that was privatized in 2002. It wanted the money for its university system and seems likely to get a lesser amount, perhaps $200 million.

“Connecticut has tried to issue its own accounting rules. Hawaii has inaugurated a four-day school week. California accelerated its corporate income tax this year, making companies pay 70 percent of their 2010 taxes by June 15. And many states have balanced their budgets with federal health care dollars that Congress has not yet appropriated.

“California’s stated debt – the value of all its bonds outstanding – looks manageable, at just 8 percent of its total economy. But California has big unstated debts, too. If the fair value of the shortfall in California’s big pension fund is counted, for instance, the state’s debt burden more than quadruples, to 37 percent of its economic output, according to one calculation.

“The state’s economy will also be weighed down by the ballooning federal debt, though California does not have to worry about those payments as much as its taxpaying citizens and businesses do.

“In January, incoming Gov. Chris Christie of New Jersey announced that his predecessor, Jon S. Corzine, had concealed a much bigger deficit than anyone knew. Mr. Corzine denied it.

So far, the bond markets have been unfazed.

“Moody’s currently rates New Jersey’s debt “very strong,” though a notch below the median for states. Moody’s has also given the state a negative outlook, meaning its rating is likely to decline over the medium term. Merrill Lynch said on Monday that New Jersey’s debt should be downgraded to reflect the cost of paying its retiree pensions and health care.

In fact, New Jersey and other states have used a whole bagful of tricks and gimmicks to make their budgets look balanced and to push debts into the future.
One ploy reminiscent of Greece has been the use of derivatives. While Greece used a type of foreign-exchange trade to hide debt, the derivatives popular with states and cities have been interest-rate swaps, contracts to hedge against changing rates.

“The states issued variable-rate bonds and used the swaps in an attempt to lock in the low rates associated with variable-rate debt. The swaps would indeed have saved money had interest rates gone up. But to get this protection, the states had to agree to pay extra if interest rates went down. And in the years since these swaps came into vogue, interest rates have mostly fallen. ”

Wait until interest rates go up! They’ll catch the states…and catch households…businesses…and the US federal government. They’ll all be in trouble.

There are two parts to the debt story. The first part is just the gross size of the debt. The second is the cost of carrying it. As the debts get bigger so do the potential problems. Those problems become acute when interest rates rise.

Then, debtors can no longer afford to pay the interest.

Today, we got a first-hand look at how that works. We invested in a project that needed to borrow to survive – a development project. The borrowing was just supposed to tide it over until the managers could get control. Instead, it dragged on for years. And now the debt is so large that the interest is more than the company’s revenues. Year after year, the company couldn’t pay its interest, so we added it to the principle of the debt. Of course, that just made the following year’s interest greater. And now, there is no way the business can survive…because it can never make enough money to pay its operating expenses and the interest.

We decided to take it out into the back yard and shoot it. Get it over with. We diddle-daddled long enough. Instead of cutting the losses at $1 million, we waited until they reached $7 million.

This happened under the watchful eye of a group of supposedly competent, cynical, experienced businessmen. Imagine what goes on in households run by psychologists! Or businesses run by Democrats. Imagine what goes on in enterprises where management takes Tom Friedman seriously? Or sends its employees to a “Get Motivated” conference with Sarah Palin, Rudy Giuliani and Colin Powell as speakers?

We don’t want to think about it.

Debt sneaks up on you. Before you know it, it has taken over. It becomes too large to manage. You can’t cut costs enough to stop it. You can’t raise revenue enough to pay for it. You can’t do anything but admit that you’ve been an idiot.

That’s not easy for people to do. They’ll try everything else first.

Then, with no other way out, they go broke…

The Daily Reckoning