Don’t Play Near the Cliff

As a nation or a corporation moves from being a safe credit [borrower] to being an unsafe credit, often the transition is more rapid than one would expect.  Success has many fathers, and people are reluctant to change their views rapidly.  But once the views change, it is very difficult to change them back.

Part of that is due to the construction of the markets.  Relatively little money is “go anywhere” in bonds.  There is significant segmentation.  Bond investors divide into safe and aggressive, with not a lot that can bridge the gap.  The same applies to banks, which have limits on what they can lend to corporate non-investment grade clients.

This problem gets worse with companies, quasi-governments and governments that are “confidence names.”  I never, ever, fully bought into the ratings agencies views on financial guarantors, mortgage guarantors, and the GSEs.  There was always a significant amount of hand-waving, suggesting that:

• Disaster scenarios were impossible, and
• There would be support from the government (for the GSEs).
• Governments can easily raise taxes to pay off bonds.

The group of credits most in question today are governments.  There are a number of stages in-between health and default.

1. Government has little debt, budget is largely in balance.
2. Government has moderate debt, budget is slightly inbalanced, but not so much that the interest rate on the debt exceeds the GDP growth rate.
3. Government has significant debt, budget is in significant deficit, but the interest rate on the debt does not exceed the GDP growth rate, because creditors expect the situation to be transitory.
4. Government has significant debt, budget is in significant deficit, but the interest rate on the debt exceeds the GDP growth rate, because creditors expect the situation to be permanent.
5. Default. Forced Exchange. Etc.

Note that the difference between phases 3 and 4 are only in the way a government gets viewed by creditors.  That shift often happens rapidly, and the ratings agencies tend to be lagging indicators.

My counsel to borrowers would be simple: don’t play near the cliff.  Once you move into phase 4, it is very difficult to move back into phase 3.

Now with governments that can print their own currency they might say that they have more flexibility. They do, economically.  They don’t, politically.  There are major constituencies against inflation that would rather force a government into default than tolerate inflation that disproportionately hurts them.

So be wary when lending to entities depending on lender confidence.  That confidence can disappear in an instant, leaving you to hold a depreciated loan with uncertainty as to whether it will be paid off.

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