PERFORMANCE ANNOUNCEMENT

As Of: August 8, 2003

Good Debt versus Bad Debt

Bad debt is the biggest factor that could interrupt an economic recovery.

      Experienced businessmen use debt to leverage profits. If a business can take the equity in one site and use it to finance four additional sites with 80% loan-to-value debt, the business can grow by 500% simply through borrowing. As long as the business is profitable, and the interest on the new debt does not destroy the profitability, this is a positive use of debt. Over time, the business can use its revenue generating ability to pay down the debt and/or perhaps borrow more to grow more when the growth adds to profitability.

      When a consumer charges a meal on his charge card, there is no revenue generated by the meal that will help to repay the debt. There is no increase in productivity and no asset that can generate income or grow in value in the future. If cash is available to pay for the meal, then using a credit card may only be a convenient substitute for the cash. But if cash is not available, the assumption of new debt to pay for a meal or a vacation or other consumable purchase is a bad use of debt. The assumption of debt without a present or future offsetting gain, weakens the borrower and is a poor use of debt.

      Over the past 50 years, a modest amount of borrowing against residential real estate has been considered acceptable because the debt rate was fixed and most real estate was increasing in value. Due to the fact that the United States was in an inflationary period, the fixed debt could be paid back over time with depreciating dollars while the value of the real estate increased. Even though it is not the same as a business generating revenue, residential real estate debt has been thought of as good debt.

      Most recently, the significant decline in interest rates had the direct effect of driving real estate prices up dramatically. Lower borrowing costs did not make real estate more affordable, it made it less affordable because real estate prices went up far faster than wages or any other measure of purchasing power. However, lower borrowing costs did make it possible for many more people to qualify to buy houses even though prices have been rising. One can argue that just because it is possible to buy a house, that doesn't mean that the property is affordable. These borrowers are often stretched to the maximum, and they typically placed too much debt on an asset that may not appreciate because the price was already driven up too high by the demand created by low interest rates. Worse yet, they may have an adjustable rate loan instead of a fixed rate loan. In other words, the low interest rate policy of the government has pushed the consumer to load up on bad debt.

      The short run gain of low interest rates has been to keep the consumer feeding at the trough. The economy has survived over the past year thanks largely to the housing sector and the flow-through of refinancing to the consumer. The long run disaster may be that an increase in interest rates may stop the consumer dead in his tracks. If that is all that happens, hopefully the economy can start to grow in other areas. But the greater risk is that real estate prices may actually go down, foreclosures and bankruptcies may increase, and the economy could collapse under a huge debt liquidation that unwinds at the same pace as the phenomenal rate of refinancings that we have recently witnessed.

      There are clear signs that the economy is starting to improve. The government has used almost every tool in its bag of tricks to stimulate growth. Whether we move forward successfully or not will depend to a large extent on whether the growth is driven by good debt or bad debt. Growth built on a foundation of bad debt is doomed to ultimately collapse.