Around the world, consumers are facing challenges not only with the amount of debt taken on in recent decades, but also with the increasing pressure of debt servicing. In addition, interest rates are the highest we have seen in 15 years, approximately between 5.00% and 5.25%.1But to put it in perspective, this is a fraction of the maximum seen in June 1981, which exceeded 20 percent. Getting a proper perspective on debt history is important when navigating financial planning in today's environment.
1950s: The era of the small business reigns
In his book "Between Debt and the Devil" Adair Turner argued that one of the reasons we have had increasing debt with relatively modest GDP growth is that in the 1950s banks primarily lent to small businesses to finance their future growth. Consequently, debt was effectively a tool to stimulate growth, create jobs and lead to long-term prosperity.
In 1953, the Small Business Administration (SBA) was formed to stimulate the postwar economy. While
While the SBA made and continues to make loans to small businesses through banks and credit unions, most of the credit risk is actually borne by the government agency rather than the bank issuing the debt. As such, the banks took comfort in knowing that the SBA had their backs.
Fast forward two decades and society's appetite for risk began to change.
A concept of "risk/return" for credit arises
Before the mid-1970s, much of the investment was focused solely on buying safe bonds when it came to fixed income instruments. The idea of being compensated for something riskier was not used when it came to fixed income instruments until Michael Milken and others developed the market for high yield bonds (also known as "junk"). They changed the conversation from "Is this tape safe or not?" to "Am I adequately compensated for the risk I am taking?"
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These events increased risk appetite and spurred the start-up and flourishing of new industries, such as the rise of venture capital, private equity, high-yield bond funds, distressed asset strategies and risk strategies. event-driven, among others. As these new players in the financial markets grew and showed a willingness to provide capital, either through debt
or capital for growth companies, so that traditional commercial banks lose their importance in the financial world.
Increased regulation also made it harder for banks to compete for higher risk/return loans. Traditional banks turned to the small group of low-margin loans that were considered safe bets. The small volume led to a change in business practices that resulted in banks increasingly lending against assets rather than business.
The rise of business and real estate loans
Until the 1980s, real estate was considered a long-term, stable and slowly appreciating asset class. Demand for houses, apartments, warehouses and shopping centers had grown commensurate with the size of the economy. But as credit became increasingly available and cheap to real estate investors, it ignited a boom in commercial real estate investment.
Before you knew it, skylines across the country were filled with cranes as new towers went up. The math of low interest rates combined with modestly rising rental prices spurred enormous wealth creation in real estate. According to the IMF, US debt to GDP was only 30 percent in 1981, the last time interest rates skyrocketed. In the 40 years that followed, that figure rose to a staggering 115 percent by 2021.
Whether in real estate, private equity, venture capital, hedge funds, or public stocks, this shift in overinvestment behavior when interest rates are low continues in the United States and much of the world. Albert Einstein best summed up this thinking when he said, "Compound interest is the eighth wonder of the world."
Looking for certainty in an uncertain world
If we are to learn from the past, it is that the world continues to evolve and change. As you explore your financial planning options, here are some things to keep in mind.
- Align your debt leverage with the certainty of future cash and cash flows. For example, it is appropriate to place debt against assets with highly predictable cash flows, such as long-term leases with credit lessees. On the other hand, you want to reduce debt or build cash reserves to secure cash flows that are speculative and subject to economic conditions, such as hospitality assets where both occupancy and room rates are unknown. By understanding the security of future cash flows, you can better protect yourself against market conditions.
- Avoid discrepancies between assets and liabilities. Although it may seem attractive, do not take out short-term or variable-rate loans to finance long-term projects, such as construction or business expansion. Instead, try to match the length of the loan to the term of the project you are financing. Always allow a margin for error, knowing that periodically there may be times when credit markets tighten and it may not be possible to refinance your asset.
- Be aware of recency bias. Just because something has worked over the past decade doesn't necessarily mean it will work in the future. For example, past market declines were often followed by some form of stimulus from the Federal Reserve that resulted in a rapid rebound in asset prices. However, we must be careful not to assume that recent history will repeat itself and avoid a "buy the dip" mentality.
- Have a professional assessor test your balance. Have your advisor run scenarios in different yield, interest, tax and credit environments. Many clients feel that they can perform such stress tests themselves; however, we can all be plagued by optimism or pessimism. The involvement of a trusted advisor can create the needed impartiality in the analysis and give greater credibility to the results.
The views and opinions expressed are for informational and educational purposes only as of the date of writing and are subject to change at any time based on market conditions or other circumstances and are not enforceable. This material should not be construed as investment advice or recommendations, does not constitute a solicitation to buy or sell securities, and should not be construed as specific legal, investment or tax advice. The information provided does not take into account the specific goals, financial situation or special needs of any particular person. All investments carry a certain degree of risk and there is no guarantee that an investment will provide a positive return over a period of time.
Amir Mossanen is a registered representative of Truist Investment Services, Inc. and an investment advisor representative, Truist Advisory Services, Inc. Hannah Busick is an investment advisor representative, Truist Advisory Services, Inc.
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