Why reckless use of credit will cause financial disaster

published 20 October 2006

In her gem of a book, Coal: A Human History, Barbara Freese clarifies why coal has proven such a boon to modern civilization. In essence, the Earth's rich coal seams are a solar bank account, packed with eons worth of sunshine. Freese expounds:

'Animals eating plants take that stored energy into their bodies, where they not only store it in concentrated form, but disperse it through space. A flock of geese, a pod of whales, a herd of caribou - they are all, on some level, mobile battery packs. They gather solar energy that falls upon one patch of the planet and deliver it to another as they migrate; in this way, they make life possible for the predators even when, for example, the snow is thick and there is not a green leaf in sight. Life on Earth is, in short, a vast and sophisticated system for capturing, converting, storing, and moving solar energy, the evolutionary success of each species depending in significant part on how well it taps into that system.'

By measure of energy output versus input, man is undoubtedly the most successful species of them all. He became so by tapping into the latent energy of fossil fuels. The process of moving from there to here - from zero to present day - was conceptually a bit like stacking hay bales. With enough bales, you can begin with level ground and build a stairway to the sky. Start with just three bales - one on top, one in front, and one on the bottom - to make the first step. Then just keep on going, stacking higher and extending further ad infinitum.

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Prehistoric man's first hay bale, Freese informs us, was his super-efficient metabolism. The ability to do more with less gave our ancestors the energy edge they needed to invest in bigger brains. Bigger brains in turn led to the use of fire, which gave man the power to harness an external energy source for the first time. Coupled with the challenges of population growth, fire enabled early civilization by way of slash-and-burn agriculture (not to mention useful fire-treated trappings, like bricks and pottery and swords). The first accounting systems were probably tied to crop dealings. After that, it was just a matter of getting more sophisticated at building and burning things.

Man greatly extended his domain by learning to consume energy he did not create. In financial terms, he has accomplished a similar thing. He has learned how to consume income not yet earned. When a man (or woman) signs on the dotted line for a 30-, 40-, or even 50-year mortgage (thank you California), he is committing a stream of future earnings to a purchase. The money to be paid usually has not yet been earned; for all intents and purposes, it does not yet exist. Financial leverage, like fire, allows man to access a power source external to himself. The fact that homeowners all across the Western world can do this, and think little of it, is a great testament to the power of innovation. The invention and explosive proliferation of the mortgage, in its own way, is as meaningful an advance as England's transition from wood to coal in the High Middle Ages.

Unfortunately, we are on track to relearn a painful lesson: Financial disasters can be just as ugly as environmental ones. The first may be caused by careless use of leverage, the second by careless exploitation of resources on a grand scale; depending on how you look at it, these are two sides of the same coin. In both cases, lax attitudes, lolling complacency, and rampant greed are often to blame.

The literal translation of the word 'mortgage' is along the lines of 'engagement till death.' That is an appropriate description of what late-to-the-party homeowners now face, particularly those saddled with adjustable rate mortgages (ARMs). Some homeowners, faced with the reality of upside-down properties and upside-down lives, will choose financial death - bankruptcy - over the prospect of indentured servitude. Keys will be left in mailboxes. Politicians will foam and froth. Bernanke will call in the helicopters. And gold, of course, will skyrocket.

Returning to the fossil fuel motif, there is another question near and dear to Whiskey readers' hearts. With all this industrious stacking going on, what happens when the world starts running out of bales? In terms of energy abundance, our stairway to heaven has a problem. With the developing world now pressing from behind, there's nothing to do but keep stacking highereven as the cheap bales get harder and harder to find. If we make it through, it will be by the skin of our teeth, not in high style. Things could come toppling down in a great mess. New foundations may be required.

Meanwhile, Wall Street is content to live in shiny-happy land, where every down tick in oil and gold is a sign of Utopia's return. Uncharitable as it may be, this attitude reminds us of a Bertrand Russell quote: 'Most people would rather die than think; in fact, they do so.' At Outstanding Investments, we are happy to take advantage of the Street's shortsightedness - just as many great investors have done. In 1974, Warren Buffett told Forbes he felt like 'an oversexed man in a harem.' Though not quite that amorous, we are certainly licking our chops at some of the bargains to be had here.

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