The ugly end of our great debt delusion: Kohler

The problem with debt is that it makes you feel richer than you really are.

Eddy Groves felt rich – he drove a Ferrari and in 2006 topped the BRW Young Rich List. Now it turns out that not only he was not rich at all, but his business wasn’t actually making money. In fact many of ABC Learning’s childcare centres are losing money and will have to close without Government support.

Phil Green and everyone at Babcock & Brown felt rich – last year Green was officially worth $442 million. This year Babcock has turned into a smoking ruin in the hands of its bankers and seems certain formally to go into receivership today or the next day (see accompanying story Finance and property giant on the brink of collapse).

Australia’s car dealers all felt rich too. They arrived at work each morning smiling the satisfied smiles of the well-to-do as they surveyed the serried ranks of their gleaming stock.

In fact we now discover that the stock is all owned by finance companies and has been overvalued. We know it is overvalued because now that two of the financiers with 40% of the market are pulling out, nobody else wants to take over that debt and the industry is in crisis.

The dealers need the Government to step in and finance the overvalued cars on the showroom floor so they don’t have to be sold for what they are really worth.

That’s already happening with housing debt. This week the Australian Office of Financial Management announced two mandates totalling $996 million for the issue of residential mortgage backed securities under the Government plan to buy $8 billion of the things.

It’s a worthy, but ultimately futile, attempt to keep the housing illusion going a bit longer. If the RMBSs were worth their current face value, banks would buy them and the Government would now not have to.

It’s not that banks don’t have any money – it’s that they no longer trust the value of the security, and the ability of the customers to repay the loans.

The housing and car industries, as well as the childcare industry (we now discover), have been propped up by debt for a decade. They were movie sets of plywood and polystyrene, appearing solid, but merely façades.

Governments must now replace the banks in propping up the plywood – or not.

More broadly, global economic growth has been fuelled by asset price inflation and rising debt for more than two decades.

In a sense, the entire world felt rich like Eddy Groves and Phil Green; driving a Ferrari and spending up large. But when the debt stops coming, the illusion disappears and the true value of the assets and the true cashflow become clear – and therefore the true wealth.

In the past year, asset price deflation around the world – of shares, businesses and property – has been dramatic and devastating, especially for those with margin loans (as opposed to mortgages).

This is now being joined by recession and deflation in the prices of consumer products, which will begin an awful process of increasing the value of debt at the same time as the value of the assets declines.

It will also lead to rising unemployment and falling incomes, which will lead to “margin calls” for those with mortgages. Many of them will join margin borrowers in distress.

Since it launched exactly 12 months ago, and especially in recent days and weeks, Business Spectator has been looking closely at many aspects of this process, 24 hours a day.

For example, yesterday I wrote about the appearance of consumer price deflation (Deflation is our new risk). The day before I examined the amazing world of synthetic CDOs, that have been used by banks to insure themselves against the very defaults they encouraged by lending too much against inflated asset values.

But really, every story these days is about the same thing; the unwinding of the great debt delusion.

Today in Australia it will be the collapse of Babcock, the biggest and messiest so far; in the US it is the crisis at Citigroup, as its shares fall more than 20% in a day despite chief executive Vikram Pandit’s announcement on Monday that 52,000 staff will go.

It shows that even as phase two of the crisis – recession and deflation – get underway, phase one – the unravelling of the financial sector – is still playing out.

As I suggested the other day, perhaps the vast bank insurance scheme known as synthetic CDOs will recapitalise the banks and end phase one. Many expert correspondents to Business Spectator’s The Conversation tell us that it won’t be that simple.

This article first appeared in Business Spectator