Posts Tagged ‘Satyajit Das’

Will China set off a derivative meltdown?

Thursday, September 24th, 2009

In Satyajit Das’s book, Traders, Guns & Money, he started off with a story of an Indonesian noodle making company getting embroiled in a complex currency derivative contract (that it did not fully understand) with a bank. Unfortunately for that company, a currency Black Swan event turned up and as a result, under the obligations of the derivative contract, the financial viability of the company was threatened. Big shot lawyers and experts were called up from both sides. The defence alleged that the Indonesian company was deceived into entering the contract whereas the bank’s lawyers insisted that the company signed the contract out of its own accord in full knowledge of its obligations. The bank’s lawyers screamed expletives, insisting that the Indonesian company honour its end of the derivative contract, or else the matter will go to court.

Today, many Chinese state-owned enterprises (SOE) found itself in the same situation. SOEs like China Eastern Airlines, Air China and shipping giant Cosco had entered derivative contracts with Deutsche Bank, Goldman Sachs, JP Morgan, Citigroup and Morgan Stanley. The Chinese are not happy with the derivative contract. So, those SOEs (assumed to have the backing of the Chinese government) sent legal letters to those American investment banks and told them, in effect, to get stuffed with the derivative contracts.

The question, as this article said,

In that case, have the banks taken advantage of them or is it simply a case of caveat emptor?

Would the SOEs end up in a court dispute with the banks (as the banks believe, the derivatives contracts are legally enforceable ones struck in Hong Kong, Singapore and London)?

The situation is much more complicated than that just a few court cases. If the banks dragged the Chinese into court, the Chinese government can retaliate by withholding the banks’ banking license in China, which will result in a tremendous loss of their businesses in China. On the other hand, if they negotiate with the Chinese, then it will set a dangerous precedent for their other counter-parties who are in the same situation as the SOEs. Should that happen, US$2 billion derivative contract default can set off a chain-reaction of other defaults.

Such a chain reaction will light up a bigger time-bomb. There are still hundreds of trillions (in notional value) worth of derivative contracts in the global financial system. As we explained with an example in Chained together, for better for worse, defaults can beget even more defaults.

As this article wrote,

Yet any escalation of the defaults to multiple countries could see a second wave of bank failures and, at the very least, a bad double-dip recession. And that’s without the increasingly worrying creeping protectionism around the globe.

An escalation is certainly deflationary.

Would the Chinese government attempt to light up such a fuse? We don’t know, but we can imagine that such an outcome will benefit them greatly. You see, during the Panic of 2008, deflation led to a surge in the US dollar and US Treasury bonds and a collapse in the prices of stocks, gold, silver, oil and other commodities. The Chinese would love for that to happen again because it will give them another golden opportunity to sell their US dollars and US Treasuries to buy real assets (e.g. gold, silver, commodities and resource/energy stocks).

This is something worth watching.

Are government interventions the first steps towards corruption & inefficiencies?

Tuesday, January 27th, 2009

The global financial crisis (GFC) has seen governments all over the world engaging in stimulus, special plans, guarantees, rescues, bailouts, nationalisation and other forms of interventions. The Australian government is no different. The first was the guarantee of all Australian bank deposits and loans. Next was the AU$10 billion economic stimulus. Then recently, there was a plan to set up a special purpose fund to help banks refinance as much as AU$75 billion worth of loans. Other plans include help for certain industries (e.g. car, construction, child-care, property sectors) cope with the global shortage of money (credit crisis). In addition, the Reserve Bank of Australia (RBA) is busy cutting interest rates. In the US and Britain, massive banks and GSEs were gobbled up through nationalisations while their limping peers have their incompetence covered by the monetary printing press. As Australia approaches a hard landing (see Realisation of hard landing ahead for Australia), we can expect what happened overseas to happen in Australia.

Among the various forms of government interventions, we have the strongest reservations against bailouts and rescues. While they ease the pain in the short term, they are detrimental to the economy in the long term. While the sting of this GFC may be soothed by each government intervention, there will always be longer term side-effects, many of which will be unintended and initially unforeseen. All these unintended side-effects will eventually accumulate and turn the GFC into a long-term economic malaise that result in a bleak future for the next generation. In other words, anyone who is concerned for the next generation will have strong reservations for today’s bailouts and rescues.

Here are some of the issues with bailouts and rescues:


They are inherently unfair because the government will have to act as the judge and decide which businesses/industries should live and which ones should die. Unfairness, by its very nature, implies preferential treatment. What is the government’s basis for favouring one business/industry over the other? Due to the ’emergency’ nature of bailouts and rescues, transparency over such government decisions will be in short supply. This will open the door for corruption as lobby groups and vested interests jostle and fight over the government’s preferential treatment. This is not to say that the current government is corrupt. Instead, our concern is that this will open the door for future governments to be corrupt.

