Masters Series: The Debt Generation

Editor's note: No writer in the financial media has been more consistent or adamant in warning about the dangers of America's debt-fueled economy than S&A founder Porter Stansberry.

In today's edition of the weekend Masters Series, we feature one of Porter's first major writings on the topic… Porter published this piece in November 2002, when he was still writing for the Daily Reckoning, the free e-letter published by our corporate affiliate Agora Financial.

The details have, of course, changed over the past decade-plus… But most of the numbers have only gotten worse. Total U.S. debt (public and private) now represents about 350% of our gross domestic product… The U.S. government is $17 trillion in debt and running an annual deficit of $1 trillion… Detroit has gone bankrupt… And America's pensions remain is dire straits. The ideas in Porter's piece remain as important as ever…

The Debt Generation
By Porter Stansberry, founder, S&A Investment Research

Throughout history, even the most important and self-evident trends are often completely ignored because the changes they foreshadow are simply unthinkable...

Examples of big, problematic trends that the "elite" missed are too numerous to list here with any authority. But consider: did the massive inflation of the 1970s come without significant warning early in the decade? No one said much when Nixon untied the dollar from its gold peg in 1971. There wasn't a huge outcry in the mass media against his price controls in 1972. And the rapid escalation of social spending coming from Johnson's "War on Poverty" went without critical analysis until the mid-1980s. Why did so few people see clearly what were huge and obvious warning signs of an enormous inflation?

Not all trends are bad, of course. But many still go unnoticed. Take the bull market of the 1990s, for example. The Netscape IPO that launched the mania occurred in the spring of 1995... five years before the market's peak. Few people understood what was likely to happen. In his 1994 book, The Road Ahead, about the future of computer technologies, Bill Gates doesn't even mention the word "Internet."

The biggest trend we see in place right now can easily be captured in one word: debt. Since 1992, there's been an ominous shift in debt from the public to the private sector. Federal borrowing rates have declined, while private borrowing has grown at a rate never seen before in America.

In 1992, the government borrowed around $300 billion; private industry borrowed $200 billion. Since then, private borrowing has increased every year except 2000, and now tallies over $1 trillion per year. Federal borrowing, as you know, declined until mid-2000 and was actually negative for a few years (indicating a Federal surplus). But, overall net debts – private and federal combined – increased during the whole period, moving from around $500 billion per year in new debt to over $1 trillion per year in net debt addition.

A high rate of debt growth, by itself, is not necessarily a problem. If these funds are invested wisely, if they spur new economic opportunities, then, as a percentage of our national balance sheet, these debts could remain sanguine. But that's not what has happened.

Instead, since the 1960s, each new dollar of debt has added less than a dollar to economic growth. This indicates our economy is suffering from systematic declining returns. Today, each new dollar of debt adds about $0.54 to economic growth (that's assuming the U.S. economy is growing at 2.5% a year – which it may not be).

The vast majority of the debts we added in the 1990s were used to fuel massive financial speculation in corporations and home mortgages. As these financial assets begin to deflate, the debt remains, causing the debt to loom higher and higher as a percentage of assets. Total debt, as a percentage of GDP, has grown from around 150% in 1982 to nearly 300% today.

Unfortunately, not even this high debt load tells the whole story of our future obligations.

As the bear market has ravaged the stock market, the assets of U.S. pension funds were annihilated. State and local pension funds – whose figures are a matter of public record – have fallen in value from $80 billion in 2000 to $25 billion today... a 70% decline. Although I don't have complete figures for U.S. corporate pension funds, those numbers won't look much different from the state and local government accounts (which often use the same pension fund managers).

Meanwhile, news of enormous future charges to earnings based on the mandatory contributions to their sagging pension funds are filling the pages of the financial media. For example, [telecomm] SBC announced this week it would take a $2 billion charge against earnings next year to begin repairing its pension plan. [Defense contractor] Raytheon says it must pay $500 million towards its pension fund over the next two years. Right now, Wall Street estimates that 10% of the S&P 500's earnings next year will go toward underfunded pensions.

There is, of course, an even bigger underfunded pension plan out there – Social Security. But describing the future impact of these costs requires more detail than I can even begin to cover in a few paragraphs.

Suffice it to say, there are two components to private debts – corporate debts and personal debts. The rise of personal debt isn't hard to figure out: Who doesn't like to live beyond his means? On the other hand, understanding why companies have abandoned all fiscal responsibility isn't that easy.

Corporate managers have leveraged their balance sheets and used debt to manipulate earnings in order to increase profits, "grow" earnings, and augment the value of their stock in the short term. Stock-option compensation gives managers an incentive to take big risks. If the risks work, the managers receive windfall profits. If they don't, managers can walk away unscathed.

