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.

Did I mention Part Two of the "Black Gold Rope-A-Dope"?

Remember that owners, more than likely, are also speculators.

Accepting this premise, and acknowledging that there is enormous wealth (growing exponentially) controlled by oil owners and related sovereign wealth funds, this might lead one to conclude that even free markets may be moved (up and down) with relative ease by a very few.

Should this ring untrue, remember the huge silver bull market nearly 30 years ago when silver spiked to more than $50/oz. Members of the Hunt family had essentially full control of the delivery of silver. This was not acceptable to people with even more money than the Hunts and the rules were changed in the middle of the game, forcing several members of the Hunt family into virtual financial ruin.

Think this process can't happen again? It's happening right now as new rules have been discussed and proposed regarding futures trading of food related commodities. It should be noted here that the oil owners have accumulated far more wealth than the food commodity owners and these rules changes have not yet been proposed for oil.

Besides, it couldn't work anyway. Money goes where it is wanted. Over-regulate trading in the US and the trading will move elsewhere.

The current oil price hearings in the House right now are a side show - a game of "Three Card Monte" - for the entertainment of the American voters.

"Something must be done!"

"Something will be done!"

Our trusted, elected officials will ask even more insightful questions such as "Did you make more than $4m last year in salary?" to the heads of Big Oil. That will show Big Oil and the voters we are serious. Quick, ask them another question so that we can adjourn and get back to campaigning.

Which rules do you think will change first?

Just another thought about oil.

How are oil prices determined? Is it "Big Oil", oil executives, speculators, the "Government"?

There is no ambiguity. You'll never need to ask this question again. Here is the only complete and correct answer.

The only people that know where the price of oil is going are the folks that OWN the oil.

This is so simple, it defies logic that anyone even asks the question. Owners can raise prices until they squeeze out the last drop of profit. They can take the world to the brink of ruin. The world reacts and begins to kind of maybe think about thinking about maybe doing something about improving a completely dysfunctional energy policy. Just after investments are made in other energy sources, the owners WILL LOWER THE PRICES to make these alternative investments no longer financially feasible. New energy goes belly-up, and the owners RAISE THE PRICES again, only MUCH higher this time.

Black gold rope-a dope.

Holy sweet crude, Oil Man, this isn't news! The owners have done this EXACT SAME THING several times before to us. Are our brains so filled with useless crap and crippled with media induced ADD ("Speed Racer" comes to mind) that we can't remember what the owners have done to us over the last 35 years? Have we no long term memory?

Consider yourself completely armed for the next idiot that asks you this question. Be swift, be merciful, put him out of his moronic misery...and don't let him breed!

With all due credit to George Carlin, circa last century, these are the seven deadly words today...Inflation, stagflation, recession, depression, peak oil, sub-prime and gold. I believe that Carlin also hyphenated two of his words.
No one is to speak of these words. And never in threes (think "Beetlejuice" and you get the idea). God forbid that a politician, ANY politician, should utter any of these words. We might actually begin to understand the enormity of our dilemma.
More liquidity? More inflation, higher gold, higher oil, lower dollar.
Lower rates? More inflation, higher gold, higher oil, lower dollar.
More bailouts? More inflation, higher gold, higher oil, lower dollar.
No bailouts? Recession, Govt. and FED try to stop it, more liquidity, more inflation, higher gold, higher oil, lower dollar.
I sense a pattern...let's see...gutless and down right stupid politicians (both parties please step forward) making horrid decisions to further their careers and appeal to the unwashed and uneducated voters. Nearly 50% of voters pay little or no federal income taxes soooooooo...that means that this 50%+ can vote for the remaining 49% to support them virtually without consequences. Since these voters don't have to work for it, environmentalism, global warming and tree hugging sound like good things to be "for". Therefore, we are "for" these causes with no plan to deal with the effects. Pols know this so they either intentionally or unintentionally pander to this block.
Oil companies-bad, profits-bad, polar bears-good, environment-bad...or good...depending upon perspective. Suspend gas tax for summer-good, build refineries-bad, beg the Saudis to produce just a few drops more oil-good (but not for our national stature). Nuclear-bad.
I really think every putz in Washington needs a basic class in cause and effect.
Today would be the effect. The cause has been happening for many years. No new nuclear plants for 30 years. No new refineries for about half that time. Can't drill off the coasts even though China and other countries drill just outside our national waters. Now we wonder why this happened all of a sudden. Oil goes up, jobs go away, the economy is "sluggish" (Did you ever think about the derivation of the word "sluggish"? To be like a slug. In this context, it sounds just a bit more repulsive rather than politically correct.)
This is all about supply. We have not even touched the surface of demand. 85m barrels of oil produced each day, 85m barrels of oil consumed. If you remember your basic college economics, the moment that there is 1 more barrel of oil demanded than there is supply, the incremental price of that barrel is indeterminate. It is what anyone can or will pay. And the price does not have to go up gradually. Just look up or remember the 1973 and 1979 oil crisis.
Everything old is new again and here we are with all kinds of causes and all kinds of effects. Only this time, the world is playing the game at the same time.
By the way, the peak oil for the US occurred in the mid-70's, more than 30 years ago. No one said we were quick studies...

