De-leveraging in the real economy- mortgages

May 18th, 2008

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In our previous article, Is the credit crisis the end of the beginning?, we said that the de-leveraging of the financial sector will usher in a new phase whereby the real economy de-leverage. Today, we will show you how it will unfold by looking at mortgage de-leveraging.

First, we will explain the concept of de-leveraging. As Satyajit Das said in Nuclear De-Leveraging,

Assume a hedge fund with $20 of unlevered capital. If a bank or prime broker allows it to leverage 5 times, then the hedge fund can acquire $100 of risky assets with $20 of equity and $80 of debt. Assume the asset falls $10 (10%) in value. The hedge fund leverage increases to 9 times ($10 of equity (the original amount less the loss) and $80 of debt supporting $90 of assets). If the permitted leverage stays constant at 5 times then the hedge fund must sell $50 of assets – 50% of its holdings ($10 of equity and $40 of debt funding $50 of the asset). If lenders (more realistically) reduce permissible leverage, say, to 3 times, then the hedge fund must then sell $70 of assets – 70% of its holdings ($10 of equity and $20 of debt funding $30 of the asset).

That is why, as we said before in Why are fantastic stocks sold off in a bear market?, with so much leverage, even a tiny fall in value of assets will result in savage selling, which results in even more fall in value.

Now, look at Australia’s household sector. For a typical first-home buyer, it is possible to leverage 9 times (i.e. 10% deposit and 90% debt for a house). With house price at record un-affordability, debt-servicing burden for such buyers are stretched to the limit. With a leverage of 9 times, highest debt-servicing burden and a loan term of 30 years, first-home buyers are most vulnerable to any fall in value of their property. 30 years is a very long-term commitment. A lot can happen in 30 years. With a leverage of 9 times, there is very little margin for error for first home buyers.

For those who are thinking of buying their first home in such a time, note this: as you start of with your loan repayments, the vast majority of the payment comprise of interests. In other words, most of your initial years of loan repayments goes to making the bank rich and not to reduce the principal of your loan. For example, suppose you have a $300,000 loan for 30 years at 10% p.a. Your loan repayment will cost $2632.71 per month. The first month of payment will only reduce the principal of your loan by a miserly $132.71! At the end of 3 years, the principal reduction per month is only another miserly $177.44! In other words, after of 3 years of slaving after your mortgage, you still owe the bank $294,454.94! That is just only a 1.8% reduction of your total debt in exchange for 3 years of slavery!

Of course, if house prices go up forever and ever till infinity, this is not a problem for the banks. At worst, the banks can just foreclose the house and get back their money. The home ‘owners’ have to bear the consequences of losing their homes and go back to renting. A consolation is that they will at least get back their 10% deposit, plus whatever is above the original purchase of the house, minus fees, taxes and charges. But if house price goes down by more than 10%, then the home ‘owners’ will not only lose their savings for the 10% deposit, they will still owe the bank money after the house is foreclosed. In the US, house prices have fallen by 13% in one year. So, you can imagine that there will be a lot of misery going on.

For property investors this is a tip: in any property downturn, newly built estates are most vulnerable because the first home buyers are the majority there.

Now, a first home buyer who can faithfully pay $2632.71 per month is doing okay (assuming they can still remain employed). But as Satyajit Das wrote,

Consumers in the USA and to a lesser degree in the UK, Ireland, Australia and New Zealand have used borrowings (against inflated real estate values) to offset a reduction in real incomes. Falling real estate prices and the reduced availability of ?easy? credit will force de-leveraging.

In the US (and to a lesser degree in other countries), banks allow the consumers to ‘extract’ the equity of their house as cash, especially in the days of rising house prices. Here, we have to emphasise that the rising of house price is an illusion (see Spectre of deflation for the concept of imputed valuation) because debt is real but the ‘value’ of houses is not real. In the case of the first home buyer, consistent and faithful repayments hardly put a dent in the amount of his or her total debt initially. If equity were to be ‘extracted’ from the loan (on the assumption that house price will rise forever and ever till infinity), wouldn’t the total amount of debt increase further due to the compounding effect?

Now that the days of Chinese deflation are over, borrowers have another worry to fret (in addition to falling house price): rising price inflation. As Satyajit Das continues,

Inflation is also a factor in the de-leveraging in personal balance sheets. Higher prices for the necessities of life reduce cash flow available to support debt. Higher food and energy cost, especially over a sustained period, may affect the degree of de-leveraging if income levels do not adjust.

Imagine the situation of a household that is already highly leveraged with crippling mortgage debt. ‘Extracting’ equity from the house will result in an increase in the amount of total debt owed. Now, with price inflation added into the powder keg mix, wouldn’t this lead to the situation whereby the chances of debt default increases (because the margin for error is reduced to razor thin level)? As debt default increases, this means banks’ bad debts will increase. This will lead to the increase of bad bank assets, which means more write-downs, capital raising and de-leveraging in the financial sector.

The only short-term fix for the household is to resort to the plastic (credit card debt) to pay for the mounting cash-flow problem. That will further exacerbate the debt problem in the longer term. With the financial sector in the process of further de-leveraging, how realistic can we expect the tap of credit to flow further? That is why Ben Bernanke and company is doing everything to keep the credit tap flowing from the banks.

Given such a situation, de-leveraging of the household sector means that consumer spending has to cut back significantly. Given that more than 70% of the US economy is made up of consumer spending, there is no avoiding of a serious recession (in fact, the US is already in a recession).

Make no mistake- the real economy will be affected acutely.

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