In 2008 the financial world, as we know it, changed.
Many of the principles we were taught were invalidated, it seemed.
Save for retirement and live happily ever after was the conventional wisdom. Then the market crashed!
In his book "The Age of Turbulence", Alan Greenspan discusses the importance of the rule of law in a healthy economy. Dr. Greenspan notes that the vast majority of business transactions go through normally because of trust and the "rule of law".
But what if the rule of law changes such that the circumstance under which normal commerce is undertaken becomes disrupted?
In Michael Lewis's book, "The Big Short: Inside the Doomsday Machine" he effectively questions the very assumptions under which businesses evaluated risk, particularly credit default swaps.
Yet the sudden increases in debt forgiveness, starting with the GM bankruptcy have wreaked havoc with the traditional understanding of debt versus equity, of stocks versus bonds.
Students had been taught that debt was a cheaper form of financing for a corporation than equity capital. Quite simply, interest was tax deductible, dividends were not.
Traditionally, financial advisors advised clients that as one was closer to retirement, you should consider shifting some of their investment funds into bonds (debt of the issuer) rather than equity. Bonds were considered less risky than equity investments. The principle portion of debt was considered "safer" than equity because of debts preference in bankruptcy.
Investment managers were advised, by legal counsel, that it was prudent for a trustee to invest funds in a "balanced portfolio" of debt and equity that reduced overall portfolio risk. A fiduciary's responsibilities under ERISA are very clear and specific and include a "prudent man" rule such that an advisor must act with care, skill, prudence and diligence under the circumstances.
Then came 2008 and the next bubble burst!
The General Motors bankruptcy saw massive debt forgiveness as a result of the bankruptcy and the value of GM bonds were decimated.
Just recently in 2012 when GM reported record profits, the President touted the great success of the GM emergence from bankruptcy. What was not mentioned, by the President, was that GM did not survive bankruptcy. A new company emerged but in the process of the bankruptcy over $100 billion of debt was forgiven.
In 2012, a write-down of Greek debt occurred which allowed Greece to avoid default. Over €100 billion were written off in this transaction.
Bondholders of other euro zone debt must be equally concerned about the solvency of the various European sovereign debt. Even the United States debt rating has been downgraded.
To further exacerbate the debt fiasco, over $2 trillion of toxic assets are still held by the Federal Reserve, Fannie Mae and Freddie Mac.
The conventional wisdom in academia and in business has been that bonds are a cheaper and safer form of investment than equity for the investor.
When a bond only has the ability to earn an interest rate with no upside earnings potential, are bonds a "prudent" investment. If the principal of the bond is not assured and given priority claim over other debts and equity, the very valuation models for the bond instrument become invalidated.
The Greek settlement was no better. Nor was the Fannie Mae and Freddie Mac settlements any better for the long term survival of our economy. All that has been done is to undermine the very foundation of the "rule of law" that Dr. Greenspan describes in his book as being essential to the normal functioning of an economy.
In reviewing the number of publicly traded companies that pay dividends in excess of a 3% yield (over 1000 companies) when yields on "safer" federal bonds issues are far less, one must question whether or not a fiduciary is being responsible by investing in a bond let alone a government bond. I would think that the fiduciary is being "prudent" should the bond repayment be relatively assured; however, when the value of the bond is undermined by the courts or government then the soundness of a bond must be questioned.
The implications of the undermining of the value proposition of the bond and the "rule of law" are severe.
First, for the investor, the value of investing in bonds will have been severely degraded.
Second, for the fiduciary in considering an asset allocation, for which bonds are included in the portfolio, may no longer be truly "prudent" when dividend yields on equities are so much higher than fixed income yields.
While with an equity investment there is downside potential, there is also upside potential. With the bond there is only downside risk. The risk of default and inflation as well as the lack of security of the underlying bond, when impaired, make a bond potentially a negligent form of investment for a fiduciary under the circumstances we have in today's markets.
Third, the ability of governments to raise debt financing may become impaired when the principles of commerce are undermined. In that event, the economies of the world will become severely deleveraged immediately as investors scrambled to the "safety of equity" markets!
The only issue that is preventing continued massive deleveraging of our economy and a depression from occurring is because no one knows where they can invest safely.
If the President and Congress are serious about stabilizing this economy, they must work together to reestablish the rule of law which permits debtors and creditors to engage in commerce with the rights of both groups protected and respected.
When people or institutions are vilified because they have lent money they will stop lending. Perhaps this is why our economy has not yet recovered. Our economy will not recover until our government reaffirms the mutual rights and responsibilities of both debtors and creditors and reestablishes a stable, balanced "rule of commerce".
Col. Frank Ryan, CPA, is a retired Marine Reserve Colonel and served in Iraq and briefly in Afghanistan and specializes in corporate restructuring and lectures on ethics for the state CPA societies. He has served on numerous boards of publicly traded and non-profit organizations. He can be reached at FRYAN1951@aol.com