If anyone thinks the financial crisis is over, then why are the banks and IB's selling their LBO debt at deep discounts AND financing the transactions at capital costs BELOW their actual cost of capital (not counting the gifts from the FED)?

The FED's money is the Treasury's money and the Treasury's money is YOUR money. Sooo...that means that the banks are using your money to rid themselves of problem debt and finance it at cheap rates subsidized by you.

But, then again, it's only a problem once everyone figures it out.

Just don't ask the question "Exactly how much debt do we owe?" While relevant, it's not immediately life threatening. It's like saying "OK, we owe $1mm and we make $100k but I can afford the payments."

But don't EVER ask the question "And just how much does it cost to service that debt?" This question is just a bit more timely, like a femoral laceration. This is the same as "Holy Cow! If I add up all of my mortgage debt, car loans, credit card debt, boat loans, second home mortgage, HELOC's, RV loans, credit lines, student loans (that I am paying for my kids), payday loans to cover the past due credit card payments, property taxes, con summer loans to pay for the new furniture and plasmas and any anything else that comes out of my paycheck, I might have just a weeeee problem here." Time for the wife to work a double at the Thrifty Mart.

OK, think of that and then add lots and lots and lots of zeros and you begin to get the idea that consummers and the government might be in the deep end with lead flippers. Or, just don't ask...

Don't believe everything you hear about "core" inflation and the "CPI" rate. Try going to the Bureau of Labor Statistics web site (bls.com) and take a look at the rates of inflation for various goods and services. I love the fact that the only thing that was cheaper in 2007 was apparel as that was virtually all made in China.

And don't talk about wild extrapolations. Inflation is worse now than in 2007. Go to the grocery, buy gas, take a vacation, pay your utilities or try to get a job in trucking.

Also, remember that inflation has the greatest effect upon average Americans as this group (no matter how you define "average") has the most fragile disposable income and is the most exposed to daily expenses of fuel and food. Oh...that's right...the government DOESN'T count food or fuel in their posted inflation rates.

But you DO eat and drive, don't you? And don't listen to the line of BP (bull poop, for those with sensitive ears) saying that inflation is only when the dollar declines. Any time your purchasing power declines, whether via dollar decline or demand/supply imbalance, you get less for each dollar you earn and that is inflation.

To make matters worse, we have virtually no pricing power when it comes to wages, due to globalization, so we are left with price inflation, stagnant wages, shrinking purchasing power, tighter credit, declining home prices and less disposable (and savable) income.

When has this combination ever been bullish? Can the market really see into the future six months and this bull rally is really a vision of future bounty? Well...NO...if the market was so darn good, you would have not had the collapse of financials and Bear Sterns.

So, the lesson of the day is do your research, trust the facts (when you can find them) and see how your financial life is changing. If you expect to be better off in six months, then maybe the market can see the future. If you are not so sure, then why are you long financials? After all, you must be betting that the FED will continue to lend against (really buy, but that is another story) bad mortgages, the Department of Education will buy bad student loans, some agency will buy bad credit card debt, the Department of Are You Kidding Me, You Spent How Much on that Boat? will buy bad boat loans, the Department of Commerce (I'm running out of Departments) will buy bad corporate debt, the Treasury Department will buy 1/5 of 1% of bad derivatives (did I mention that amounts to about $1T US dollars?) and so on and so on...

The only full employment job category in the nation is printing press operators...pass me the oil, boys, she's gonna blow....

By the way, welcome to our new fans in Oklahoma City, Chicago, Detroit, Ft. Worth, Dallas, Houston and around the country via podcasts and simulcasts.