May 7th, 2021

Debt and the Three Monkeys

Don't fall victim to the oldest trick in the book.  

Debt is a like a loaded gun. The thing you must consider is whether that gun is pointed AT YOU or you’re the one POINTING IT: 

The conceptual and productive use of debt (pointing the gun) is to advance and increase your own gains via 'interest rate leverage'. That sounds like a mouthful of textbook BS, right? However, it’s actually quite simple when you break it down another way:

Let's say you borrow money at a 5% interest rate from the bank and then make money at a 20% profit margin on the investment of the borrowed funds. You subtract the 5% (cost of the leverage) from the 20% (profit gain) and you get a positive 15% return (total levered return) using the borrowed money. 

Businesses do this every day, in every part of the world, in every industry. They borrow for working capital, inventory funding, building and construction loans for facilities, farm equipment for farmers, etc. They all look to borrow at low rates and then use the funds to purchase goods, equipment, and services to help them increase their return on their borrowing cost. This is the most productive use of debt in our advanced society. This creates the opportunity to grow employment (more jobs), advance technologies (ideas and innovations), take savings and reinvest it into the system (pension funds are usually very instrumental lenders), and build better businesses quicker (leverage allows for growth to be pulled forward). It's pretty easy to grasp that when debt is used this way, it can be very productive and very lucrative.  


Conversely, let's talk about when people and corporations turn the gun on themselves: 

Consumer purchase(s) using debt: If you’re looking to pull consumption forward, you might buy things on credit cards, for example. The average credit card interest ranges from 15%-20% a year. So, if you purchase a TV (an asset that depreciates to zero over time) using a credit card, here's your math formula: $1,000 TV at 15% interest. If you pay it off in a year - your total cost is $1,150 (purchase price plus interest). Then let’s say you sell it for $200. You lost $800 in principal value AND you paid $150 for the right to lose the money. Yikes! 

You can use this same formula for anything that you purchase for consumption: cars, clothing, travel, groceries, etc., are all things that are better purchased in cash. We understand that it’s not always easy to purchase things in cash, but when you don't purchase consumer goods in cash, then you’re paying a PREMIUM interest for the right for those things to depreciate. Let’s not even talk about boats – those are literally the worst investments in the world…we don't even have a math formula to help you with that one! 


Student loans using debt: What if you’re student and you’re looking to acquire a degree in X, Y, or Z and you use financial leverage to acquire it? Let's analyze this strictly from a mathematical standpoint. The first thing you must do is measure the likelihood that you’ll receive a paying job post-completion of said degree and what rate of pay you’ll receive from that position. If you’re confident that you’ll gain full employment swiftly post-completion and that your rate of pay will be sufficient to pay the principal of your loan back swiftly (to minimize your interest), then it makes sense to continue to evaluate the use of leverage for your education. You must then factor the cost of living (where you choose to work) and the cost of your debt (interest rate) into that post- completion formula. If all those previous factors work positively in your favor, then the formula works for getting an education on leverage. 

Many cases here in the last 5 years have shown that the problem with this formula is that upon completion of the educational path, the employment prospectus is not as fruitful, and the education leverage becomes a burden. This is why you have to really analyze pushing the future value of your working life forward and borrowing large sums to go to prestigious colleges and universities. They’ll undoubtedly suggest that you do attend their college or university, but the reality is that they can no more guarantee your employment post-completion than they can guarantee you the amount of hurricanes that’ll form in the Atlantic Ocean next year. They’re not in control of the variables that you’ll face (location, work availability, cost of living, etc.). You have to factor in all of the variables and look at the cost of education on leverage before proceeding with that decision. There are always alternatives to this, you just have to look a little harder for them.


Corporate 'zombie' companies that survive only because of debt: A zombie company officially points the gun at themselves and is just waiting for someone to pull the trigger. The definition of a zombie company is where the firm’s profits DON'T COVER ITS INTEREST PAYMENTS. This means that the only way the company can operate is by refinancing its debt on a revolving basis. To draw an individual comparison, this would mean that at the end of the month, you cannot even cover the interest payment on your credit cards, house, or car, much less the principal payment that month. The only way this can be sustained on a month over month basis is by drawing down on your own principal savings (or working capital in the business example). In effect, these companies are insolvent but are surviving solely on credit, which leaves them susceptible to any interest rate shock or business downturn. Even the slightest downturn wipes them out.

Now...knowing what a zombie company is...would believe us if we told you that 14% of the S&P 1500 are technically Zombie Companies and over 12% of all companies in developed markets are as well? They are. Staggering right? At, we steer away from narrative (qualitative views) and focus on quantitative (statistics, math, and algorithms). This is case and point. Mathematically, these companies (without some rectification of their business models) are insolvent and waiting for the trigger to be pulled. These are prime examples of why debt is a gun. You just have to understand whether you’re pointing it or it’s being pointed at you.  


See no debt. Hear no debt. Speak no debt.

You hear a lot of positive conversation about debt and its usefulness in the media these days. Hence our three wise monkeys reference. The media and narratives would suggest that you 'see no debt, hear no debt, speak no debt'. The modern monetary theory debate isn’t something we really wish to address…it's never worked in 5,000 years of recorded monetary history, but maybe it’ll work this time (maybe it won’t). Our stochastic mathematic formulas give it low probability of success because of the sheer unsustainable debt models of our aforementioned examples. Mathematically speaking, we must find equilibrium (balance) between what we’ll produce in the future and what we’re producing now and can afford. This goes for both us people (taking student loans or buy goods) and us as businesses (taking leverage to increase our profits and drive consumption forward). That requires us to use good formulas and to assess the risk/reward of our potential outcomes and make sure that we measure those in grounded realities.   


Don't fall victim to the 'see no debt, hear no debt, speak no debt' narrative. Debt is real and has both very real positive and negative consequences. We should talk about it and understand it more as a society. Make sure that you’re measuring BOTH the positive and negative outcomes when assessing how much leverage to put on your life and investments.  


Manage debt. Shop interest rates. Do the math and make decisions that are in your advantage. Be realistic with the probable outcomes of your decisions (don't lie to yourself). Don't let any narrative sway you. Use math to think less and invest yourself. Three Monkeys
TagsDebtStudent LoansInterest RatesSavingRetirementFinancial Planning MacroGeneral InvestingBeginning InvestorsThree Monkeys