What Type of Borrower Are You?
There’s been a lot of talk lately about the future of interest rates. RBA governor, Glenn Stevens, recently issued the following prediction: “Global interest rates are still going to be very low for a good part of the decade ahead.”
St. George Bank’s chief economist, Hans Kunnen, agrees. He adds, “The whole structure of interest rates will be lower over the next decade.”
A well-known mortgage industry executive recently said, “The new norm of the future will see variable rates stay below seven percent, with an average far less than the historical past.”
These insiders are all pointing to one simple fact: the financial markets are now addicted to cheap credit. Low borrowing costs are propping up the value of real estate and shares where most Australians have stored their wealth. If interest rates were to rise, trillions could be lost.
Getting to Know Hyman Minsky
Hyman Minsky was an economist who warned us about this phenomenon decades ago. Having earned a Ph.D. from Harvard, he taught economics at Washington University in St. Louis for over 25 years. Until the global financial crisis of 2007 to 2008, he was mostly ignored.
Minsky argued that the primary cause of a financial crisis is the accumulation of private debt. He believed that asset booms and busts are inevitable in a free market economy unless, of course, governments intervene.
He believed that regulatory measures to prop up asset values, such as artificially-low interest rates, only serve to make the busts more painful when they finally do occur. Unwise investors are gradually drawn deeper into debt through the acquisition of inefficient assets. Eventually, the whole system implodes.
He explained this by identifying three different types of borrowers: hedge borrowers, speculative borrowers and Ponzi borrowers. See if you can figure out which one you are.
1. Hedge Borrowers
Hedge borrowers are the most conservative and efficient of the three. They can fully cover all debt repayments, both principal and interest, from the current cash flows of their investments.
These are the real estate investors with principle plus interest loans on a positive or neutral cash flow property. The rental income generated by the asset pays the borrowing costs and also reduces the debt.
Rather than betting exclusively on future capital growth, these investors “hedge” against the risks of future serviceability and asset value depreciation by gradually reducing their debt exposure.
2. Speculative Borrowers
Speculative borrowers carry greater risk than hedge borrowers. The cash flow from their investments can service their debt, but exclusively on interest-only loans. Their investments don’t produce enough income to reduce the principal amount. Therefore, the borrower must sell the asset before the loan term expires or else roll-over the debt.
Speculative borrowers “speculate” primarily on capital growth, and secondarily on future serviceability. They are betting the asset will either be worth more at the time of sale, or they will be able to qualify for a loan to refinance the debt.
This is the real estate investor who has sufficient cash flow to cover interest-only repayments on their property, but they never reduce the principal.
3. Ponzi Borrowers
Ponzi borrowers take their name from the Italian con artist, Charles Ponzi. He became famous for devising a money-making scheme in the 1920’s by paying early investors using the investments of later investors.
Ponzi borrowers don’t have enough cash flow from their investments to make interest or principal payments. They borrow under the following assumptions:
- Income from other sources will be sufficient to make up for the cash flow shortfall.
- The appreciation in the value of the asset will be greater than the negative cash flow.
These are the real estate investors who are negatively geared. They carry the greatest risk and are the least efficient out of Minsky’s three different types of borrowers. Ponzi borrowers can only stay afloat through the perpetual appreciation in asset prices.
The “greater fool” theory states the price of an asset is determined, not by its intrinsic value, but by an assumption that another buyer will exist in the market in the future who is willing to pay an even higher price.
As long as the Ponzi borrower can find a “greater fool” who is willing to purchase the asset before the bust, the Ponzi borrower is saved. Then the buyer becomes the next Ponzi borrower who perpetuates the folly, until they can no longer find anymore “greater fools.”
Minsky believed the inevitable fall of the Ponzi borrowers would eventually cause the financial system to collapse. When asset prices stop increasing, or worse, when the bubble bursts, the Ponzi borrowers begin defaulting. This can lead to a contagion that eventually takes out the speculative borrowers who can no longer roll over their debts. If the collapse is dramatic enough, the speculative borrowers could even take out the hedge borrowers.
How Should Investors Respond to Minsky’s Insights?
Minksy’s insights can offer the following pearls of wisdom for investors:
- Hedge borrowers should maintain a healthy fear of debt.
If you’re a hedge borrower, don’t assume you’re safe just because you can pay your mortgage while reducing your principle. You still carry risks related to your asset’s performance, as well as the possibility of market contagion brought on by less efficient borrowers.
- Speculative borrowers should seek to improve cash flow.
If you own an asset that can’t produce enough income to cover borrowing costs while also reducing debt, you should either make the asset more efficient or consider selling it. If you are unable to improve the cash flow and choose to continue holding the property, do so with the full knowledge that you can only win if asset values increase.
Also, be aware that a wave of defaulting Ponzi borrowers could someday take you out.
- Ponzi borrowers should consider selling while there’s still a “greater fool.”
If you own negatively-geared real estate, recognise that you’re a Ponzi borrower. Without your salary or business income, and without perpetual capital growth, your investing strategy is unsustainable.
Recognise that asset prices can’t increase forever. If central bankers ever lose control of the system or if interest rates rise, Ponzi borrowers will feel immediate pain. Educate yourself to learn how to redirect your equity toward more efficient assets.
Steve McKnight’s Property Apprenticeship
According to Barclays, Australian households are the most indebted in the world. Our private sector debt-to-income ratio is currently at an all-time high of 206 percent.
In Steve McKnight’s Property Apprenticeship course, we teach investors how to leave the crowd of Ponzi borrowers behind and invest more wisely. To be in total control of your outcome, you need an investing strategy that depends upon your competency and skill, not on the whims of the market gods.
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I always knew my strategy but it was never succintly put as this article has done with the 3 types of investors.
I’m sure many would be quite opposed to being “Ponzi” Borrowers – however they are at least legal in doing so, but should be aware theirs is a house of cards!
It certainly isn’t a flattering title!
“These are the real estate investors with principle plus interest loans on a positive or neutral cash flow property. The rental income generated by the asset pays the borrowing costs and also reduces the debt” – Minsky
I dont think offset accounts existed in Minsky’s time?
Probably not. But whether the surplus goes toward paying down principle or into an offset account, the heart of the issue is how much rental income is left over after paying interest.
Let’s hope that the whole system implodes, the sooner the better as with the current property prices and debt level the whole system is a house of cards propped up by the paternal government. In other countries you can build a whole house in double brick for $50k where in Sydney $50k is a rounding error in the price of an old dump.
What most people do not understand is that our national debt has been increasing by 40-50bn every year since 2008 which combined with the record commodity prices have allowed Australia to escape the recession and prevented the bust in the property prices. The game can definitely go on for much longer as government can add an extra 200-300bn in debt quite easily without anyone noticing which means that some of the so called Ponzi and Speculative investors probably still have time to get in and get out.
It will be interesting to see how long the party lasts. As you say, with each new dollar printed, the chances of a soft landing aren’t getting any greater.
I get the lesson, however if i followed this line of reasoning i would of never got into property investment.
That said i started of as a Pozzi borrower and through both the passage of time and growth in the marked has made me a Hedge borrower.
Know the risks and gamble what you can afford to loose but don’t procrastinate. As you cannot win a game if you do not participate. Nearly every young home buyer goes through the same process on the only difference to me is they live in their investment.
Ray
Point well taken Ray. If you wait for perfect circumstances you’ll likely never start.
Can I ask… what year did you start investing and what were your gross yields like in the beginning?
As an expat living in the states its hard for me to make accurate assessments however…..Sydney is booming at the moment with construction (both private and government), its about appropriate if you compare it to how other economies are operating eg usa or Europe.