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Now that 2008 has gone down in history as one of the worst years the market has ever seen, I thought I’d post about the heart of the problem.  Down to the individual, our country has a problem with debt.  Debt enables us to purchase goods and services, but also enslaves all earnings after we incur the debt to the debtor.

I posted on my blog the following quote, and I thought about it for a little bit and decided that it’s very appropriate as a summary of the market in 2008:

Would you hold overnight positions at 4 times your equity every single day of your life? I doubt it, but some companies leveraged themselves 20 times equity every day of the quarter, and it just took that one quarter to send their stocks to 0.

I believe this quote is exactly why we’re in the situation that we have right now.  It’s not mutually exclusive to financial companies, however.  It’s not even exclusive to corporations.  It seems even individuals have problems with their debt ratios, as we see in the housing market and for unsecured credit card debt.

The problem I see with Americans in particular is that we have the ability to finance substantial desires that have the potential to bankrupt us if something unexpected occurs.  Here’s an example at the individual level:  I have no debt, but I don’t have insurance.  I get into an accident and require major surgery.  Immediately you are abjectly bankrupt from the $25,000 to $50,000 expenditure that comes as a hospital bill.  This is understandable for an individual, sure, but corporations for the last decade have gorged themselves on debt.  So much so that it is equivalent to saying I make $50,000 and I have $50,000 in the bank.  I decide I’m doing well and borrow $1 million to loan to my friend at a higher rate than I was loaned the money, earning what I believe is a risk-free spread between the two.  When my friend is unable to pay, I suddenly own whatever he bought, and it becomes my obligation.  The problem is that whatever my friend bought is now worth half of what it was.  The catch is that my friend might have chosen voluntarily to walk away from his purchase and stick me with the bill.  Both parties lost everything in this situation.  You might say this is exactly the nature of a sub-prime loan, and this is primarily what has caused the market to collapse, but this ignores the fact that I should have charged substantially more for the loan in the first place.  I basically miss-priced risk, but more on that later.

When we issue debt or go to buy a bond (which is also a loan, either to governments, individuals, or corporations), we seem to have miss-priced risk.  I believe risk management is a fallacy.  Most risk managers trust “experts”, like debt rating agencies, but the catch and the gotcha really comes when you find out how risky the loan you made actually was.

The main point of this post is that as long as everybody, either corporations, individuals, or governments do not stop financing everything through debt, then essentially all we have left is a worthless IOU.  Sure there are cases where it’s collateralized, but even then, if it was not appraised correctly in the first place, we miss-priced risk and lost substantial amounts of money.

At the personal finance level I don’t believe many Americans are well behaved in this regard.  So much so, that even when the average American runs a behemoth corporation like Lehman, Bear Stearns, Ford, or GM, we pretend like debts will be magically repaid.

Work goes into paying back debt, but a lot of the work that goes into repaying the debt fails to account properly for an adequate level of return.  The Golden Rule of Corporate Finance is: Are we investing the firm’s capital in investments that our shareholders do not have the capacity to invest in as well? Corporate America in 2008 got this question dead wrong.  For that, our debt snowball finally caught up with us at the bottom of the hill and crushed our economy.

I’m not saying debt is bad, but that it has been misused for too long in our economy.  So much so that I’m extremely dubious of any company with a current ratio below 1 and would go so far as to say that any company with a debt to equity ratio above 1 actually has a negative net worth.  For the lay person, this simply means that all of your whole net worth is less than the size of your debts.  That’s not bad by itself, but the kicker is that the debt requires payments in excess of the money you bring in.  In Corporate America, this usually violates the debt covenants and triggers a technical default.

Ford, Lehman, GM, Bear Stearns were and are all in technical default.  They have negative net worths.  We know Lehman and Bear Stearns are no more, but no one saw this coming until it was too late and what little liquidity there was dried up.  In the case of F and GM their losses on a per share basis are more than double their market cap.  This implies that they are bankrupt.  F and GM shouldn’t be saved, because they behave like teenagers with their money, aside from the fact that no one wants to buy their cars.

It’s been difficult to tie personal financial behaviours with Corporate America, but on both, when you understand what it means to be in debt, neither the individual or the corporation emerged from 2008 profitably.

My hope for 2009 is that Corporate America starts to behave itself with regard to debt financing as well as executive compensation.  Any company with debt to equity ratios exceeding 5:1 I believe are violating their fiduciary duties to the company, because these are unreasonable levels of debt.

The old adage is that debt is cheaper to issue than equity because of the tax savings inherent in the interest payments.  The fact is that with debt to equity ratios at these levels, when you’re paying 5% in interest, you have to earn 25% on your assets to cover the interest.  Is there any company out there making that much on their money consistently to the point that you’d bet on your ability to make the payments for the next 30 years?  Probably not, however,  I’m not saying that there isn’t, but I’m saying the average company and individual in 2008 is engaged presently in this sort of over-leveraging.

I would want my investors to come to me with all debts paid off, and I’m of the mindset that there are only 3 things in this world worth borrowing money for because they increase your productivity capacity.  Those are 1) House, 2) Car, 3) Education.  Everything else should be paid for with cash, and all corporate growth should be financed organically.  For you high net worth individuals, jets are never to be purchased under any circumstances and neither should boats.  If you do a cost benefit analysis 99.9% of the time you’ll find that they don’t improve your productivity.  In the rare case it does there’s only a marginal benefit.  Boats and Airplanes are for renting, not owning, and that goes for corporations as well.  (Note that it’s different if you’re an Airline Company or plan to open a private Airline).

The best performing companies in 2007 were ones with squeaky clean balance sheets, and did well until mid-2008.  Most of these were technology companies, like Apple, Research in Motion, and some other tech bellwethers. I found very quickly in 2007 that companies with no debt of any kind, and high returns on equity are very well positioned to capitalize on opportunities, because their earnings accrue to the shareholder, and not to the debtor of the company.  I absolutely urge any reader to sell any stocks with long term debt.  Buffet states this as well, and while it’s true that this increases the leverage of the assets, you should see in 2008 that the debt financing is what caused our economic collapse.  So please be warned in advance.

I know it was a very long post, but in 2009, I believe we’ll see a rebirth of the proper use of debt to finance growth.  I find that companies that have to closed stores not only did so with debt, but also received negative returns on their stores.  This makes these companies as corporations to be avoided in the near future, because it suggests that management does not know how to analyze opportunities correctly.

I believe 2009 will be an up year, and I think Americans will be better behaved financially, both at the individual level as well as the corporate level.  Best of luck in 2009.

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Opinions expressed in the article are those of Beau Wolinsky who can be reached directly at 859-583-9016.  Blog is TheMarketChatter.blogspot.com.