Tag Archives: debt

subprime is still suspect (revised)

ss-subprime

The housing market has seen a rise in subprime lending recently. As banks slowly returned to the market, they offered harsh terms involving large down payments (25% or more) and charged rates between 8-10%. As reported in the Wall Street Journal, the down payment requirements have recently been dropped to 5% of the loan. The individuals in the article that took the loans gave reasons such as “I wouldn’t have been able to get the place I wanted without this” and being “ priced out” of the market if they waited. By analyzing subprime mortgages more closely, we can get a better idea of the assumptions these buyers are making.

Assume that it is possible to repair a borrowers credit in 2 years. This is reasonable, assuming there are no bankruptcies or judgments in the borrowers recent history. Using the average housing price of $272,000, I assume a subprime borrower would have a down payment of 5%, or 13,600, and that they borrow at 8%. Assume that the loan will be refinanced no sooner then 2 years; banks often require such a condition on subprime loans to ensure they get enough interest for the risk they are taking. I will not include a prepayment penalty for simplicity, but there will generally be a prepayment penalty.

Whether the subprime loan is better comes down to whether or not the buyer can accumulate enough equity to refinance the home out of the subprime loan and into a prime loan as soon as possible. The amortization schedule of a subprime loan with the above assumptions is in this Google doc. Assuming the house price stays the same, the schedule shows when various equity milestones occur.

Assuming that the loan is for 30 years, the subprime borrower would have a monthly payment of almost $1,900, yet all but $173 of the initial payment goes to interest, assuming it is not an interest only loan. By month 24, the borrower has paid about $41,000 in interest equivalent to $1,708 a month. With all that interest, they have only paid about $4,500 on the principal. With the down payment, they now have $13,600+$4,500= $18,100 or about 6.65% equity. The situation could be even worse if any of the payments where interest only.

In order to refinance, the owner needs to have equity in the house, typically around 20%. Since the borrower isn’t going to have anywhere near that amount of equity, the house would also have to appreciate to roughly $317,000, a return of 16.5% on the purchase price. To put this in perspective, the highest growth rate over two years in the national composite home price index was 29.5%, between Q1 2004 and Q1 2006. Whether 16.5% is a reasonable assumption is up to the borrower, but in a sense the subprime borrower is speculating on the value of the house in two years, where the payoff is the ability to refinance their mortgage before it ruins them.

fredgraphMany subprime borrowers cite the investment benefits of owning a home. They are tired of paying rent, and want to start building equity. However, by taking on a subprime loan, they are gambling with their financial future for very little payoff. Since so much of the early payments go to interest, the owners may end up paying more in interest then they may have in rent for the same period. More over, should they fail to refinance the loan, they will most likely lose thousands, if not the house. The analysis presented here shows some of the math that needs to be done by subprime borrowers.  Subprime loans are not inherently bad, but borrowers need to understand the assumptions they are making about the value of their home in the future, their ability to refinance. The gains may not be worth the cost.

 

 

 

 

subprime is still suspect

ss-subprime

Subprime lending has been making a comeback.  As banks slowly returned to the market, they offered harsh terms involving large down payments (25% or more) and charged rates between 8-10%.  As reported in the Wall Street Journal, the down payment requirements have recently been dropped to 5% of the loan. Considering subprime borrowers will most likely want to refinance as soon as possible to get better terms on the loan, would prospective subprime borrowers be better off taking out the loan or waiting and rehabilitating their credit to become a prime borrower?

Assume that it is possible to go from subprime credit to prime credit in 2 years.  This assumption is convenient to use because of terms in subprime lending contracts, but it is reasonably realistic, assuming there are no bankruptcies or judgments in the borrowers recent history.  If there are, then the borrower’s ability to refinance out of the loan in a timely manner is questionable to begin with. Using the average housing price of $272,000, I assume a subprime borrower would have a down payment of 5%, or $13,600, and that they borrow at 8%.  For this analysis I will include the requirement that the loan be held for 2 years.  This is not unreasonable; banks often require such a condition to ensure they get enough interest for the risk they are taking.  I will not include a prepayment penalty for simplicity, but for subprime loans, there will generally be a prepayment penalty. Calculations are done in nominal terms, as that is what the borrower would see on their statements.

