Government Debt: Cause of the Next Financial Crisis

Government debt financial crisis

Spending Addiction

Governments across the globe have grown far too comfortable with expansionary policy. Increased military spending, entitlement programs, tax cuts, and bank bailouts simply add to the amount of debt governments owe to their lenders. As one would expect, government spending is politically popular. Tax cuts put more money in consumers’ pockets, which drives short term economic growth. Government welfare creates confidence among citizens that when times are tough, they’ll have a lifeline to grab on to. Politics aside, one reality awaits any debt addicted government: interest payments.

Paying the Piper

There is no need to engage in a complicated explanation of financial matters to highlight the problem the global economy is encountering. When the sum of debt (principal) increases, the amount owed in interest payments increases as well. Conceptually, interest is predicated on future growth. Debt investments, one hopes, generate future positive returns, which enable the payment of principal and interest overtime. However, when interest rates begin to rise at the same time the economy contracts, governments will be unable to pay their debt service. This leads to increased pressure applied by lenders. Foreign assets can be seized, domestic bondholders can turn against their government, and war can be waged. It’s worth noting that China owns over a trillion dollars of U.S debt. With a debt crisis looming over China itself, this dynamic between the U.S. and China will prove problematic in the future.

When Does the Music Stop?

If I could predict exactly when the crisis will take effect, I’d be a very rich man. Having said that, the first signs of a problem are beginning to show. The luxury real estate market has reached the point of oversupply. The risk of continued interest rate rises coupled with astronomic home prices has caused luxury home sales to decline. Similar trends are affecting the lower end of the market, as the appreciation of home values is slowing if not halting entirely.

While these developments aren’t necessarily a reason for concern, the outstanding mortgage loans have reached their former 2008 peak at nearly $15 trillion. We recently bore witness to the aftermath of a real estate bubble, so I won’t enumerate the details. However, governments have a lot more debt now than they did during the recession. Government stimulus is no longer a viable solution to financial woes. Debt must be paid, not built upon. Without a government savior, citizens will be hit incredibly hard. The suffering may not end for over a decade.

What Will Happen?

A collapse in the real estate market is just one component of the impending disaster. Corporate debt levels are at all time highs, due in large part to direct lending practices. Simultaneous defaults throughout the real estate, corporate debt, and government debt markets will leave all consumers exposed to a financial collapse. Citizens will lose their homes, companies will go bankrupt causing jobs to disappear, and government tensions will escalate further. I believe gold may offer me protection from collapsing markets (I cannot know for certain whether this will or will not be the case). Unsustainable debt levels spread across asset classes will lead to unprecedented chaos. I can only hope that you do what you can to prepare for it.

Have an opinion or question about the impending debt crisis? Leave a comment or contact me directly.

Government debt financial crisis

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Direct Lending: Exacerbating the Next Financial Crisis

Direct Lending Financial Crisis

Alternative Asset Managers Smell Opportunity

In the wake of the financial crisis, banks became more tightly regulated by external authorities. Regulators put controls in place to reduce the prospect of banks growing too big to fail and to help avoid another taxpayer funded bailout. Moreover, banks changed their own lending standards in an effort to reduce the financial risks they exposed themselves to. This risk aversion made it more difficult for a small or medium business to receive financing from banks.

Sensing opportunity, alternative asset managers like private equity firms and hedge funds filled this void. Companies with under $50-100 million in EBITDA now have loans directly underwritten by alternative asset managers. This direct lending strategy employed by alternative asset managers has become a booming market. While it’s difficult to assess the size of the market, fund managers raised $107 billion last year to invest in “private debt.” Unfortunately, there is more capital invested in the strategy than there are deals to deploy the investments to. This market dynamic is leading to fierce competition and relaxed underwriting standards.

Why Do Investors Like Direct Lending?

We’re finding ourselves nearing the end of the credit cycle. Interest rates are increasing at a steady pace, which pushes investors to search for “defensive” positions. The direct lending strategy is palatable because these loans have floating interest rates. As rates rise, investors get a more sizable return, assuming, of course, the borrower can continue to service its debt. The amount of debt small and medium businesses are burdened with, though, is incredibly concerning. These direct lending investments are illiquid for the term of the loan. In a private market, it’s difficult to assess the true fair value of a company, but easy to inflate it. These estimates are therefore incredibly subjective. High leverage ratios can be more easily justified, which enables alternative asset managers to magnify returns. This development is similar to the improperly rated mortgage securities that led to the previous financial crisis.

Business Development Companies: A Source of More Leverage

Private equity firms and hedge funds have been either partnering with or purchasing business development companies as a means of implementing their direct lending strategies. Business development companies, or BDCs, are publicly traded entities that invest in small, risky companies that cannot issue bonds or get financing from banks. BDCs themselves are highly leveraged (sometimes 2:1), which exposes all investors to great risk. The average returns of 13% have been quite handsome, but a house of cards has been erected. Unfortunately, the lesson in debt reduction we hoped both borrowers and lenders would learn as a result of the last financial crisis didn’t sink in.

A Race to the Bottom

Due to the high returns the direct lending strategy has gotten, alternative asset managers are having a difficult time deploying their capital. Direct lending deals are getting crowded, so, in order to win, many of the protections (covenants) investors expect as part of a deal are removed. “Cov-lite” deals allow borrowers to sell their assets in the event of a contraction, defer their scheduled interest payments, and other such activities. These cov-lite loans can prevent investors from recovering a large percentage of their investments.

What Will the Impact Be?

Direct lending will not be the cause of the next financial crisis, but the dynamic is indicative of our global economy’s obsession with debt. Highly leveraged borrowers will go bankrupt and employees will lose their jobs. Retail investors who have invested in BDCs will lose their money. The institutions investing in the direct lending strategy (pension funds, university endowments, retirement plans, sovereign wealth funds, etc.) will see their capital commitments disappear. The scale of corporate debt will reverberate throughout the market and further exacerbate the larger issue of government debt. I suggest you find means of preparing yourself for the inevitable crash we will see within the next 1-3 years. Reduce your exposure to the market and find safe haven investments, like gold.

Do you have thoughts on the direct lending market, or the next financial crisis? Contact me or leave a comment below.

 

 
Direct Lending Financial Crisis