Deleveraging
De-leveraging is the opposite of leveraging. Of course. But, what is not obvious is that the term "leveraging" means different things to different people.
- Operating leverage: To business managers, the leverage means having lots of fixed assets and fewer variable assets. In this amount of fixed costs that the firm must cover in order to start making a profit (fixed costs vs. variable costs analysis).
- Financial leverage: Financial leverage like this is the amount of debt that the firm must first pay back before there is any money left over for the shareholders (debt vs. equity analysis). Financial leverage tools of evaluation measure the likelihood that a company will default on their debt obligations. If a firm adds too much debt (which they have an incentive to do because debt financing is cheaper due to tax advantages of interest being deductible), then the ratios are there to alert bankers and lenders that the firm is entering the danger zone, and that some loans might want to be called in, and further loans might be canceled. These ratios are meant to be warning signs before bankruptcy.
Both of these factors are related to the risk of a firm, and have the potential to magnify potential returns for good performance, and punish the firm for poor performance. But, neither of these types of "leverage" are focused on the macro-economic leverage that is wreaking havok through the financial system in 2008. Instead, what we are seeing is the unwinding of financial SYSTEM leverage on a massive scale...
Total world financial system is shrinking right now, and we’re not at the end of that process.....Total credit market Debt / relative to our GDP…still above 350%....double what it was in the 1920’s
According to Martin Wolf: "there must be a credible programme for what Americans call “deleveraging”. The US cannot afford years of painful debt reduction in the private sector – a process that has still barely begun. The alternative is forced writedowns of bad assets in the financial sector and either more fiscal recapitalisation or debt-for-equity swaps. It also means the mass bankruptcy of insolvent households and forced writedowns of mortgages."
Table of Contents:
see also fixing global finance , global imbalances (finance)
and Commercial Banking , leverage , Possible recession in 2008, credit crisis of 2007, margin call , Private equity
Financial "System" de-leveraging:
In early 2008, there was talk about "deleveraging" of the financial markets (and how that was going to cause a recession). But what is "deleveraging" exactly? and what is causing it?
Deleveraging is the rapid disappearance from the market of leverage, money borrowed by investors to magnify what they can buy.
In deleveraging, 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.
From investors stand point: “When you could lever 30-1 on agency debt you didn’t need much spread and that caused a lot of demand,” said Paul Miller at FBR Capital Markets in Virginia.....but, “When you are levering 15-1 you need more spread to hit your (target) on returns.”
FT, Nov 14, 2008: "The long-term shape of global finance will be determined by future levels of bank leverage....but reducing the total leverage in the banking system by at least a half - not an unreasonable start - would probably cause a worldwide depression. That leaves injecting capital. But, the private sector is nowhere big enough to stump up what in some countrie could be up to 10% of output. Historic banking crises often resulted in wholesale nationalizations. This one could too".
Future after Deleveraging:
Look for permanently higher prices for access to credit, with a very hefty premium for bonds that are smaller and harder to sell.
Impact of deleveraging on the US dollar?
In its essence, the trend toward "deleveraging" is a movement away from a credit-based financial system, and one toward a cash-based one. This is the great deleveraging in its essence...a process by which financial institutions around the globe cut back on the level of credit they offer to their customers.
But while people demand the same level of products, they now need to pay cash rather than credit for them. So, my theory is that a great contraction of credits will mean a greater demand for hard currency. This could mean a greater demand for dollars (the world's reserve currency).
In its essence, this is why we see the dollar appreciate during most of the credit crisis. As investors had borrowed in dollars and invested or extended credit overseas, we now see a contraction of credit whereby credit shrinks, and the dollar demand increases.
On the other hand....
Regulations for bank leverage:
Basel II: steered banks to have minimum amounts of equity-type capital versus assets.
As the western banks’ funding collapse and Basel II problems require a significant reduction in lending.
They dont make much sense... making banks (30x gearing) seem more risky than directional hedge funds (4x gearing). Of course, other hedge funds such as arbitrage funds are very highly leveraged.
Effect of Deleveraging on the Economy:
Back in early 2008: According to Jan Hatzius, chief US economist at Goldman Sachs, major banks and brokers would suffer about $200bn (£99bn, €127bn) in subprime-linked losses in early 2008. But, due to deleveraging, the impact of these losses on bank lending could be much greater. Mr Hatzius suspected that a $200bn subprime loss would cut bank capital by 12 per cent; if banks then shrank their balance sheets by 12 per cent, the implied reduction in overall lending - due to leverage - would total $2,300bn.
Lending is based on "leverage". If a bank looses a certain amount of assets (x), then they must reduce lending by some multiple of (x).
September 2008: Tim Bond, of Barclays Capital, reckons that, thanks to the gearing effect, a shortfall of bank capital of around $170 billion may reduce the potential supply of credit by $1.7 trillion.