Whether the subprime loan is better comes down to whether or not the buyer can accumulate enough equity to refinance the home out of the subprime loan and into a prime loan at the 2-year mark.  The amortization schedule of a subprime loan with the above assumptions is in this Google doc.  For those that wish to play with it, the values at the top can be changed as inputs, but there must be a % symbol with the rates.  Assuming the house price stays the same, the schedule shows when various equity milestones, as well as credit rehab events would occur in the life of the sub prime loan.

Assuming that the loan is for 30 years, the subprime borrower would have a monthly payment of almost $1,900, yet all but $173 of the initial payment goes to interest, assuming it is not an interest only loan.  By month 24, the borrower can finally get out of the loan, but they have paid about $41,000 in interest, and only about $4,500 of the principal.  With the down payment, they have $13,600 + $4,500 = $18,100 in equity, or about 6.65% equity.  They have also spent the equivalent of $1,708 a month in interest.  While shorter loans would result in equity accumulating faster, it would also result in a much larger monthly payment. The results would only get worse if we included a prepayment penalty.

In order to refinance the loan, the owner needs to have equity in the house, typically around 20%.  Since the borrower isn’t going to have anywhere near that amount of equity, the house would have to appreciate to roughly $317,000, a return of 16.5% on the purchase price.  This is possible, but in a sense the subprime borrowers are speculating on the value of the house in two years, where the payoff is the ability to refinance your mortgage before it ruins you.

Contrasting that with a prudent alternative, a borrower that lived in a modest apartment with only $1,200 per month rent would accumulate an additional $12,000 to add to what ever else they had saved, resulting in a much larger down payment.  Assuming they rehabilitated their credit to prime, they get a much lower rate, and a more manageable monthly payment.

Many subprime borrowers cite the investment benefits of owning a home, tired of paying rent, they want to start building equity.  However, by taking on a subprime loan, they are gambling with their financial future with very little to gain.  Since so much of the early payments go to interest, the owners may end up paying more in interest then they would have in rent for the same period, and should they fail to refinance the loan, they will most likely lose thousands, if not the house entirely.

The analysis presented here shows some of the math that needs to be done by subprime borrowers.  Subprime loans are not inherently bad, but borrowers need to understand the assumptions they are making when they sign up for them.  They may find that patience could pay off.

 

 

 

 

Japan Boosts Sales Tax, May Test Abe’s Policies

Japanese citizens across the country have been rushing to the malls and supermarkets ahead of the sales tax increase this Tuesday. According to George Nishiyama of the Wall Street Journal, Japan plans to implement a sales tax increase from 5% to 8%, which was designed to help pay for the nation’s exploding social welfare costs and public debt. It is expected that citizens will begin to rein in their spending habits after the tax increase, which appears to contradict Prime Minister Abe’s plan to stimulate the economy. As Nishiyama points out, in 1997, the last time Japan initiated a sales tax increase from 3% to 5%, Japan ended up plunging into a recession lasting 18 months. He also points to a poll by the Kyodo new agency that suggests that

“66% of respondents plan to cut spending, while 33% said they don’t plan any changes. Nearly 80% expressed worry about the economic outlook.”

Overall, Nishiyama seems to suggest that the sales tax rise may be dangerous, in that it could contribute to factors leading to a failure by Abenomics to lift the economy, which in his words “has already faced criticism that it is a policy of exiting deflation by creating a bubble through easy money at the expense of ordinary Japanese.”

Whether this was a causal relationship is yet to be seen, but in any case it seems as though there may be unforeseen consequences of issuing sales tax increase is arriving at the wrong time, and, on one hand, that it has the potential to weaken Abe’s efforts to boost the Japanese economy.

