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HomeInvestingDon't Finance Long-Term Assets with Short-Term Debt

Don’t Finance Long-Term Assets with Short-Term Debt


By Dr. Jim Dahle, WCI Founder

Warren Buffett is famous for saying, “Only when the tide goes out do you learn who has been swimming naked.” He meant that you don’t learn which investors and investment managers have been taking on too much risk until there is a downturn. There are many risks in investing, but one of the most serious is leverage risk. Leverage risk is when you borrow to make an investment but then cannot service the debt long enough for the investment to pay off.

One of the most important aspects of investment and debt management is ensuring you do not finance long-term assets with short-term debt. This seems so obvious. Imagine if you financed your medical education with two-year loans. Suddenly, you hit your MS3 year, and you have to pay off (or at least refinance) the loans you took out your first year. But interest rates have gone through the roof, and your debt-to-income ratio is infinite. And frankly, given your USMLE Step 1 score, maybe you’re not a good bet for a future high income. It would obviously be stupid to have debt like that.

Likewise, you wouldn’t buy a house on a credit card with a 0% 12-month deal. In 12 months, that interest rate is going to go from 0% to 19.9%, and you won’t be able to afford the payments. This was basically what was behind the 2008 global financial crisis. People took out NINJA (No Income, No Job, no Assets) loans, usually in the form of Adjustable Rate Mortgages (ARMs), and then these terrible loans were packaged up with a bunch of others and rated as high-quality debt. When the rates adjusted, it all blew up. People lost their houses. They stopped making payments. The investors lost their money. Money market funds started worrying about breaking the buck. Banks failed. The economy went in the pot, and 20%-50% of our retirement funds evaporated over a matter of weeks.

 

Attractive vs. Not Attractive Debt

One of the few educated proponents of using debt to invest is Thomas Anderson, author of The Value of Debt series of books. He argues that you should limit your debt to 15%-35% of assets, and he also recommends you use

  1. Long-term
  2. Low interest rate
  3. Fixed
  4. Secured
  5. Deductible
  6. Non-callable

debt to do so. There’s a lot in that statement. Some debt is more attractive than other debt.

Long-term assets include such things as your education, your residence (most of the time), and investments like stocks and real estate. Owning these things is likely to provide you with a very nice return but only in the long run. In the short run, it’s a coin flip. A gamble. Maybe it goes up in value; maybe it goes down. Thus, financing them with short-term debt can occasionally leave you sitting there needing to do something about the debt while the value of the asset is down.

This is the problem with investing using a margin account at your brokerage. You’re buying long-term assets (stocks) with short-term (because it’s callable) debt. It’s far better to get a 30-year non-callable mortgage (even at a higher interest rate) against an investment property and buy stocks with that than to open a margin account.

Two recent examples demonstrate the importance of not financing long-term assets with short-term debt.

More information here:

How to Leverage Debt; The Best Ways to Use Debt to Your Advantage

Should You Pay Off Debt or Invest?

 

Example #1 – Silicon Valley Bank (and Others)

med school scholarship sponsor

Silicon Valley Bank took in deposits from numerous companies, entrepreneurs, and individuals. However, these deposits were all essentially short-term. The depositors could request back their money at any time. Essentially, it was callable debt. What did the bank do with it? It bought long-term assets—in this case, long-term Treasury bonds. Sure, if SVB could hold on to those Treasuries until they matured, it would get all of its principal back.

However, when rates go up, the value of bonds goes down. So, being forced to sell Treasuries after rates rise might mean selling them at a 10%, 25%, or even 40% discount. The bank used short-term debt to buy long-term assets, and when rates rose, Twitter went nuts, there was a run on the bank (i.e. the tide went out), and SVB was found to be swimming naked. It required the government to step in as it sent tremors throughout the financial system.

More information here:

Lessons Learned from the Silicon Valley Bank Meltdown

 

Example #2 – A Single-Family Housing REIT

There was a private fund/REIT that invested in single-family homes that was, until 18 months ago, one of our partners here at WCI. The company paid us and we introduced it to our audience. I even invested a little money with it, as did a number of other white coat investors. I liked the people and the investment plan. The basic premise was to buy a bunch of single-family homes and rent them out. The investors would enjoy the income, would probably see some long-term appreciation, and would never be called about clogged toilets. As a long-term asset, the value of these homes will fluctuate, but in the long term, you expect a nice return on the investment.

The underlying investment wasn’t the problem. The problem was the way it was financed. The “capital stack” was composed of equity at the top (i.e. my money), followed by some preferred equity from another fund, and then the senior debt. That’s not so unusual. The debt was mostly (about 80%) fixed. The other 20% was floating. That wasn’t so hot when rates went from 4% something to 9% something, but that wasn’t really the main problem. The main problem was the preferred equity.

Apparently, the preferred equity fund had been granted a call option, i.e. the option to call its capital even before the REIT was ready to pay it back. After rates dramatically increased in 2022, the preferred equity fund exercised that option. By granting this call option, the REIT was essentially taking on short-term debt. But the underlying asset, rental homes, is a long-term asset. When the tide went out, the REIT and its investors were found swimming naked. The preferred equity fund seems to be willing to be patient enough to make sure it gets its money back, but not patient enough to allow the fund enough time for the equity investors to get their money back.

This story isn’t over yet, but the consequences so far include:

long-term assets with short-term debt

    1. Business plan interruption (the REIT is no longer accepting new investments nor buying rental homes to add to the REIT).
    2. Suspended liquidity for investors (i.e. they’re stuck along for the ride however this turns out).
    3. No dividends, at least for a while (all cash flow from the investment is going toward paying off the preferred equity fund).
    4. Being forced to sell some (probably all) of the homes in the portfolio at discounts ranging from 8%-20%—which, after leverage, means a loss on the sold homes ranging from 27% to more than a total loss.
    5. Reputational loss for the REIT, its managers, and anyone associated with them (including WCI).

While it is not yet clear how much investor principal will be permanently lost (latest estimates are 87-100%), better debt management would have minimized it and perhaps allowed the REIT to continue operations. The REIT should not have financed long-term assets with short-term debt. The managers thought they would be able to refinance that preferred equity at good rates. That money was kind of being used for a short-term purpose (to do renovations and other “value-add” activities that would increase the value of the homes), but the underlying asset was still a long-term asset. Management was only planning to have it for a little while, and it seems to have been surprised when the preferred equity fund exercised its option. But when rates rose and the preferred equity was called, the tide went out, and guess who wasn’t wearing swim trunks?

 

Be careful with debt in your life. Nobody ever went bankrupt without it.  Think about debt properly. The debt-free life has its benefits. And remember: when taking on debt, don’t finance long-term assets with short-term debt.

What do you think? Have you made this mistake? Did you get away with it? Comment below!



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