The worst abusers of shareholder trust aren't hard to find. Just look at America's biggest and most respected companies. IBM bought back $9 billion worth of stock while issuing $20 billion in new debt during Lou Gerstner's reign as CEO from 1993-2000. Why would you issue debt that costs you 8%-12% in interest when your stock only pays a 1% dividend? The only reason you'd do this is to juice earnings in the short term. In the long term, you're only adding risk and shrinking your future profit margins.

But what did Lou care? He received 500 million stock options (all of which he sold when he retired in 2000). There's no doubt that Lou Gerstner leveraged IBM's balance sheet to increase its operating margin. That's not against the law... but it's not the way great companies are built. It's the way great companies are devoured.

Since Gerstner's departure, IBM also admitted to booking asset sales as operating revenue – a common accounting trick to hit earnings forecasts. Selling assets is also another way to leverage a balance sheet. Within one year of Lou's retirement, his replacement had taken huge billion-dollar charges, sold off major underperforming businesses (hard drives), and closed nonperforming (but long-held) businesses like PCs.

Unbelievably, Gerstner wrote a self-congratulatory book about his tenure at IBM. It's being published.

Or how about GE, perhaps the most respected company of all time? Since 1992, GE has been a net borrower. How could America's best company be a net borrower for 10 years? Well, look at what the company is doing to make money, and it's easy to figure out.

About 50% of the company's total debt is in the form of short-term paper – the 90-day commercial paper market it can access thanks to a triple-A rating by Moody's. The company uses this debt, which carries a low interest rate, to finance credit cards, which carry a high interest rate. If you walk into J.C. Penney or Macy's and take out a credit card, chances are pretty good that you're on the hook to GE. In total, GE Capital has spent $43 billion on buying such receivables in the last three years alone.

And here's the scary part. Fifteen times since 1997, the company has sold a large batch of these securities (at a loss?) less than three weeks before the end of a quarter. That's how the company is able to match its earnings forecasts so precisely.

Meanwhile, GE's debts have mounted. Today, its balance sheet stands precariously at four times debt to equity. Why take such risks? Because these debt-laden acquisitions accounted for 40% of GE's revenue growth from 1985 to 2000, according to Merrill Lynch analyst Jeanne Terrile (who retired immediately after publishing her study of GE's use of debt).

Again... these are America's best companies. As profit margins slipped in the '80s and '90s, corporations leveraged their balance sheets to make profits look better. More sophisticated companies played more sophisticated games. And the whole time, fundamentals continued to deteriorate without any clearly discernible warning.

Since 1975, capital expenditures have exceeded cash flow, meaning that corporations have been raising debt or equity faster than profits. This game catches up to you as demand slowly declines. Eventually, capacity utilization rates begin to fall on everything from computers to credit cards, indicating a broad surplus of goods and services in our economy. And that's what we see was slowly happening, starting as early as 1985 and accelerating with amazing rapidity over the last two years.

Across the board in our economy, capacity utilization has fallen from around 85%-90% in 1985 to below 75% today, according to the Board of Governors of the Federal Reserve System. The data make sense: Areas of our economy that had the biggest investment boom show the biggest decline in capacity utilization today. Capacity utilization in electronics, for example, has declined from 90% in 1999 to under 65% today.

This rapid decline in capacity utilization is one of the symptoms of a credit bubble bursting. A healthy economy is driven by savings-fueled demand. When savings and investment become badly maladjusted, there will be problems.

If you think of these problems in the abstract, they're easier to understand. Imagine your own family's balance sheet. What would happen if you maxed out every available credit source over the next six months? Your rate of consumption would soar, you'd place great demands on the economy and, eventually, your needs would slowly decline. You'd be left with few wants... and a lot of debts. You'd stop buying anything for a long time, until you were able to repair your family's balance sheet.

That's essentially what has gone on in America over the last 10 years. The savings rate here declined from around 5% (which is weak) all the way to a negative figure in the late 1990s. People were spending more than they made each year, mostly by tapping into home equity loans. Now we've reached the point where most people (and most corporations) are close to tapped out.

The amount of money people have borrowed against the value of their homes is unprecedented. Since 1992, quarterly adds to home mortgage debt have increased from around $200 billion per quarter in 1992 to more than $600 billion in the most recent quarter. This is an amazing amount of debt...

Take a look at the data we have on consumer credit, which includes auto leases and home equity loans. Back in 1992, consumer credit as a percentage of disposable personal income stood close to 16%. Today it's over 25%. And that means an overwhelming majority of people's income today is going toward taxes, interest, and paying down debts.

Future demand is going to be weak... and could be for a surprisingly long time.

Regards,

Porter Stansberry

Editor's note: Since Porter first wrote this piece, America's debt situation has gotten worse and worse… and the consequences more dire. Porter's landmark "End of America" report and video laid out how our government's debt-addicted spending will inevitably destroy the dollar.

Earlier this year, Porter updated his End of America research and released a new video describing how he expects the scenario to unfold from here. To watch the video, click here.