Moral hazards

Bailouts and rescues introduce moral hazards because by not letting the free market punish incompetent, reckless and stupid business behaviours, they are making conditions ripe for more of such nonsense to continue. After all, why bother be good when bad behaviours are not punished?

The whole point of free market capitalism is to let the incompetent businesses be eliminated so that the competent ones can take over the incompetent ones and be rewarded. This competition forces the survival of the fittest and most efficient. By bailing out and rescuing, the government is taking precious economic resources (which is scarce in such a time) from the competent (via taxes) and awarding them to the incompetent. The net result is that the economy as a whole will become more and more inefficient. This is precisely the reason why communism ultimately fails.

Now, there are talks of the need for more government regulations to curb such nonsense in order to prevent future financial crisis. The idea is to bailout and rescue first, then come up with more rules and regulations to ‘prevent’ another global financial hazard from happening again.

The problems with rules and regulations are:

  1. Administering, monitoring and enforcing them are costly. They are a drag on economic growth as they introduce more red tape for businesses to handle.
  2. Rules and regulations may be so effective that while they prevent the bad things from happening, they cab also stifle the good things from bearing fruit too. Those entrepreneurs with brilliant ideas who have to battle government red tape to get their projects moving another step forward can relate to that.
  3. As we said before in Where do we go from here? A journalist?s questions…,

    … at the root of this Global Financial Crisis (GFC) lies the moral failure of humanity. Through this moral failure, the world is allowed to get carried away and believe in what it wants to believe.

    Rules and regulations can only work up to a certain extent because beyond that, it is impossible to legislate morality.

  4. No matter how tight and comprehensive rules and regulations are, there will always be loopholes and gaps to allow circumvention. For example, as Satyajit Das revealed in his book Traders, Guns & Money, derivatives routinely make a mockery out of laws. It has come to a point that poking holes at the legal system via derivatives has become a sport!

As we quoted Jimmy Rogers in Jimmy Rogers: ?Abolish the Fed?,

More regulations? You want Alan Greenspan and Ben Bernanke? These are the guys who got us into this situation. They are supposed to be regulating the banking system for the past 50 years. These are the guys who let it all happen. I don?t want more regulations. Let the market regulate it. If xyz needs to go bankrupt, let them go bankrupt. I promise you, that will send a very straight signal and you will have a lot of self-regulation when these guys start to go bankrupt.

If the Federal Reserve did not bail out LTCM in 1998 and let it go bankrupt instead, it would have sent a very strong signal to the market back then.


One day, the GFC will end. But this generation will leave a legacy of corruption and inefficiency for the next if today’s governments continue to intervene in such an unprecedented scale.

Government intervention leading to more risk for banks?

Tuesday, December 23rd, 2008

Back in How do you define risk?, we wrote,

In today?s financial services industry, a large part of risk is defined by the volatility of the price?the more volatile the investment is, the more ?risky? it is.

Also, as we wrote in Real economy suffers while financial markets stuff around with prices,

Right now, deflationary forces are acting on the economy while at the same time, central bankers and governments are attempting to inflate. Consequently, the result is extreme volatility in prices. Volatile prices hinder business calculations, which in turn hinder long-term planning.

Paradoxically, government interventions, for all their good intentions, are making the situation worse by introducing unintended consequences into the global financial system. For example, in the case for banks, Satyajit Das wrote in Fear & Loathing in Financial Products: Banks – The ?V?, ?U? or ?L?,

Risk models in banks are a function of market volatility. The low volatility regime of recent years reduced the amount of capital needed. Increased market volatility will increase the amount of capital needed. This may restrict the level of risk taking and therefore earnings potential.

Everything else being equal, the increase in the amount of capital needed implies a reduced availability and amount of credit to the real economy. This in turn will have an effect on economic activity.

Test for credit default swaps (CDS) begins…

Monday, September 15th, 2008

We are supposed to continue from yesterday’s article, What is the meaning of ?oversold?? Part 1: Technical analysis perspective, today. But the latest news on the financial markets takes precedence over the continuation of yesterday’s article.

As you will probably have heard by now, Lehman Brothers, one of the biggest investment banks in the United States has just gone bankrupt. Its peer, Merrill Lynch was bought over by Bank of America at a fire-sale price. Central bankers all over the world are bracing for vicious reactions from the financial markets. In Australia, the RBA had already injected extra liquidity into the financial system (see Reserve Bank injects extra liquidity). The Federal Reserve is intending to already made preparation for accepting stocks as collaterals for loans, as this news article says,

One of the biggest changes the Fed made was to accept equities as collateral for cash loans at one of its special credit facilities, the first time that the Fed has done so in its nearly 95-year history.

