Nobody really knows for sure when you cross it. A definitive milestone or reliable metric does not exist to identify it. We just know it happens. At some point along the path of accumulating more and more debt, a borrower loses control of its ability to repay it. The borrower crosses the point of no return.
We have found that non-amortizing debt can sometimes lure the borrower across the line.
With debt that amortizes, like a mortgage, a little piece of the principal gets paid off with each monthly payment. The borrower incorporates the monthly principal and interest payments into its budget and, as long as the borrower stays on schedule with the payments, the debt eventually gets repaid.
Non-amortizing debt is different. The principal gets repaid not in small bitesize chunks, but in one lump sum when the loan matures. Many borrowers simply assume the loan can be refinanced when it comes due. By assuming away the principal repayment obligation, the borrower considers its debt service as just the interest payment. The borrower blissfully assumes more and more debt as long as cash flows cover the interest payments.
In the fall of 2008, General Electric was the largest issuer of commercial paper on the planet. Commercial paper is a short-term financing option that matures about every 30 days or so. It was an attractive option for GE because it was incredibly cheap. The proceeds of GE’s commercial paper program funded longer-term assets at GE Capital. In funding long-term assets with cheap short-term debt, GE used the commercial paper market as a source for permanent long-term financing. In doing so, it relied on its ability to refinance the commercial paper as it came due.
We suspect GE did not even consider a scenario where it was unable to refinance its commercial paper. The company simply ignored its obligation to repay the principal.
During the financial crisis of 2008, the lenders to GE’s commercial paper program began questioning GE’s ability to repay its debt. Some refused to refinance GE’s commercial paper as it came due. New lenders were not stepping up. According to Hank Paulson, the U.S. Secretary of the Treasury at the time, GE’s CEO called him on four separate occasions expressing concern about GE’s liquidity and its commercial paper program. Eventually, GE got bailed out by the U.S. Government.
GE had crossed the point of no return long before the Global Financial Crisis. The GFC simply exposed its vulnerability.
In late 2022, Sri Lanka defaulted on debt equal to 67% of its GDP. The country had amassed so much debt that it had no realistic way of repaying it. As interest rates started to escalate in 2022, Sri Lanka’s lenders started to question the country’s credit and refused to refinance Sri Lanka’s debt as it came due. Sri Lanka had no choice but to default, which triggered a financial crisis and deep depression in the country.
Like GE in 2008, Sri Lanka in 2022 was well past the point of no return long before its lenders refused to refinance its debt. Higher rates in 2022 simply exposed its vulnerability.
Once a borrower crosses the point of no return and loses its ability to repay its debt, the financial destiny of the borrower lies squarely in the hands of the lender. The borrower has long ago lost the ability to pay off the lender or grow out of its debt problem. The borrower sits in a no-mans-land waiting for some financial bump in the road that will cause its lenders to question its creditworthiness and refuse to refinance its debt as it comes due. When that happens, the party is over.
Responsible borrowers monitor their debt to make sure they either amortize the principal or carefully manage refinancing risk. Irresponsible borrowers ignore refinancing risk and let their debt grow and compound beyond the point of no return.
Shockingly, lenders continue to lend to irresponsible borrowers that are far beyond the point of no return. Some lenders even let irresponsible borrowers finance interest payments with incremental new debt.
The U.S. Federal Government by this definition is an irresponsible borrower. Its cash flow is not sufficient to ever repay its debt. Not even close. It relies on the capital markets to refinance its debt as it comes due. It is in a no-mans-land at the moment, beyond the point of no return, but before the bump in the road that will showcase its lack of creditworthiness. What that bump might be, we don’t know. But, rest assured, it will come.
