The De-leveraging Cycle Will be Televised

The Mother of All Margin calls has taken its first victim in the personage of Bear Stearns. Just like seeing Spitzer step down must make any wayward husbands have second thoughts about illicit activities, so should the brutality of Bear's sudden collapse make leveraged investors shudder. In both cases, the magnitude of the example is likely to cause changes in behavior. Advice from folks like Citibank's strategy team recently - yes the irony is thick - is to reduce portfolio exposure to leveraged investments. According to the sharpies over at Citi:

Steady growth, low inflation and rock-bottom interest rates encouraged economic and financial participants across the world economy to gear up over the past few years. Easy money encouraged many to buy a bigger house, a bigger car or a bigger speculative position. But now, any behavior that relied upon continued access to easy money is being dramatically reassessed. Leveraged banks must lend less, leveraged consumers must acquire or invest less, and leveraged speculators must speculate less.

Yes, they pay these strategist guys a lot of money to state the incredibly obvious, but hey, you have to pony up these days for the relatively few people with now valuable history degrees. Who else would be able to recall this quote from the July 23, 1990 issue of the New York Times? : ''Debt is not king anymore and equity is becoming the favored way to fund,'' said John Trygg, head of investor relations at U S West, the Denver-based regional telephone company. And the further commentary from this article written by Leslie Wayne:

For issuers, what lies behind these numbers is a psychology of fear. Corporations are troubled by the collapse of the ''junk bond'' market, the specter of Donald J. Trump's problems, the bankruptcy of many celebrated buyout companies and an economy that could be headed for rough times. ''Debt is becoming a four-letter word,'' said Richard L. Kauffman, director of equity capital markets at the First Boston Corporation.

Now if you think all of the writedowns that banks have taken on marketable securities scared them into tightening credit, and frightened customers into demanding less credit, wait until the actual loan losses hit, semi-permanently erasing capital from bank balance sheets. With the Fed's recent invention of the term securities lending facility, banks may be able to use the Fed as a warehouse for low-quality securities that they hope will eventually prove more valuable than their current mark to market prices, but they can't easily reverse write-offs of loans that go sour. Not only will loans that banks already suspect to be of poor quality go bad, but the slowing economy and surging job losses will bring forward a new slew of problem debts. I think it's safe to agree with the Citi strategizers that as in the early 1990s, debt will become a four-letter word again.

Just to get some perspective on the likely extent of the coming de-leveraging, let's look at some historical statistics, from the blog of Economist Paul Deng of Brandeis University:

Before the deleveraging came the leveraging. Take the U.S. The ratio of all sorts of debt to gross domestic product rose to 342% at the end of September 2007 from 160% in 1975. Through 2000, debt increased by 2.4 percentage points a year faster than GDP. But after the turn of the millennium, the rate accelerated almost to 3.7 percentage points a year.

If you agree with the supposition from my piece The Psychology of Asset Cycles, that after a period of out spending demand for an asset, you need to have a period of under-spending to get back to the long-term trend line, you will agree that the leverage cycle should work in a similar way. During the course of the cycle, the world will go from over-leveraged to under-leveraged, it won't stop at "just right". Deng the economist seems to agree with me:

In deleveraging, too, one thing leads to another. Start with a bank that has lost a few billion dollars on subprime mortgages. The bosses are likely to decide that troubled times call for higher capital ratios. That means calling in lines of credit. Some borrowers are forced to sell assets, pulling down prices. The banks then look at the value of their collateral and think: "Oh my god, it's not worth what we thought." They then cut their credit again -- giving another turn of the deleveraging screw.

The housing market was just the start. A series of debt mountains -- credit cards, car loans, LBO loans -- risk being leveled. The credit contraction strikes down financial arrangements that once looked solid -- from structured investment vehicles to auction-rate securities.

If the original debt helped fuel consumption, deleveraging will feed into lower economic activity. If the original debt fueled asset purchases, the consequence will be lower asset prices. There could be a dual effect because lower asset prices can make people feel poorer and less willing to spend money. This is especially the case with people's homes.

