Over the weekend I read The Value of Debt: How to Manage Both Sides of a Balance Sheet to Maximize Wealth by Thomas J. Anderson. His intriguing suggestion is that we need to take a more open-minded approach to debt and that paying it off as fast as possible isn’t necessarily the best approach. He says that companies — run by some of the smartest people in the world with a very explicit goal of making more money — don’t eschew debt but instead use it strategically and that households can as well.
Here’s an example from the book (table D.2 from Appendix D) about how it might work in practice. (Note: Anderson’s book is explicitly for people with at least $1,000,000.)
Imagine there is A Couple who have a $500,000 home that is totally paid off. They also have a portfolio of $5.5 million. They want to buy a second home priced at $1.5 million. Here are two possible ways they can buy the house:
- The “zero debt” approach: Sell $1.5 million from their portfolio (paying the resulting capital gains taxes) and pay cash for the second home. They are left with $4 million portfolio and 0% in debt.
- The “maximum debt” approach: Take a loan for $1.5 million and use that to buy the second home. They are left with a $5.5 million portfolio and 20% in debt ($1.5 million of debt versus $7.5 million in total assets).
The only difference is that in one scenario they have a $4 million portfolio and in the other they have a $5.5 million portfolio: an extra $1.5 million.
Assuming your portfolio earns 6% a year, that’s an extra $90,000 a year. Except you need to pay for the debt. At 2% interest, the $1.5 million loan costs $30,000 a year. So you still come out $60,000 ahead every year by not paying cash.
So far, this is simple leverage. You’re borrowing money at 2% and investing it at 6%, so you’re making 4% every year. But Anderson adds two twists:
- He suggests using what he calls an “asset based loan facility”
- He suggests having an “ideal debt ratio” of around 25%
Asset Based Loan Facility (ABLF)
Anderson’s book is frustratingly vague on what an ABLF is in practice.
Virtually every major financial firm offers what I have labelled an ABLF, or assets-based loan facility. Each firm will typically brand this type of loan facility under some marketing name.
Given that bare outline, I’m honestly not sure where to even start looking. I looked at my bank’s website and couldn’t find much. They have margin accounts through the trading platform but the rates are substantially higher than the ones he talks about in his book. 6.5% and up. So he must be talking about something else?
(Some further googling and reading this afternoon turns up that these things appear to usually be called a portfolio line of credit or a pledged asset line.)
Still, the basic idea seems sound (if you can ever find these ABLFs he is talking about). It seems a lot like a home equity line of credit. I can see a case for opening one even if you don’t buy all of Anderson’s other ideas about debt; just for the extra liquidity you get in the case of emergencies.
Ideal Debt Ratios
Anderson suggests every family target an “ideal debt ratio” of around 25%. Add up all your debts and divide by all your assets. If that numbers is much above 25% then you should think hard about being more aggressive at paying off debt. But if the number is under 25% then consider:
- Don’t make payments on current debt and just let the interest accrue. This assumes the loan isn’t amortising.
- For amortising loans, stop making aggressive payments on debt. Just make the bare minimum.
- Take on more debt.
Where does the 25% come from? Again, Anderson is not very forthcoming with explanations but reading between the lines it seems to be:
- At most places, you are subject to a margin call if your loans ever exceed 50% of the assets pledged against them.
- In “worst case market scenarios”, things can drop by 50%.
- 50% of 50% is 25%. Even if the market drops 50% you are still under the 50% margin requirement. So as long as you stay under 25% you are extremely unlikely to have a margin call come at an unfortunate time.
The combination of these two — an ideal debt ratio along with an asset based loan facility leads to an interesting strategy.
Using loans for living expenses
Here’s an example more intriguing than the earlier “second house” example.
- The Johnsons have $5 million in assets and $1.25 million in debt, for a 25% debt ratio. Exactly at their “ideal debt ratio”.
- They only pay interest on their debt: they don’t pay down the debt at all.
- The next year, their assets are (slightly) more valuable. Their two houses were appraised $15,000 higher. Their portfolio went up $210,000. Now their debt ratio is 23.85%.
So they are under their ideal debt ratio. How do they get back up to ideal? They are $75,000 under “ideal”.
- First, they definitely don’t pay down any of their existing debt. They don’t make any mortgage principal payments.
- They could skip even paying interest on some (or all) of their debt.
- They could draw on their asset based loan facility, pulling out “almost $5,500 per month — to pay for trips, taxes, credit card bills, miscellaneous expenses, and so on. The $5,500 that they would have been spending on those expenses now becomes savings and can be directed to their portfolio on a monthly basis!”
You are paying of things via a loan from your asset based loan facility which means that, although it feels like income…it isn’t taxed like income. This opens up the possibility of, say, dramatically increasing your (pre-tax) IRA contributions and drawing on the loan facility for your living expenses, resulting in the same quality of life at a substantially lower tax burden.
What Anderson doesn’t talk about is what happens in the opposite scenario?
Say your portfolio has gone down. Not a lot. The market didn’t crash. It just went down a little bit, like markets do sometimes. Say it is down just 2%. That means your debt ratio is at 25.3%. That’s above ideal. To get back to ideal you need to come up with $70,000. Not a lot compared to your $5 million in assets but it is equivalent to suddenly buying a brand new luxury car out of the blue. Say you spread that out over an entire year — that means you every single month you need to come up with $5,833 that you weren’t spending the year before.
Even though we’re talking about wealthy families here, suddenly coming up with $70,000 to maintain your “ideal debt ratio” just because the market fluctuated a tiny bit seems like an pretty big ask.
This really where Anderson’s book falls down. The idea is intriguing but it is hard to say how it actually works in practice. When you are at a debt ratio of 15% and the market crashes (like it did in 2008) pushing you up to 30% or more…do you suddenly sell some of your portfolio to bring your debt ratio back down to the ideal level? But selling stocks when the market is down is the opposite of what you want.
In the introduction he says that,
a good exercise would be to imagine “what if” you applied these concepts to the United States in the 1970s, France in the 1920s, England in the 1960s, Japan in the 2000s, and Argentina in the 1990s.
But this feels like huge cop out. Come on. You’re the one writing a book here. Why don’t you do that — especially since normal people don’t really have ready access to what things were like in France in 1920s — and show us some examples of how your strategy works in those scenarios?