Debt continues to plague the balance sheets of corporate America and U.S. consumers. Not only is debt wreaking havoc in the form of consumer credit cards (think reduced limits and increased interest rates), but the credit crisis is costing corporations billions. Just today, Rio Tinto announced 14,000 layoffs in the face of the crisis. Much of this need to reduce costs was due to their $39B in long-term debt that they carry on their balance sheet. This debt is great when business is good. They can get a low interest rate because credit risk is low because their profits more than cover their debt liabilities. Banks have no problem lending them money and lending them lots of money (sound familiar – yeah, that’s what got us into this mess) because they pay the banks back regularly out of their massive mining profits – everyone wins! But now, banks have turned off the credit spigot. Rates are rising and companies can’t refinance long-term debt. Their interest expenses sky rocket. Profits shrink and suddenly it’s like you’re swinging an axe by its head rather than its handle.
Below is the cost of debt for high yield rated companies. You’ll see how the credit crisis can impact their balance sheet (yes, that is a 2,000 BP increase in just over a year). The cost of carrying this debt in many cases will wipe out profits depending on the level of debt the company carries – and most small companies carry large amounts of debt to finance their growth.
The main reason why these problems are likely to persist throughout 2009 is due to these high debt levels. The entire world is in the middle of a massive deleveraging process. While we’re likely closer to the eye of the storm now than we were when Lehman Bros failed it’s unlikely that the sledding will be any calmer when the other half of the storm hits. And yes, I do believe we are in the eye of the storm currently….
Mr. Roche is the Founder and Chief Investment Officer of Discipline Funds.Discipline Funds is a low fee financial advisory firm with a focus on helping people be more disciplined with their finances.
He is also the author of Pragmatic Capitalism: What Every Investor Needs to Understand About Money and Finance, Understanding the Modern Monetary System and Understanding Modern Portfolio Construction.