On the other hand, the Economist appears more impartial than the Wall Street Journal to the idea of the sales tax increase, considering fiscal consolidation over the longer term a “fourth dart in the quiver” against Japan’s anticipated financial woes. According to the Economist, Japan’s national public debt issue is one of them most pressing problems in the Japanese economy, as the national debt is anticipated to exceed 240% of national GDP later this year. The Liberal Democratic Party of Japan (LDP) last year cooperated with the Democratic Party of Japan (DPJ) to pass the sales-tax bill. This will reportedly increase the sales tax from 5% to 8% this April, and to 10% in October of this year. Prior to Prime Minister Abe’s inauguration, this policy initially looked like it would help get the country on track; it would reportedly cut the Japanese budget deficit to around 3.2% of GDP. This was, of course, before Prime Minister Abe’s stimulus package that would make hitting the 3.2% of GDP target improbable.

The authors don’t appear very worried about the potential negative effects of Abenomics on the  Japanese debt market. They mention that yields on Japanese government bonds (JGBs) are currently historically low, and that the market for the bonds is dominated by Japanese savers and institutions, which are more loyal and less “flighty” than foreigners who would demand high yields. This would make it less likely that there would be a rapid escape from Japanese bonds over worries that the nation could not pay its debts, and therefore may make the market more stable. Furthermore, the Bank of Japan is currently purchasing 70% of new JGBs issued annually. Essentially, much of Japan’s debt is being paid for with money that the Bank of Japan prints, that the rest is mostly in the hands of Japanese citizens, and that this is not an immediate problem. The economist also points out that while Abe’s policies may hurt Japan in the near-term, that it should boost economic activity, both raising tax revenues and making it easier for the government to raise the consumption tax.

If I were forced to pick a side, I’d stick with the Economist on this issue. First, like in many situations in Economics, it’s difficult to discern causality between events, especially one time events. This throws a bit of doubt into whether the tax increase would inevitably lead to further financial problems for the Japanese economy. The tax increase would mean that Japanese citizens would have less disposable income to spend on consumption, but Abe’s current stimulus policy may be large enough to take the edge off and could make it less likely that a subsequent recession will occur. Furthermore, it may be advantageous use the increased tax revenues to wind down the Japanese debt problem now rather than later. As another Economist article points out, the Japanese also face an aging population that in the near future will begin to withdraw money from their retirement plans. This will mean that the national savings rate could decrease in the near future and make it difficult for the Japanese government to find able citizens to buy up its debt. A tax increase now may be a proactive way to reduce this burden before things get bad. Of course, this is a contentious issue in Japanese politics, and the effects of Japan’s current policies are uncertain, so in the end it will be important for both sides to proceed cautiously.

 

The Macroprudential Debate

In interesting Wall Street Journal article caught my attention this morning.  With the title, “Think Financial Systems are Safe? Think Again, Warns Carney” I immediately questioned the stability of America’s current financial systems.  But after further thought, it seems that the Great Recession inspired massive amounts of de-leveraging in the US financial system, thereby offering some hope of economic stability.  Indeed, the graph below illustrates that financial institutions have cut back on leveraging in the past 6 years, likely in response to the devastating consequences over-leveraging had in 2008.  But the aforementioned Wall Street Journal article is not about the United States; it’s about the United Kingdom.

Financial System Leveraging

Mark Carney, the governor of the Bank of England, is concerned about mounting levels of debt in the United Kingdom’s financial sector.  Specifically, he believes that England’s massive monetary stimulus is beginning to show its hand in the credit cycle by encouraging financial institutions to borrow excessively.  Certainly, more borrowing (and accordingly more investment) is desirable during today’s economic downturn; anyone who has taken macroeconomics knows that increased levels of investment will boost GDP and help pull a suffering economy out of recession.

