Laundry Detergent, Toilet Paper and Bad Debt

This morning’s Bloomberg News has an article on how easy it has become for China’s population to invest in “Non-Performing Loans,” otherwise known as debt on which no one is making the payments. Apparently, China’s largest e-retailer, Taobao, now offers these investments alongside grocery and household items on the shopping page. Bloomberg’s reporter provides us the example of a Zhejiang steel mill currently in default on a 9.95 million-yuan loan, alongside a villa seized for nonpayment and some smaller corporate debts.

The catchy part of this article, of course, is the fact that you can buy out the bad loans of a steel mill while loading up your kitchen pantry – convenient! But the article also presents a good opportunity to think about the role that debt plays in our investing.

It’s tough for any lender to guess whether a debt in default will ever be paid back, even partially. For instance, let’s take that Zhejiang steel company debt for about $610,000. If I bid at auction and win for $200,000 I am betting that I can get more than my $200,000 bid out of the company. If I am smart, I will have researched how many other debtors there are, whether some of them are ahead of me in line, how much equipment the company has to sell off, and so on. If all of my findings are accurate and the steel equipment sells for the price I estimated, I could get back my investment with a profit. If the equipment sales go badly, another debtor turns up, or any number of other scenarios unfold, I could lose the entire $200,000.

Our markets around the world have created new investments by “bundling” these sorts of debt for us. The asset manager of say, an investment trust, will seek out (and hopefully research) a whole portfolio worth of debts on which no one is making payments. She will then use your investment money to bid for the debts and contract with other companies to collect on the debts. From the money that is paid back by borrowers, she will take her fees and then distribute the rest to you and the other investors.

How much do you know about the debts in which you are investing? Probably not much. The investment company should be able to tell you what their criteria are for choosing debts to buy, but you are pretty much just trusting the discretion and diligence of the manager.

What makes the case of Non-Performing Loans interesting is the light they shed on more mundane bonds. Average investors in the U.S. are accustomed to equating bonds with U.S. government bonds, and in this context the chance of us getting our money back from the debtor (the U.S. Treasury) is excellent. But bonds can refer to much riskier debts (as in “junk bonds”). You can go online right now and buy shares in a fund that bundles household mortgages, car loans or company debts. And, some of these funds specialize in the loans that are less likely to be paid off. As with the Chinese Non-Performing Loans, you are ultimately putting your faith in the diligence wisdom of the asset manager.

Here is the final piece of this puzzle: you aren’t the only one investing in these debts. Your national bank and your private investment fund may also have bought in. And then you and thousands of other investors bought shares in that same bank and in the investment fund, which are depending on the returns to make good on their own margins… you see how this keeps going.  Which is why we might not be able to bid on a flailing company loan when we order our toilet paper, but dodgy loans are much more a part of our households than you might think.