The following charts are lifted from Deng's blog, but appeared in a recent paper by David Greenlaw (Morgan Stanley), Jan Hatzius (Goldman Sachs), Anil Kashyap (University of Chicago), and Hyun Shin (Princeton) called Leveraged Losses: Lesson's from the Mortgage Market Meltdown, discussed by Fed Governor Mishkin in a recent speech.


The chart compiles the equity capital to assets ratios of various financial entities (something I touched on with a couple of examples in The Mother of all Margin Calls). The paper goes a step further and attempts to quantify the reduction in liquidity that will take place as a result of losses and consequent forced deleveraging. It assumes a 50% capital loss re-coupment and a reduction of leverage ratios by 5% (I would argue that the latter assumption is optimistic and doesn't take into account the propensity for human beings to run to the other side of a listing boat in an emergency as opposed to running to the middle of the boat (credit here to my partner Jim Gannon for the perfect analogy). These data are shown in the chart below.



If you agree with me that the reduction of leverage will be worse than current projections, just slide your finger to the right of this chart and the reduction of debt supplied by U.S. financial institutions goes from $2 trillion to $3 trillion. Neat, huh?

Corporations seem to be lone market participants that stuck with the de-leveraging trend that began after the dot com bomb dropped. Corporate balance sheets are generally believed to be in very good shape. But even this supposition has recently been called into question, due to potential accounting ledger main. See the article Corporate Deleveraging May be Overstated for details.

The great de-leveraging seems to be starting to impact commodity traders as well. Is it availability of credit, or just the sense that the economic impact of global de-leveraging will mean lower demand for all physical goods. Hard to say, but this week's commodity liquidation can't be ignored as another signal of an overall caution regarding leverage. While I am not calling for a commodities bear market as some others are, one of my 8 Predictions for 08 was a correction in commodities and I'm sticking with that call.

Don't get me wrong. I am not calling for any more implosions like Bear Stearns either. In fact I agree with the historical analogy cited in this Street.com article by Doug Kass of hedge fund Seabreeze Partners:

The decade of the 1980s gave birth (and death) to an upstart brokerage firm, Drexel Burnham, which created, sold and traded high-yield junk bonds -- the turbo debt and foundation of the previous "decade of greed." After the insider trading indictment of Drexel's Denis Levine was followed by Michael Milken's demise, junk bond liquidity dried up, recession befell the U.S. economy, and, by 1990, default rates on high-yield debt more than doubled to over 10%. Drexel, forced to buy the bonds of its junk bond clients, depleted its capital and filed bankruptcy.

In much the same manner as Drexel did in the junk bond market, Bear Stearns emerged as a leader in a parabolic growing market -- mortgages. As we are now witnessing at Bear Stearns (as we did during the Drexel era), a brokerage's well-being relies, in large measure, on the kindness and confidence of strangers to accept its collateral and accept counterparty risks. That confidence is impaired swiftly when price discovery unveils a diseased portfolio of assets, which is further exacerbated by a high degree of leverage employed. This is especially true when the brokerage's business is not diversified and is narrow in scope -- Drexel (junk bonds) and Bear Stearns (mortgages).

I do believe, however, that much more prudent and "normal"use of debt will come out of this episode. We will get there through the normal cycle of over-conservatism and re-regulation. Same as it ever was. So for the final bit of irony, if I am right the world will be developing an aversion to leverage, just when long-term interest rates are likely to hit bottom for many, many years to come. I call these juxtapositions the poetry of the financial universe...check this chart - its a beauty!






From the Blogosphere:

Deleveraging will take its toll - but on whom is unclear

Bank's Squeeze out high-risk customers

Welcome to A Deleveraging World

DELEVERAGING - Gold & Commodities Teetering on the Brink of a Bear Market

Seeking Alpha - Citi & The Great Unwind