Posts Tagged ‘de-leverage’

De-leveraging in the real economy- corporations

Monday, May 19th, 2008

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.

De-leveraging in the real economy- mortgages

Sunday, May 18th, 2008

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.

Is the credit crisis the end of the beginning?

Wednesday, May 14th, 2008

We will introduce another character today- Satyajit Das. He is a world-leading expert in derivatives and risk management and has a good inside knowledge of the murky world of derivatives. He is best known as the author of the fascinating book, Traders, Guns & Money.

Unlike the mainstream media and market, Satyajit Das is under no illusion that the credit crisis is over. In fact, as he wrote in Nuclear De-Leveraging,

An alternative and, arguably, better view of the current state of the financial crisis is that stated by Winston Churchill: ?… this is not the end. It is not even the beginning of the end. But it is, perhaps, the end of the beginning.?

Why is it so?  The short answer is de-leveraging. As we said before in Why are fantastic stocks sold off in a bear market?,

Today, there are so much leverage in the financial system and by extension, the market. Both retail and institutional market participants borrow and employ leveraged derivates (e.g. options, CFDs, futures, etc). The problem with leverage is that, when the market goes against you, your losses are magnified and you find that you are suddenly short of cash (to repay the debts, obligation, margin calls, collateral, etc). Sometimes, the only way to increase your cash level is to liquidate whatever you have- the good investments along with the bad. If enough people are in the same situation as you, this will result in widespread indiscriminate selling in the market.

As long as the de-leveraging process is confined to only the financial markets, the sell-off in stocks presents an excellent buying opportunity. Unfortunately, according to Satyajit Das’s opinion, the de-leveraging process in the financial market is only the first phase of a much larger process. He believes that this process will spread to the real side of the economy (see Analysing recent falls in oil prices?real vs investment demand on the difference between the financial and real sides of the economy), which means that the person on the street will eventually feel the impact. As we said before in The Great Crash of 1929,

Also contrary to popular impressions, that Great Crash was not a one-day event. It was a series of events that marked the beginning of an even more devastating consequence?the Great Depression. In fact, it took a year after the Great Crash for the average person on the street to feel the effects of the ensuing Great Depression.

If Satyajit Das is right, then in the future, we will look back at the credit crunch as just the beginning events of a greater scheme of things.  Currently, from the looks of things, the first phase is over. The effect is that money has become more expensive (see Rising price of money through the demise of ?shadow? banking system).

Next, another process is currently under way- the returning of bad quality assets into the bank’s balance sheet. As we explained before in What is SIV?,

The recent deterioration in the credit market is severely disrupting the SIV funds because of the high cost of obtaining short-term funding. As a result, many of the lenders have to buy back the mortgage assets from the SIV, resulting re-loading those mortgage asset into its balance sheet.

As Satyajit Das said,

High inter-bank rates and the deceleration in bank lending reflect, in part, banks husbanding their cash resources to accommodate the involuntary increase in assets.

In addition to this return of bad assets to their balance sheet, the banks also have to contend with losses incurred by the write-down of bad debts. What will happen then? As we said before in Banking for dummies,

As you can see by now, the banking business is a balancing act of managing a portfolio of assets and liabilities. Since the banking industry is a highly regulated one, there are rules for them to follow in this balancing act.

Now that the banks’ balance between assets and liabilities are out of equilibrium, what will happen? To restore balance, banks will have to raise capital (i.e. issue shares for cash) and/or cut down on lending and/or sell assets. Indeed, central bankers and foreign sovereign wealth funds have been very ‘helpful’ in this balance restoration process (see Central banks & pawnshops and Why did the foreigners bail out cash-starved financial institutions?).

As Satyajit Das continues,

The new capital noted above will merely restore bank balance sheets. Growth in lending and assets will require additional capital. The banking system?s ability to supply credit is significantly impaired and will remain so for the foreseeable future. Credit is clearly being rationed in the global financial system. If the banks are not able to re-capitalise, then the contraction in credit supply will be sharper.

Guess what will happen when the supply of money and credit contracts sharply? This is what we call “deflation” (see What is inflation and deflation?). During deflation, businesses and individuals have to de-leverage. Already, this process is already under way in Australia. When reading the mainstream newspapers, you will get to read numerous reports that credit is tightening. For example, take a read at Debt down as rates hurt in the Sydney Morning Herald,

The value of debt taken on by consumers and businesses slumped in March as higher interest rates continued to bite, according to figures published yesterday.

An economist at Lehman Brothers, Stephen Roberts, said the decrease in credit use was further evidence of the global credit crunch rippling through the broader economy as companies and consumers wind back their exposure to debt.

In Australia, with total private debt to GDP ratio of around 170%,  you can be sure that there will be more de-leveraging in the private sector to go.

This is the beginning of the next phase where the real economy is affected. In the next article, we will show you how this phase will unfold.