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Debt as Diversification

This piece originally appeared in the May 2023 edition of MortgagePoint magazine, online now.

Although debt can be a useful tool to solve pressing problems, it often has serious long-term consequences that can last for years or even decades.

The global history of government debt run amok runs as long as the institutions have existed, but let’s focus a bit closer in time for context. In World War II, when Britain was fighting against the Axis powers, the monarchy needed a ton of capital to finance the war efforts. To meet this need, Parliament borrowed extensively from Canada and the United States.

Conventional fiscal theory usually agrees that a country’s economy begins to slow down once its debt-to-GDP ratio exceeds 77%, which Britain blew past during and after the war; they eventually accrued nearly $10 billion in debt by 1945 and hit a staggering 200% debt-to-GDP ratio.

Debt that’s twice a country’s entire annual output is definitively not a good thing, particularly when you have infrastructure to rebuild and industry to restart. For about a decade after the war, Britain’s economy was severely hampered due to its outstanding debt. Ultimately, state privilege meant that British taxpayers bore the brunt of the debt costs, paying hefty taxes annually in service of the country’s wartime debt. In fact, it took until 2006 for Britain to make its final payment.

Although Britain eventually rebounded from its debt burden, many countries with high debt-to-GDP ratios struggle for decades before rebounding. For example, Argentina defaulted on over $100 billion in debt in 2001 when its debt-to-GDP ratio reached 156% and an eventual $100 billion default. Other countries like Greece, Zimbabwe, and Venezuela have also stared down the barrel of a series of serious economic challenges induced by debt.

Emerging markets aren’t the only ones impacted by hefty debt, as we saw with Britain in World War II, but the truism remains in the present day. Here in the United States, our economy has historically been on enough of a solid footing, being large and constantly growing, that taking on tens of billions of dollars in debt hasn’t had a significant impact.

In 2005, despite ongoing war efforts, the United States’ national debt-to-GDP ratio stood at a stable 60%. However, during the 2006 financial crisis, the country had to take on trillions of dollars in debt to boost the economy, which resulted in a debt-to-GDP ratio of 106%. More recently, the COVID-19 pandemic has had a significant impact on the U.S. economy, further increasing the debt-to-GDP ratio. As the pandemic peaked in Q2 2020, our ratio also peaked at around 134% before settling to the comparatively modest (but still high) 120%.

Economic Overview
It goes without saying that the COVID-19 pandemic had a major effect on U.S. government debt. To offset the economic impact, the government put into effect stimulus measures including the Coronavirus Aid, Relief, and Economic Security (CARES) Act which, provided cash infusions for individuals, businesses, and state and local governments. These actions led to a big rise in government spending and a concurrently significant increase in government debt.

As of 2022, the U.S. national debt was over $30 trillion and is still increasing. Even though it’s improbable that the United States will default on its loans, the high debt ratios are likely to cause lower economic growth, higher taxes, reduced funding for programs, and economic insecurity—some of which we’re already seeing, and the impacts of which will no doubt echo throughout the remainder of the decade.

Increased government debt has a knock-on effect on the macroeconomic environment, which can have serious repercussions on the average person’s financial well-being.

One of the most evident impacts is in consumer debt markets, specifically when it comes to mortgages.

Higher interest rates and inflation make it tough for borrowers to make their mortgage payments, and the issue is compounded as the previously hot real estate market cools and makes quick sales difficult or impossible, leaving many underwater on loans they can no longer afford. This, in turn, can lead to an increase in mortgage defaults and foreclosures, which can have ripple effects throughout the economy.

However, those ripple effects also offer an opportunity for investors to renew and reinvigorate struggling economies while diversifying their portfolio—an investment in both human and financial capital.

Distressed Debt, NPLs, and REOs
High debt ratios can also present investment opportunities, particularly in the distressed debt market. Distressed debt investing, which includes nonperforming loan (NPL) and real estate-owned (REO) investments, are becoming increasingly safer despite a higher default rate as digitization and technology create new, advanced, and sophisticated markets with substantial liquidity.