However, Carney notes an important distinction between the business cycle and the credit cycle.  According to Carney, the business cycle, which is monitored to determine if a nation is in a recession, is significantly shorter than the credit cycle, which refers to the leveraging and de-leveraging of institutions.  Carney asserts that the credit cycle is as much as 2 times longer than the business cycle.  This assertion implies that while monetary stimulus may show positive effects in the short and medium run (by positively impacting the business cycle), it may show negative effects in the long run (by adversely impacting the credit cycle).  The graph below seems to support Carney’s theory of a longer credit cycle, as it illustrates that the recovery in America’s real GDP (the business cycle) occurred much faster than outstanding financial liabilities (the credit cycle).

Screen shot 2014-03-19 at 11.20.10 AM

To address the varying time scales of the business and credit cycle, Carney and the Bank of England are exploring the use of “Macroprudential Policy.”  According to an informative Wall Street Journal video, Macroprudential Policy is monetary policy that targets a single sector rather than the entire economy.  Examples include targeting the housing market.  For example, given Korea’s massive boom in housing prices recently, the Korean Central Bank recently instituted Macroprudential Policy to regulate this sector.  By requiring 50% down payments on all mortgages and limiting mortgage payments to less than 40% of one’s income, the Korean government has effectively caused housing prices to flatten.  And in their opinion, by flattening housing prices, the Korean government has prevented a housing bubble without raising interest rates and punishing the entire economy.

It is this type of sector-specific intervention that intrigues Carney.  He believes that by regulating the financial sector more intensely (by setting limits on borrowing, etc.), the Bank of England can reduce the risk of over-leveraging in the financial sector without raising interest rates.  Doing so presents a “best-of-both-worlds” scenario; interest rates will remain low, helping to fuel a business cycle recovery, while financial leveraging will also remain low, helping to prevent over-leveraging.  Given that Macroprudential Policy is a relatively new tool and that no consensus exists as to its effectiveness (Israel has not been as successful as Korea in applying Macroprudential Policy to the housing market), it will be interesting to see which policies the Bank of England ultimately pursues.

While Carney may think Macroprudential Policy is important for the United Kingdom, I do not think it is appropriate for the United States.  The graphs above illustrate that America’s financial sector is not binging on debt; rather outstanding liabilities have been relatively flat since 2009.  Furthermore, a desire to remain solvent has inspired many financial institutions to limit leveraging without instruction (JP Morgan, for example, dropped student loans in 2013 to limit its “bad debt”).  For these reasons, I don’t think Macroprudential Policy is appropriate for the United States right now.  As a matter of fact, I think it could harm the US recovery by limiting business cycle activity.  Nevertheless, I think Carney’s distinction between the business and credit cycle is significant.  In the future, it will be very important for policymakers to monitor debt-levels closely to ensure there are not long-term, adverse effects of Quantitative Easing on the magnitude and riskiness of outstanding liabilities.

How may lower growth rate affect to make debt harder not easier?

On March 1st, 2014, Paul Krugman wrote a supplementary blog post, CBO Mix-And-Match, supporting Floyd Norris’s criticism about the inconsistency in budget projections done by Congressional Budget Office (CBO). Krugman’s main argument was that CBO seems to leave out the expectations for future interest rates in CBO’s budget projection calculations. Paul Krugman commented that this will lead to “excessive fiscal pessimism”. I do not blame him for using such as strong negative word, because future interest rate is used in just about every financial projection calculation.

Paul Krugman then further gives the reason that this miscalculation is important; that is because its relationship with debt as share of GDP. When real interest rate “r” is further greater than “g” economy’s long-term growth rate, this can cause recession, such as debt spirals, Paul said. In terms of economic growth, I partially agree with Paul saying that “lower g to lower r too”. I understand how lowering real interest rate can favor the economic growth rate; however I do not quite grasp the entire picture when Paul Krugman says “lower g to lower r too”. For example, when economy is running well and more people enjoys economic prosperities, I suspect to rise in price levels. People will try to make more money out of their business because they can assume that people’s willingness to spend is high when economy is in a boom than in a recession. Of course, this is not a hundred percent true, because we have witnessed the people were afraid to spend money even after when recession ended.

