Why bad debt matters

This is the financial equivalent to the crazy uncle in the basement...something no one talks about or understands. It is bad debt.

Bad debt is a very different animal. Ask someone that is not in the business to define it and they'll get it wrong. Bad debt, also called charged-off debt, is the direct result of a customer not paying their bill. It is not past due debt or delinquent debt. It is debt that the customer has never paid and your company has fully reserved for the debt and your company now carries debt that is a net $0 value.

Let's take an easy example. Say your company revenues are $100. The average company makes about 10% or $10 in after tax profit. Built into this number is an expense to cover the cost of the part of the $100 in sales that are never collected. To be very simple, say that 1% or $1 has been expensed and charged to the bad debt reserve and the 10% net income is after this expense.

Next, assume that your company is public and trades for 20 times earnings. Your stock is worth 20 times $10 or $200.

Now, let's say that your bad debts go from 1% up to 2%. This is commonly referred to in the media as "only up 1%". It seems insignificant and nothing to talk about. Dismiss it. It's lost in the details. What are you worrying about?

He's why you should be very concerned. If the bad debt goes up from 1% to 2%, that means that your earnings have gone down from $10 to $9, or 10%. Your stock price has just gone from $200 down to $180.

Does that seem important to you? Now imaging that this bad debt goes up another 1 or 2 percentage points. This is real erosion of your stock price or market capital. All due to just a few more consumers and companies not paying their debt.

Most people think of this debt as mortgage debt because that is all the rage in the financial media. There is also auto loan debt, consumer debt, RV debt, boat debt, lines of credit, HELOCs, payday loan debt, signature loan debt, utility debt, property tax debt, bad check debt, overdraft fee debt, parking ticket debt, speeding ticket debt, library debt, medical debt and credit card debt.

And that is just the consumer side.

Don't forget commercial debt. Oooops, forgot LBO debt and derivative debt.

The point is that every dollar of unpaid debt destroys a much larger amount of capital. When that capital goes down in value, transactions based upon that asset value decrease in value. It's the equivalent to the "Dead man's spin" to a pilot.

The FED knew this when they bailed out the banks and the investment banks. These folks cannot earn money quickly enough to rebuild their capital base without significant FED intervention. Without the $400-$500B provided by the FED, many, many more banks and investment banks would have been in the trash heap by now.

Since the FED is taking care of the banks and the IB's, just who will take care of the consumer credit issuers, hhhhmmmmm?

So, next time someone says that debt charge-offs are up "just 1%", you now know that this is a rather nasty increase. Knowing this, financials are a very difficult long position right now as every bank, by its nature, makes loans and is exposed to the declining ability of both consumers and companies to service their debt.

Last point, now add into this equation just a slight drop in disposable income, due to, say, oil, food, taxes or some other such insignificant expense. Since disposable income as a percentage of gross earnings is at exceptionally low levels, just a small increase in expenses drives disposable income into the ground. And it is this very disposable income that allows you to service your debt.

Such simple circular logic, really. And now you know. Sleep well.