A Valuable Lesson On Debt

Let’s take a look at debt in the context of a financial statement to see what we can learn from the situation in Poland: In the recent New York Times article, Homeowners in Poland Borrowed in Swiss Francs and Now Pay Dearly, we learn that many homeowners in Poland have found themselves in financial trouble due to the dynamics of currency. A look at debt and savings in the context of a financial statement will give us some important insight into the situation in Poland.

A basic financial statement shows income and expenses, which combine to equal cash flow, and assets and liabilities, which combine to equal net worth or equity. Think of it in terms of opposites: the opposite of income is expenses, the opposite of assets are liabilities, and the opposite of cash flow is net worth. Assets are generally something that you buy to own. Liabilities are things that you borrow and own. Assets minus liabilities equal net worth.

At the heart of the situation in Poland is this dynamic of assets and liabilities. If the value of an asset diminishes, the net worth also decreases. On the other hand, if an asset increases in value, the net worth will also increase. The value of liabilities also impacts the net worth. As a liability's value goes up, the net worth decreases. When the liability's value goes down, the net worth increases.

For example, if I were to borrow one million Zimbabwe dollars and trade them to US dollars, I would need to pay the bank back in Zimbabwe dollars. If the Zimbabwe dollar goes up and the currency is now two million US dollars, my debt would be greater because I would need to convert back to Zimbabwe dollars. If the Zimbabwe dollar goes down and the exchange rate becomes 500,000 US dollars, my debt would increase.

We can use that same principal to look at the situation in Poland. Polish homeowners believe that the Swiss Franc currency was stable, so they decided to borrow Swiss Francs and convert them to the Polish currency, Zloty, to pay their mortgage. Unfortunately, the currency was not as stable as the Polish had hoped. The value of the Franc has increased significantly. As the Swiss Franc’s value gets stronger, it required more Zlotys to convert into a Franc, which increases what Polish homeowners must pay for the money they borrowed. In short, they have had a 40% increase in their mortgage payment because the power of the Franc has gone up.

This is an important lesson to us as we put money into the US dollar, Japanese yen, the Euro, or any other currency. All of these currencies go up and down, impacting us as investors. The dynamics of currency gives us both opportunities to gain or lose money. Remember the lesson of the basic financial statement: assets – liabilities = net worth. You’ll be a richer person if you borrow things that go down in value. You’ll be a poorer person if you borrow things that go up in value because it is more costly to pay them back.

Check out my Four Pillars of Investing for a more in-depth look at the concepts we’ve touched on here.