On March 2nd, 2014, Paul Krugman wrote a following blog post, Growth and Interest Rates: I Appear to Be Wrong, and gave this graph to show the title of this blog.

030214krugman1-blog480

According to Paul Krugman,

Postwar US history broadly breaks into two eras: a fast-growth generation after World War II, and generally slower growth thereafter. If my hypothesis had been right, r-g should have been lower in the second era than the first. Well, it looks as if the opposite was generally true, even if you ignore the spikes around big recessions.

As Paul mentioned, in Japan, GDP growth rate was lower in the presence of low interest rates, of course this fact is bounded by the zero lower bound problems, yet in some extent, we cannot ignore this contains some degree of truth. By looking the graph above, Paul concluded that “lower growth does appear to make debt harder, not easier, to carry.” And I wonder if this can be related to what I said earlier. I said, when Economy is boom, people tends to make more money out of their business by assuming that people’s willingness to pay is high. In a similar way, when economy is running in a recession or when economic growth level is low, people are afraid to lend out money because they are afraid that borrower may not repay them back interests on time. My logic is more based on behavior economy rather than a theory. However, many times we see what constitute the world is people’s behavior rather than a solid theory.

Consumer Debt and the Economy (Revised)

Everyone has had that one credit card bill that they’ve opened up and cringed at the amount due. But how can such small purchases add up so quickly in only a month? Most people don’t realize just how much money they are spending when they use a credit card to buy their purchases. However, most of the debt in our country comes from consumer spending. Since consumer spending drives the economy and fuels nearly 70% of U.S. GDP, consumers must be in a sound financial position. If consumers become overburdened with debt, they will not be able to drive economic growth. The table below shows the total amount of household debt, total nominal GDP, total nominal disposable personal income, and the ratio of household debt to both GDP and disposable personal income; all the numbers are in billions of dollars:

econ

As you can see, over the past 30 years, U.S. consumers have increased both total household debt and the percentage of that debt relative to overall GDP and DPI. At some level, the total amount of debt can become so large that it can force consumers to slow their spending and thus begin to negatively affect the health of the economy. This is why in times of a recession, governments try to encourage consumer spending by lowering taxes and lowering interest rates. When consumers slow down their purchases, business’ profits are lowered which eventually lead to lay-offs; worsening the downward spiral. The more debt that is held, the less money is available to be put away in savings and reinvested in the economy.

After 2009, consumer debt began to slowly decline for the next few years. Recently however, since the beginning of 2013, Americans have been taking on debt at a rate not seen since the country spiraled into the Great Recession. Consumer debt increased in just the fourth quarter of 2013 by $241 billion, the largest quarter to quarter increase since 2007. Below is a graph of the quarter to quarter household debt balance since 2003 and its composition:

Household Debt 2013Q4A

This total debt balance was a combination of Americans boosting credit card balances, increasing borrowing to buy more homes and cars, and taking on more student debt. Balances on credit card accounts alone increased $11 billion during the fourth quarter, making it the third largest source of household indebtedness. Only the mortgage and student loan debt markets were larger.

You would have thought that after the chaos of the recession, we would have become better at keeping track of our debt. However, data shows otherwise. According to a survey released by Bankrate.com, 28% of Americans have more credit card debt today than they have in a savings fund. This means that over a quarter of Americans wouldn’t be able to pay off their debt even if they used their entire savings! But, despite consumers’ savings records, banks are loosening up their credit card limits to levels not seen since the recession. This easy access to credit along with low interest rates during boom years is what brings Americans to take on record levels of debt. This does not mean that we are on the road to a second recession however. Americans’ increase in household debt could actually have to do with increased consumer confidence in the economy as it relatively improves. Higher spending leads to more jobs and higher incomes, which ultimately leads to higher consumer spending. For consumers with extra money in their wallets, taking on more debt may not seem so risky. And, as we know, consumer spending puts the economy on a positive track.