In real estate, distressed debt is debt tied to properties that are in financial distress, such as foreclosures or bankruptcies, both of which are rising. NPLs and REO assets are two forms of real estate distressed debt. NPLs are loans that are in default or at risk of default, while REO assets are properties that lenders have foreclosed on and now own. Investors who specialize in distressed real estate debt may purchase these assets at a discount and work to recover the underlying value of the property. This can involve restructuring the loan, working with the borrower to find a solution, or selling the property to recover some or all the lender’s investment.

In many communities, investors and management firms are leveraging REOs and NPLs, stepping in to fill the gap and keeping communities stable while providing options and opportunities to families in financial despair.

 Distressed Debt Today
In particular, the number of delinquent FHA-insured high-risk loans is a cause for concern, particularly among those who were hardest hit by the COVID-19 pandemic.

As the ramifications of forbearance ending come to fruition, many of these borrowers may face foreclosure or need to sell their homes. This is happening while individual debt is increasing, creating undue financial pressure and stress on underrepresented blocs of American citizens.

As of January 2023, the delinquency rate for FHA loans, mortgages insured by the Federal Housing Administration, was nearly 5% and represented a steady increase throughout the year. This means that over 1 in 20 FHA loans were delinquent and either in foreclosure or behind on their mortgage payments by 90 days or more.

The higher delinquency rate in FHA compared to conventional mortgages (which are rising, albeit more incrementally) is likely due to the fact that FHA loans are typically offered to borrowers with lower credit scores or otherwise an inability to afford a hefty down payment. These borrowers may be more likely to experience financial difficulties and fall behind on their mortgage payments.

How Distressed Debt Anchors Your Diversified Portfolio While Bettering Communities
The 60/40 investment portfolio is a traditional investment strategy of allocating 60% in stocks and 40% in bonds. This portfolio’s performance can be influenced by the correlation between the prices of stocks and bonds. When stock prices rise, bond prices tend to decrease and vice versa.

However, the correlation between stocks and bonds can vary over time, which can affect the portfolio’s performance.

Today, volatility and unprecedented monetary policy combine to challenge the conventional wisdom of the 60/40 investment portfolio. Higher yields on bonds suppress their price, and although the higher yield is great for fixed-income investors, the additional BPS annually have yet to match inflation, let alone surpass it. Most concerningly, the correlation between stocks and bonds is markedly in lockstep rather than inversed, meaning that the bond portion of the portfolio is providing less protection in current times of market stress.

Investors are exploring alternative strategies such as increasing their exposure to nontraditional asset classes like real estate or commodities to provide more diversification benefits. Others are considering increasing their allocation to stocks or shifting to more active investment strategies that can better navigate changing market conditions.

Investing in distressed real estate debt can present challenges due to the many factors that affect the market, including the property’s location, market conditions, and borrower behavior. However, investors who are willing to take on these risks may find significant profit opportunities.

Real estate investments and related private debt or lending markets have a relatively low correlation with stocks and bonds, as they are driven by factors such as local demand, supply, and economic growth. Including these types of alternative investments in a portfolio can help to reduce overall portfolio risk and increase returns by spreading investments across multiple asset classes. By investing in different types of assets with low correlations to one another, the portfolio’s risk is reduced, and investors can benefit from the diversification benefits that alternative investments offer.

Ultimately, investing in NPLs and REO assets are an increasingly reliable and dependable anchor in a diversified portfolio, as the markets remain viable and liquid. These types of investments not only promote homeownership and retention but also contribute to neighborhood stability by often improving homes and infrastructure while offering continued housing opportunities for disenfranchised Americans.

For those seeking diversified investment opportunities with higher-than-average return profiles, working with a financial advisor to manage NPL and REO investments may be the ticket to increased stability despite unprecedented volatility.

About Author: Louis Amaya

Louis Amaya is Co-Founder and CEO of PEMCO Capital Management, which provides an institutional platform for investors to gain exposure in niche sectors within the distressed residential mortgage and real estate markets. Over the firm’s history, PEMCO has supported the acquisition and management efforts for prominent commingled and single-investor family offices, hedge funds, institutional investors, and private equity funds. PEMCO is now launching a Reg D fund to allow retail investors to participate in the fund’s institutional platform. Amaya is also the Founder and Host of “Capital Markets Today,” a podcast focusing on real estate and mortgage capital markets.

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