De-leveraging in the real economy- corporations

May 19th, 2008

Share |

Yesterday, in De-leveraging in the real economy- mortgages, we said that,

… 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.

Nowadays, corporations and businesses are more highly leveraged too. At one point during the private equity boom, corporations with ‘lazy’ (i.e. ‘lack’ of debt) balance sheets felt vulnerable to takeover attempts. Those private equity funds uses vast amount of leverage to flip corporations, which is reminiscent of speculators flipping property in Florida and stocks on the NYSE.

For the high quality businesses, the cost of funding will increase. Those weaker ones will find it difficult to access funds. In total, it is estimated that there will be at least hundreds of billions of dollars of loans to be re-financed by businesses over the next few years. For many businesses, an environment whereby money is more expensive (see Rising price of money through the demise of ?shadow? banking system) may prove too much to handle. Such businesses will fail. As Satyajit Das said in Nuclear De-Leveraging,

Non-investment grade bond issuance over the last few years was concentrated in the weaker credit categories and is vulnerable to deterioration in economic conditions. Standard & Poor?s rating agency estimates that Two-thirds of non-financial debt issuing companies are junk-rated currently, compared with 50 per cent 10-years ago and 40 per cent 20 years ago. In recent years, around half of all high yield bonds issues were rated B- or below. These borrowers will face refinancing challenges.

In other words, those businesses who are weaker financially are the primary beneficiaries of the money obtained from the ‘shadow’ banking system. With the ‘shadow’ banking system now in shambles, a lot of these businesses will fail.

Guess what will happen when businesses fail?

Unemployment will rise. With households already so highly leveraged, even unemployment of a secondary job can spell the loss of a mortgaged home. This will result in even more bad debts for the banks, resulting in deteriorating bank assets, which in turn will make credit even scarcer (see Banking for dummies). Scarcer credit will deliver the second round of effects for businesses and households.

By now, it should be clear that the de-leveraging process is a vicious cycle.

Tags: , , , ,