So can this notion that “Americans are spending way too much” be curbed and should it be? Financial advisers offer several tips on how to stop spending so much money and get back on track financially. Two of these tips include tracking your cash flow and tapping into your feelings to restrain your urge to spend. There is a difference between needing something and wanting something, and budgeting helps you to see areas where you may be overspending. Therapist Nancy Irwin says that overspending tends to be a coping mechanism. “You need to find the underlying issue that is trying to be fixed by overspending and learn how to deal with it in a healthy manner. There is nothing wrong with keeping up with the latest trends or being indulgent from time to time, as long as the intent is in the right place.” There is a fine line between spurring growth and digging the nation deeper into an economic sinkhole if too many houses are burdened with debt. Before you hand over your credit card, you need to think twice. You should ask yourself what need you are trying to fulfill and if you are going to be able to pay it off when the bill comes in the mail.

 

Consumer Debt and the Economy

Everyone has had that one credit card bill that they’ve opened up and cringed at the amount due. But how can such small purchases add up so quickly in only a month? Most people don’t realize just how much money they are spending when they use a credit card to buy their purchases. However, most of the debt in our country comes from consumer spending: buying more than you can afford at the moment with the presumption that you will be able to pay it off later. Since consumer spending drives the economy and fuels nearly 70% of U.S. GDP, consumers must be in a sound financial position. If consumers become overburdened with debt, they will not be able to drive economic growth. The table below shows the total amount of household debt, total nominal GDP, total nominal disposable personal income, and the ratio of household debt to both GDP and disposable personal income; all the numbers are in billions of dollars:

econ

As you can see, over the past 30 years, U.S. consumers have increased both total household debt and the percentage of that debt relative to overall GDP and disposable income. At some level, the total amount of debt can become so large that it can force consumers to slow their spending and thus begin to negatively affect the health of the economy. This is why in times of a recession, governments try to encourage consumer spending by lowering taxes and lowering interest rates. When consumers slow down their purchases, business’ profits are lowered which eventually leads to lay-offs; worsening the downward spiral. The more debt that is held, the less money is available to be put away in savings and reinvested in the economy.

So can this notion that “Americans are spending way too much” be curbed? Financial advisers offer several tips on how to stop spending so much money and get back on track financially. Two of these tips include tracking your cash flow and tapping into your feelings to restrain your urge to spend. There is a difference between needing something and wanting something, and budgeting helps you to see areas where you may be overspending. Therapist Nancy Irwin says that overspending tends to be a coping mechanism. “You need to find the underlining issue that is trying to be fixed by overspending and learn how to deal with it in a healthy manner. There is nothing wrong with keeping up with the latest trends or being indulgent from time to time, as long as the intent is in the right place. It’s OK to keep up with the latest technology if you are into that or you enjoy giving your kids the biggest pool on the block as long as it comes from a creative place and serves your high consciousness and not just your ego.” There is a fine line between spurring growth and digging the nation deeper into an economic sinkhole if too many houses are burdened with debt. Before you hand over your credit card, you need to think twice. You should ask yourself what need you are trying to fulfill and if you are going to be able to pay it off when the bill comes in the mail.

Detroit’s Debt Problems

Its no news to many that the city of Detroit is in financial shambles. Last July, they filed for bankruptcy protection and they are in the process of restructuring their debt. Throughout this process, it is likely that the biggest losers will be those to whom the city owes a pension and investors in the city’s unsecured debt. How much debt does the city of Detroit have? $18 billion, a pittance compared to the magnitude of the public debt of the nation as a whole. To put this number into perspective, the city of Detroit contributes a little over $20 billion per year to the GDP. In other words, their Debt to GDP ratio is just under 90 percent. In 2011, the United States federal debt passed 100% of GDP and has only grown since.

