The Snowball

Warren Buffett, the 3rd richest man in the world, is known as “the Snowball” because his amazing increase in net worth year over year has been akin to a snowball rolling down a very large snow covered hill. As the ball (his fund) rolls down the hill its size increases exponentially; the bigger it gets the bigger the incremental size of the expansion. Compound interest is Warren Buffett’s friend.

By way of example: If you had invested $1000 with him when he started out 45 years ago, then that investment would be worth $3.4 million today, at the 20.3% average annualised return on his Berkshire Hathaway fund. Not bad.

Perhaps more striking is the fact that had his annualised return averaged 2% per year less – a mere 18.3% – the value of your $1000 today would be less than half the $3.4 million at $1.62 million. Still not too bad, but considerably less.

Anyway – I’m using this tale to illustrate that rolling up interest matters. A lot.

Consider the opposite situation where you are the one having to pay the interest on a debt of some kind. We can call this the “reverse snowball” effect, where continuing to roll-up interest at high rates of return is likely to drive you at an increasingly rapid pace into a brick wall – $1000 loan turning into a $3.4 million liability over a lifetime. Anyone who had a mortgage in the UK in the late 1980s will understand this quite well. There was a period when mortgage rates were in the high teens, which even though it was relatively short-lived didn’t work out so well.

So the scene is set. The amount of interest you pay on your mortgage or that credit card with an APR of 20.3% matters. The more time you hold that debt the more exponentially costly it becomes. When interest rates are relatively low, compound interest doesn’t matter as much as when the rates are high.

Anyway – on to making this somehow relevant. This last month saw the US monthly budget deficit hit an all time high at $221 billion. Federal income was $107.5bn and outlays were $328.4bn, bringing the ‘on balance sheet’ debt total to over $8 trillion (some would say the real figure is much higher). Against this backdrop, however, the average interest rate across all US government debt hit an all time low of 2.548%. Furthermore, in the past month the US dollar has hit record recent highs against all major currencies around the world.

Amazing really – the more they are borrowing the lower the average cost of interest. And this shows a number of scary things.

Firstly, how rubbish the prospects in the rest of the world must be if investors are willing to buy the dollar and the debt of an already massively indebted country and demand only an average of around 2.5% return for the privilege.

Secondly, the US government can not only sustain a massive budget deficit if the trend continues, but expand upon it. It doesn’t matter (much) that the main buyer for these debts happens to be the Federal Reserve Bank of the US.

The privileged position that the US happens to be in will allow it to sustain an increasingly high deficit – the extent of the reverse snowball effect isn’t all that problematic if borrowing costs average 2.5%. If however that average interest rate kicks up higher, then the effect will start to get very ugly very quickly. That’s for another day, however, and the joyous borrowing situation for the US will be welcomed in the corridors of power in Washington.

Not everywhere has the privileged position that the US has. The safe haven perception being applied to the US dollar doesn’t yet exist for Sterling or the Euro for example. For a whole host of fundamental and technical reasons the desires to hold these currencies just aren’t (yet) what they are for the dollar. As a consequence the cost of the borrowing for Eurozone countries and for the UK have not lowered in the same way as investors seek safe havens around the world.

Having said that, within different Eurozone countries – the relative costs of borrowings have obviously moved significantly over the recent past, with Greece being at one end of the spectrum and Germany at the other. Greece is now borrowing at a rate that is likely to see them “snowballed” towards default sometime in the not-too-distant future, whereas Germany is rolling over its borrowings at US-style rates.

In between the two of these are the UK and Ireland, with Ireland being perceived until recently to be closer to Greece and the UK closer to Germany in the credit worthiness spectrum.

Since Ireland announced its tough budgetary measures, however, the bond markets have seen fit to reduce the yield on Irish 10year debt by around 1%. That may not sound like a lot, but when considered in the snowballing effect of compounding interest, adds up to a hell of a lot of taxpayers funds saved on interest expenses into the future.

On the flip side, the UK is continuing to postpone the necessary budgetary cuts and sterling and gilt prices have taken a bath, raising the expected cost on all future borrowing. In January the Office for National Statistics said public sector net borrowing was £4.3 billion – which is unprecedented: the first time the Government has had to borrow money in January since records began. The Government usually enjoys a surplus at the beginning of the year because of increased amounts of income and corporation tax. Analysts had predicted that the Treasury would actually repay around £2bn.

Jonathan Loynes, an economist at Capital Economics, said that extrapolating the figures for the rest of the year would see the UK budget deficit head close to 13%: Greece’s deficit for 2009 was 12.7%.

‘For now, the markets and credit ratings agencies seem prepared not to put the UK in the same category as the fiscally-challenged euro zone economies like Greece,’ Loynes said. ‘But it is clear that a more credible plan to restore the public finances to health will be required.’

Without a credible plan the UK’s cost of borrowing will continue to rise and rise with the long terms costs of debt service increasing at an exponential rate. If on the other hand a credible plan is presented then the UK would likely see the same benefits that Ireland has done. Given the nature of the snowball effect, acting sooner rather than later is the only viable option.

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