Wednesday, January 14, 2009

Real S&P returns and Debt Coverage



The real S&P returns have taken a sharp hit over the last few months. Returns on the S&P have now reached levels not seen since the 1970s. 30 years of no real wealth creation in this country, mostly due to inflationary polices set by the Federal Reserve and the Treasury.

As a banker, one of the biggest sources of risk is the debt coverage ratio. Bankers tend to look at a "global" debt service coverage to determine the credit worthiness of potential borrowers. If I were an international banker and the US wanted to borrow from me, I would look at some sort of debt coverage ratio. You could look at the national debt which is over $10 trillion but that would not take into account private and corporate debt. The total debt by private individuals and corporations is in the neighborhood of $47 trillion. To determine debt coverage, you have to make some assumptions on the term and interest rate structure, but to me the picture is very clear: the US is in a lot of trouble. Below is a scenario analysis of debt coverage based on varying terms and a weighted average interest rate of 6%:


Commercial real estate bankers look for debt coverage ratios at least above a 1.2 to compensate for market shocks. Currently, I believe they are looking for projects above a 1.5 just to make loans. A look at this chart shows that the US is probably around a 1.5 on a global basis, assuming about 7 year average term and 6% interest rates. We have so much debt that we are paying 2/3 of our income on debt service alone. This is a dangerous figure that can't really continue too much longer.

This is why I ultimately believe that the bankers (The Federal Reserve Board) will choose to print money to save themselves. Inflating their way out of this mess will be the only option to ease the debt coverage burden. They're going to have to print a lot of money to get us out of this hole, and this is where the hyperinflation theory posed by Austrian economists comes in. The bankers will only take so much deflation before they see a need to throw caution out the window and save their asses. I believe we will be coming to that point very shortly as evidenced by Bernanke's speech yesterday at the London School of Economics. He says we've run out of many traditional options (lowering interest rates, TARP, etc), so we must try new options (blatantly printing money).

Will this hurt the dollar? Theoretically, it should, but given that many central banks are doing the same thing, it may not tank the dollar with respect to other currencies. I believe that Asian currencies will perform better because they are not saddled with quite as much bad debt as the US and Europe. I do believe commodities will become more valuable as long as manufacturing picks up. I just do not know the exact timing of this, but the Fed seems to be on the brink of taking massive action to save the banks.

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