So why is it that the United States can handle public debt levels over 100% of its GDP, while cities like Detroit collapse under the weight of much less? The experts on this topic of debt tolerance are the widely cited Harvard economists Reinhardt and Rogoff. Their 2010 paper “Growth in a time of Debt” finds that advanced economies begin to have growth slowdown after debt passes 90 percent (perhaps one reason that the United States has been sluggish to climb out of this recession). For emerging and underdeveloped markets, this threshold for debt problems is much lower. Since I can remember hearing about Detroit’s debt problems for years, Detroit probably began experiencing these problems around similar lower levels of debt to GDP.

So are there comparisons to be drawn between the economies of Detroit and underdeveloped economies? While obviously there are differences between comparing the economy of one city to a term coined to describe countries as a whole, I would argue that there are. Wikianswers lists 15 characteristics of underdeveloped economies, some of which align with the situation of Detroit. Detroit happens to face high levels of employment problems and faces high debt. They also rely on outside aid. While the outside aid of underdeveloped economies usually comes from abroad, the need of the United States judicial system to mediate the unwinding and renegotiation of their debt could constitute “outside aid”.

While Detroit was propped up for so many generations by a thriving and unrivaled auto manufacturing sector, when the Big 3 began to experience trouble, it is sad to see how quickly an economy can unwind and begin to exhibit many characteristics of an economy that had never taken off in the first place.

An Analysis of ‘How the Economic Machine Works’: Part 3

In my last blog post, I discussed the short-term debt cycle and began to talk about the long-term debt cycle. This is the third post in the set and will focus on the long-term debt cycle and will begin to look at some of the data backing up Dalio’s claims.  In the short-term debt cycle (STDC) spending is restricted only by the willingness of lenders and borrowers to provide and receive credit, but as was discussed at the end of the last blog post, the STDC doesn’t give us a full picture of what’s going on. The long-term debt cycle gives us a broader view of what is happening.

3. The Long-Term Debt Cycle (LTDC) (60-80 years)

The LTDC is the final of the three factors that Dalio asserts drives the economy. The LTDC has three parts: (i) leveraging (50+ years), (ii) depression (2-3 years), and (iii) reflation (7-10 years). The main idea is that over the course of about 60 to 80 years, the economy undergoes a large cycle, starting with a period of above-average productivity growth (leveraging), which eventually falls dramatically (depression), and then starts growing again (reflation). Let’s take a closer look at each part separately.

The leveraging period has been discussed throughout my past two blog posts and is directly tied to the idea that credit allows people to increase income growth beyond productivity growth in the short run. During the leveraging period, the economy is undergoing short term debt cycles of expansions and recessions, but each cycle’s bottom and top finishes with more income per person and more debt per person than the last one. At first, incomes increase faster than debts do, and as long as borrowers’ incomes rise faster than their debts, they remain creditworthy. This is what is known as ‘a bubble’; with asset values and incomes growing quickly, lenders are still willing to lend even though the public debt burden is increasing. Goods, services, and financial assets are all being bought with borrowed money. At some point, however, this false paradise must end. The bubble pops at precisely the moment when debt repayments start growing faster than incomes. Queue the depression.

In a depression, the large debt repayments cause incomes to fall dramatically. Many borrowers can no longer afford to pay back their debts with income, so they resort to selling assets. Since many borrowers are selling assets at once, the market is flooded with supply causing asset prices plummet. Plummeting asset prices mean that the value of borrowers’ collateral drops as well, making them even less creditworthy. Incomes drop, credit disappears, asset prices fall, and borrowers can’t repay their debts, making for a self-perpetuating disaster. It’s the same negative feedback loop I talked about in the last blog post, except in epic proportions.

Take a look at the following graph that illustrates the U.S. debt to GDP ratio from 1916 to 2012. Notice that the debt/GDP ratio increased steadily before both 1929 and 2008, spiked upward right after, and then falls dramatically:

U.S. Debt to GDP Ratio

This graph is not a full justification of Dalio’s claims, but it does illustrate a certain cyclical nature in the debt/GDP ratio, which gives credence to the LTDC. It’s pretty clear that after the Great Depression was over by the mid 1940’s, debts began to grow steadily until 2008. That’s about 50 years and resembles the characteristics of the leveraging period of the LTDC I discussed earlier.