Deleveraging leads to Unemployment & slow growth:
Delevering means relying less on borrowed money and more on capital. Normally this leads to less efficient companies (from the financial point of view) because adding value would be more difficult. Capital is more expensive than debt because shareholders require a higher return than what they would get from bank accounts and the likes. The consequence is a reduced undertaking of projects, especially the high risk ones, and keep the money on the infrastructure (or core business). In other words, less expansion capacity and a more conservative approach. A return to a more traditional and coherent goal-strategy-implementation cycle. In principle a good thing, except probably for employment. One may expect a return to relatively high unemployment and slow growth.
Capital Ratios: banking
Higher Capital Ratio:
HSBC Holdings Plc Chief Executive Officer Michael Geoghegan said in an interview with the Financial Times this week that he expects banks will be required to have core tier one capital ratios of about 10 percent, higher than the 8 percent that regulators had been suggesting in private discussions.
Before the crisis started...BBVA may report core Tier 1 capital, a measure of solvency, of 6.1 percent for the end of 2008, Barron said. Santander, which raised 7.2 billion euros in a rights offering in November, said it’s targeting a core Tier 1 ratio around 7 percent.
How far does Deleveraging have to go?
Dec 2008: Total world financial system is shrinking right now, and we’re not at the end of that process. Total credit market Debt / relative to our GDP…still above 350%....double what it was in the 1920’s
Back in February 2008, the Economist magazine put it like this:
"The Great D(eleveraging)
Leveraging Took Awhile,
And So May the Unwinding;
Little Comfort in History"
"How far can this go? Historical parallels aren't terribly comforting. In Japan, a boom in the 1980s was followed by a painful deleveraging. Despite massive government borrowing and five years of a near-zero interest rate on overnight borrowing, the prices of shares and real estate declined by 40% to 70%. The U.K. did better in its deleveraging after 1990 -- house prices dropped by 40%, after taking inflation into account, but share prices rose...The deleveraging snowball will eventually reach the bottom of the mountain. Banks will start to see opportunities, and borrowers will become more courageous. But it could be a long and painful wait."
US debt levels unsustainable:
see our page on : USA macro data
Household deleveraging:
Leverage build up (till 2007)
In a credit bubble, one thing leads to another. You can bid more for a house because banks are willing to lend more. So house prices rise, giving the banks more confidence about lending yet more. So you build an addition or buy a new car. Multiply that by a few hundred million borrowers and presto, asset prices go up and economic growth is high. Banks rejoiced. They set up off-balance-sheet vehicles that piled on debt. Leveraged-buyout groups borrowed to take companies private; hedge funds borrowed to invest in assets. And so on.
Effects of the (USA) credit crunch:
"What the financial and household sectors are doing is unwinding more than ten years of a credit boom," says George Magnus, an economist at UBS
Less money to lend, less money to borrow....After the subprime lending crisis in the US, banks became more fearful that borrowers may not be as credit-worthy as they may appear. As a result of deleveraging, there was a subsequent reduction in credit available to all borrowers. This led to a fear of recession (Possible recession in 2008)
In the leveraging era, the world's banks and other great lenders lent far too much - to businesses, to various financial speculators, such as hedge funds and private-equity investors, to homeowners, to shoppers, and even to each other.
A great bubble of debt was created.
That bubble was punctured last summer, when lenders suddenly realised that some of their loans - the subprime ones to US homeowners with poor credit histories - weren't ever going to be repaid in full.
'Bad risks'
Since then lenders have been asking for their money back from those perceived to be a lousy credit prospect - and pushing up the cost of credit for almost everyone.
This deleveraging process, which has gone in fits and starts, moved up a gear in the past fortnight, as lenders became increasingly fearful about the outlook for the biggest economy in the world, that of the US
Expect defaults:
Martin Fridson, of Fridson Investment Advisors, says that the default rate on high-yield bonds may climb to 10%
Margin Call
see GloboTrends page on margin call
Further Reading:
Capital Destruction
FBR Capital Markets, in a Nov. 19 report, estimated that Goldman Sachs (ticker: GS), Morgan Stanley (MS), Citigroup (C), JPMorgan Chase (JPM), Wells Fargo (WFC), Bank of America (BAC), AIG (AIG) and GE Capital (GE) combined need $1 trillion to $1.2 trillion of equity capital to shore up their balance sheets so they can begin lending again. FBR estimates that the eight have $12.2 trillion in assets and just 3.4% of that -- $406 billion -- in tangible common capital. "The sheer size of the capital deficiency, coupled with the opaque nature of credit risk, will keep private capital sidelined... ." FBR says.
Freddie & Fannie:
When the two mortgage giants were nationalized...capital was destroyed, resulting in the need for deleveraging..
Retired securities lawyer Frederick Feldkamp, a Michigan native, says the Treasury's nationalization of Fannie Mae and Freddie Mac alone erased $33 billion in bank capital. The Treasury inadvertently wiped out the two mortgage giants' preferred stock, which hundreds of banks had held as core capital, and which was considered so safe that regulations let the banks leverage that capital by as much as 50 to 1 when making loans. Feldkamp reckons that when banks wrote off the $33 billion in preferred stock, support for about $1.65 trillion in debt was erased -- a significant credit contraction.
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