When cities, companies or individuals borrow money, they are expected to repay it on time and with the agreed upon interest.
However, that may be playing out differently in the Stockton, California bankruptcy as well as with lots of individual home equity and commercial property loans as well.
Borrowers fall into three broad categories; (1) hedge, speculative, and Ponzi. Hedge borrowers have the ability to make both interest and principal payments in a timely manner. No problem there.
However, speculative borrowers are only able to make interest payments and rely on future asset appreciation or the ability to roll over the principal at maturity to avoid default. Ponzi borrowers depend solely on asset appreciation to be able to repay the loan.
The city of Stockton and many home-equity borrowers are classic speculative borrowers. They can make the interest payments, but they can't repay the principal amounts borrowed as scheduled and depend on lenders who will be willing to roll over the loan at maturity.
Stockton Bankruptcy Puts Muni Market on Edge describes the relevant debt related events unfolding in Stockton currently:
"Stockton's bankruptcy case is making some municipal-bond market
participants queasy—and for good reason: If the California city gets its
way, it will become one of the first local governments to use the
federal bankruptcy process to impose potentially big cuts on its
bondholders. . . .
"There's no history of any significant give-up" for local government
bondholders in bankruptcy . . . .
Market participants are nervous because the city . . . skipped
payments on bonds earlier this year and plans to continue that pattern
while it reorganizes its debts in bankruptcy.
"They are citing debt as part of the problem and have made comments
to the effect of 'We are trying to spread the pain around and not just
put it on employees,' " said John Miller, managing director and co-head
of global fixed income for Nuveen Asset Management, whose firm owns
roughly $8 million of Stockton lease-revenue debt. "That is different
from prior recent municipal bankruptcies, like Vallejo, Calif., and
Central Falls, R.I., where they have made more of an effort to say 'We
want to keep bondholders whole, or at least keep principal intact.' ". . .
"Chapter 9 is just a process; it's not a solution . . .
It doesn't solve the issue of a bad economy, housing problems or
unfunded pension obligations."
"These are tactics that we haven't seen in the past," said Mr.
Larose, who represents one of the bond insurers in Stockton's bankruptcy
case. "Whether the municipalities will benefit from these strategic
defaults in the long run remains to be seen."
Home-Equity Loans Pose Looming Threat to Banks describes the home owner's ability and willingness to pay off its loans as scheduled:
"U.S. banks may be hit with a new round of mortgage losses over the
next five years as borrowers who took out home-equity loans a decade
earlier face increased monthly payments, a regulator warned Thursday.
The Office of the Comptroller of the Currency warned
that more than half the amount borrowed on equity lines at national
banks, or $221 billion out of $380 billion, will face higher payments
from 2014 to 2017, exposing banks to the possibility of losses if some
equity-line borrowers default.
Home-equity lines extended during the mid-2000s housing-market boom
years typically had a 10-year period in which the borrower made only
interest payments. When that period ends, borrowers must start to pay
back the principal balance as well, increasing monthly payments for some
homeowners who have seen their incomes and property values decline.
Darrin Benhart, deputy comptroller for credit and market
risk at the OCC, said "banks are going to have to be thinking about
ways that they're going to address" the problem, including debt
restructuring. . . .
The OCC is separately studying which banks could be hit the hardest
if interest rates rise. . . . The
agency will also scrutinize smaller banks to look at loss exposure from
commercial real estate loans and new types of auto and other lending
The report said banks still face a huge overhang of delinquent and
foreclosed properties stemming from the nationwide housing bust. And the
nation's largest banks "continue to face profitability challenges" from
deficiencies in their foreclosure-processing operations, which bank
regulators are forcing the nation's largest mortgage servicers to
Whether an individual, city or other type borrower, we either repay loans as agreed or we default. And in a default situation, we often are able to restructure our obligations by extending maturities, reducing interest rates or some combination thereof.
There's no other way (except for national governments that can print money and largely inflate their way out of their debt problems by weakening their currencies. However, individuals and cities can't print money, and neither can banks.)
When loans aren't repaid as agreed, even if restructured, the borrower's future credit will be greatly impaired, to say the least. Thus, while default or restructuring is apparently the easy way out the first time, there may be no second chance.
It's hard to believe that Stockton and the state of California will default, but bondholders have no guarantee that they won't. Hence, all parties to this fiasco are properly incentivized to strike a deal which will result in pain to all.
With household debt, however, the household has no taxing power, unlike the city of Stockton. Thus, if the debt is greater than the value of the house, which it likely is with most home-equity loans having been taken out in the early 2000s, the home owner may choose to default rather than attempt to pay off the principal. In that case, of course, banks will be properly incentivized to rework the homeowner's debt, just as the bondholders of Stockton will be.
All in all, we have a very long way to go before the worldwide debt debacle is finally brought under control --- whether at the individual, commercial, city, state or national level.
My bet is it will be a very long time before anybody faces this set of circumstances again.
And certainly not in my lifetime.