In the next blog post I will take a closer look at the strategies government use to deal with large-scale recessions and further explain the reflation period of the LTDC.

Suntory’s Acquisition of Beam: Expensive and (Hopefully) Lucrative

On January 13, Suntory Holdings Ltd. announced it would acquire Beam Inc. for $83.50 per share, which is a 25% premium to the January 10 closing price (the 1/10 stock price is the unaffected price before the news of the acquisition was announced and the stock price jumped). The deal, expected to be completed in June, values Beam at 20.5 times EBITDA (earnings before interest, taxes, depreciation, and amortization). Beam’s enterprise value-to-EBTIDA multiple, which is a common financial metric used in valuations, is expensive when considering that median multiple in the industry in the last five years is 12-14 times EBITDA. In addition, it is the fourth highest valuation in the spirits industry in the last decade. To add a little more perspective, this is the largest beverage deal since Inbev acquired the remaining 50% of Modelo SAB for $17.2 billion in 2012. Although Suntory is certainly paying top dollar for Beam, Suntory expects the acquisition will offer them many lucrative growth opportunities.

Suntory produces Yamazaki whiskey and Premium Malt’s Beer, which are household names in Japan. However, Suntory wants exposure overseas where there is high growth compared with slow growth at home due to an aging population. According to the Wall Street Journal, “Suntory Holdings Ltd. tried to cast aside any lingering doubts that its $13.6 billion acquisition of Beam Inc. is overpriced, saying it will successfully capitalize on the overseas brand recognition of the U.S. whiskey maker as it transforms into a global spirits competitor”. In 2011, 80% of Suntory’s revenue came from Japan. Following its acquisition, 60% of Suntory’s revenue is expected to come from the United States. As a result, Suntory’s acquisition of Beam is positioning the firm to be more diversified away from Japan. I believe this is a good decision because it decreases idiosyncratic risk of having most of its revenues be dependent on the health of the Japanese economy.

Beam is also a rare example of a pure play alcohol company, which means it has a single business focus. Suntory, which approached Beam with an unsolicited offer, is demonstrating “strong enthusiasm for forging ahead with its whiskey business”. For Suntory, the scarcity value of a pure play alcohol company might have provided additional incentive to pay a high price. Furthermore, there has been significant growth in spirits within the beverage industry. Suntory’s acquisition of Beam increases its market share in the United States, the world’s biggest spirits market, from 1% to 11%. In the United States, Beam is the second largest whiskey maker behind Jack Daniels. Similar to Jack Daniels, Beam has a very strong brand. According to the Wall Street Journal, “While Suntory’s whiskey products have been gaining aficionados and accolades in the U.S. and Europe, their brand recognition is still much weaker than Beam’s labels… The company therefore hopes the deal will give it strong ammunition in the form of globally recognized brands to embark on an offensive in overseas markets”. The value of a brand is hard to quantify because it is hard to determine what amount of sales or pricing power come from the strength of the brand. Although critics claim Suntory overpaid for Beam, I believe Suntory will benefit from Beam’s strong brand and its exposure in the United States.

Despite the tremendous potential for growth in this acquisition, Suntory will also be taking some calculated risks due to the financing of the deal. Suntory’s acquisition of Beam is an all cash offer, which means Suntory will issue debt. Suntory will need to issue $12 billion in debt and credit agencies have warned that this massive amount might result in a downgrade of Suntory’s debt. Downgrading of debt is never a good thing as it usually increases borrowing costs for the company (lenders demand a higher interest rate to be compensated for the larger perceived risk). However, Suntory should be able to reduce this debt over time and restore its credit rating. If Beam proves to be as profitable as Suntory hopes, then Suntory may be able to pay off this debt sooner than expected.