Don’t be fooled, debt matters

M&M’s were, as far as us kids were concerned, an inferior effort to copy the Canadian equivalent, Smarties. But while we were busy separating the local candy by colour (not because we were racist, because of the jingle) the American marketers were busy red-herring-ing the issue at hand, so to speak. I began to doubt.

Did Smarties actually melt in your hands? And would that make them inferior? The consternation eventually won me over to the enemy side. The shame of my betrayal haunts me.

Today, I’m a serious chocolate snob (also not a racist thing – except that continental chocolate is by far superior to anything conjured over here, but that’s because we’ve taken the fine art of yummy stuff and Henry-Forded it.) In Europe, it was never lost on yummy-makers that fine chocolate should melt.

My later exposure to the M&M theory of capital structure, through which I waded in my second and third level finance classes, also left scars.

I held my tongue every which way, and never quite understood how Modigliani and Miller’s famous hypothesis made sense. Their proposal said that – subject to an ethereal set of assumptions – the amount of debt carried by a public corporation didn’t matter. And since it didn’t matter, it mattered.

Loading up the balance sheet with loans will give the corporate shareholders an advantage, offloading risk to bondholders, and granting a juicy interest write-off against taxable corporate profits. Of course the idea was as much about theoretical investigation as practical application, I get that, but... say whut?

My fourth year finance professor rescued me. He was a Wall Street guy who landed at SFU for a couple of years while his mother-in-law was dying from cancer, and he was a very special kind of smart. Publishing in academic journals several times a year, his brand of cocky seemed more factual than self-congratulatory.

He was very funny, always poorlydressed, and somewhat greasy-haired, but he could breezily explain the most baffling financial theory without hiding behind hyper-academic lingo. Every lecture turned lights on for me: “Oh… I get it now!”

We clung to his words like Beatles fans. Late in the year, it came as a great relief to me when he quipped something about the Modigliani Miller debt hypothesis being mostly the slippery sort of stuff that fell

from the sky… from seagulls. A shiny new pair of M’s:

Popular amongst populist left-leaning faithful, Modern Monetary Theory (MMT) is also about debt not mattering, and therefore mattering as a policy good, this time at the government level.

The idea suggests that governments and the central banks they influence can just… give’r. That is, spend and borrow in Everest proportions, limited upwardly only by inflation, and currency considerations, ignoring the amount of debt completely. Jonathan Livingston seagull couldn’t have launched a dreamier concept.

His flighty financial advice: “Don’t believe what your eyes are telling you. All they show is limitation. Look with your understanding.”

Splat.

Democratic Party congresswoman, and presidential hopeful, Alexandria OcasioCortez recently announced that MMT “absolutely (needs to be) a larger part often conversation.”

In this mindset, MMT is a sweeping answer to the question: “Other than taking more from the wealthy, (which quickly shows its mathematical shortfalls) how do we pay for our policy of free stuff for everyone?”

The concept brings to mind the Weimarera (post First World War) when wheelbarrows of cash were eventually needed to buy basic foodstuffs.

Canadian household debt – an economic threat looming in the sky like… well, never mind.

According to RBC Economics, “Household indebtedness held relatively steady in Canada in the third quarter (2018) as credit market debt and household income grew at a similar pace.

This steadiness took place at a higher level of indebtedness than previously reported, however. Downward revisions to household income over the past couple of years… boosted the value of indebtedness metrics measured against income.

The revisions in particular led to increases of more than four percentage points in the debt-to-disposable income ratio in 2017 and 2018. The updated ratio stood at 173.8 per cent in the third quarter of 2018, still down from a peak of 174.3 per cent reached a year ago.”

I don’t think any reader needs a lecture on the many ways this kind of debt matters, but here’s one point that applies to all loans.

Interest rates often go up when we can least afford them, because low interest rates attract excessive debt.

For example, according to Stats Canada, the total number of insolvencies in April 2019 was 9.6 per cent higher than the total number of insolvencies in April 2018. Consumer insolvencies increased by 9.3 per cent, while business insolvencies increased by 21.4 per cent.

Let theories be provocative, but let principles be grounded. Debt matters.

Mark Ryan is an Investment Advisor with RBC Dominion Securities Inc. (Member–Canadian Investor Protection Fund), and these are his views, and not those of RBC Dominion Securities. This article is for information purposes only. Please consult with a professional advisor before taking any action based on information in this article. See his website at: http://dir.rbcinvestments.com/mark.ryan.