Collectively, Americans have accumulated a mountain of public and private debt in the past 20 years. The essential nature of all debts is that they someday must be repaid. Debts can be broken down into three categories:
The Good. This is debt with low fixed interest rates, secured by tangible assets that have value that exceeds the amount of the loan. Everything is copasetic as long as the borrowers have a steady cash flow and can make their payments
The Bad. This is debt that is either insufficiently secured, or that has a nasty contractual surprise waiting, such as an adjustable interest rate reset date, or a balloon payment date.
The Ugly. This is the call loan. It can be called at any time, for any reason.
An interesting thing happens when an economy heads into a deep recession. Credit tightens, and assets begin to lose value. The quality of debt drops. Employees get laid off in large numbers and installment credit delinquencies and then defaults soar. In very rough terms the following plays out:
Good Debt starts to resemble Bad Debt,
Bad Debt starts to resemble Ugly Debt, and
Ugly Debt becomes Hideously Ugly Debt.
Hedge fund managers are in some ways like high states poker players. The risks are large, but so are their potential rewards. Well-managed hedge funds make gobs of money in good economic times, when there are stable–or at least trend-predictable–interest rates. They apply leverage, often as much as a 30-to-1 ratio, to make their profits. They make most of their money by borrowing short but lending long. Again, this works fine in good economic times with stable interest rates. But when interest rates fluctuate wildly, hedge funds can run into trouble. Periods with an inverted yield curve can be the most perilous.
The collapse of the subprime mortgage bubble signaled an end to a decade of debt-driven good times. Almost overnight, liquidity dried up.
Now we are entering some very scary times. Bankers are getting margin calls. The only way that they can meet those call demands is to call in loans that they have made. So, at present, the bankers are making margin calls of their own: They are calling their loans made to hedge funds (among other borrowers). This is putting many hedge funds in an impossible situation. Many hedge funds will collapse.
There is an old saying on Wall Street: “A one million dollar debt keeps the borrower up at night, worrying. But a one hundred million dollar debt keeps the lender up at night, worrying.”
Exceptional times like these will result in some huge write-downs and write-offs. The only good news is that many assets will lose a lot of value. Everything from vintage cars to vintage wines, to grand estates will drop precipitously in price. Desperate for cash, the holders of those assets will be offering them at fire sale prices at the bottom of the market. If you are one of the few people with extra cash in your pocket, you will be able to pick up some tremendous bargains. (OBTW, the firm J.P. Morgan just did exactly that. They just inked a deal to buy troubled Bear Stearns for 2 cents on the dollar from its value of just one week ago.)