As we said before in Central banks and pawnshops,

Traditionally, the Fed would only accept the highest quality assets, US Treasury bonds, as collaterals. But due to the credit crisis, the Fed (along with other nations? central banks- see Reserve Bank of Australia entering the landlord business) is lowering the standards of collaterals to include top-rated residential and commercial mortgages. The Fed?s most recent statement indicates that they are lowering the standards even more (to auto loan and credit-card bonds). Using the pawnshop example, it?s like the pawnshop lowering the standard of the pawns that it will accept, say from gold jewellery to silver jewellery.

By accepting equities as collaterals, the Fed is lowering their standards even more. The central banks may be preparing and bracing for devastating fallout in the debt and equity market, but the question still remains: will the derivatives markets able to stand in the coming test? As we quoted Satyajit Das in How the CDS global financial time-bomb may explode?,

CDS documentation is highly standardised to facilitate trading. It generally does not exactly match the terms of the underlying risk being hedged. CDS contracts are technically complex in relation to the identity of the entity being hedged, the events that are covered and how the CDS contract is to be settled. This means that the hedge may not provide the protection sought.

This introduces systemic problems to the financial markets that have yet to be tested. Here are the technical difficulties with CDS:

  1. Who problem– As we explained before in Potential global economic black hole: credit default swaps (CDS), CDS is like insurance against default by a specific entity. Let’s call this entity the reference entity. The problem is, modern companies work through a complex web of entities mainly for tax reasons. What if the reference entity in the CDS does not match exactly with the defaulting entity? Furthermore, what if there is a restructuring, merger, de-merger, sale of divisions, break-ups takeover, etc. The definition of the reference entity becomes murky.
  2. What problem– What events constitutes a “credit” event? The common ones are (1) failure to pay, (2) bankruptcy, (3) repudiation or moratorium, (4) restructuring. But sometimes in real life, “credit” event may not be that straightforward. Restructuring may follow further restructuring, followed by even more… Different countries may have different laws regarding the form, definition and handling of bankruptcy that is at odds with local laws, which in turn put the CDS contract into a conundrum of definitions. As we quoted Satyajit Das in Potential global economic black hole: credit default swaps (CDS),

    The buyer of protection is not protected against ?all? defaults. They are only protected against defaults on a specified set of obligations in certain currencies. It is possible that there is a loan default but technical difficulties may make it difficult to trigger the CDS hedging that loan…

    A CDS protection buyer may have to put the reference entity into bankruptcy or Chapter 11 in order to be able to settle the contract.

    Imagine the economic mayhem it will create as companies push and jostle each other into bankruptcy at the slightest excuse to protect their own cash flow!

  3. How problem– How do you get paid the insurance payment in a CDS contract? Should you rely on publicly available information and use it as a basis to get paid? What if the reference entity makes a partial payment and then the news wire reported that it defaulted when it is going to pay the rest later?

By now, you can see how the idea of CDS can be mired into complex legal entanglements. This will have systemic ramifications for the financial markets. We will be holding our breath to see how the drama will unfold in the weeks and months to come.

How the CDS global financial time-bomb may explode?

Monday, June 2nd, 2008

Back in Potential global economic black hole: credit default swaps (CDS), we first introduce credit default swaps (CDS) and warned that it is a potential global financial time bomb that is waiting to explode. Should it explode, we will see another major panic in the global financial system, possibly even surpassing the panic back in January this year. So far, the CDS market has not yet been tested through a trial of fire and the risk is that it may turn out to be a house of cards when put under stress.

Satyajit Das, a character whom we introduced back in Is the credit crisis the end of the beginning?, has this to say about CDS in The Credit Default Swap (?CDS?) Market – Will It Unravel?:

CDS documentation is highly standardised to facilitate trading. It generally does not exactly match the terms of the underlying risk being hedged. CDS contracts are technically complex in relation to the identity of the entity being hedged, the events that are covered and how the CDS contract is to be settled. This means that the hedge may not provide the protection sought.

As we explained before in Potential global economic black hole: credit default swaps (CDS), the buyer of a CDS is basically buying insurance against the default of a debt. The problem is that how do you define what a “default” is? If a defaulted debt cannot fulfil the technical conditions to satisfy the trigger of insurance payment, then the insured party may find themselves in danger of insolvency. As Satyajit Das wrote,

The CDS contract is triggered by a ?credit event?, broadly default by the reference entity. The buyer of protection is not protected against ?all? defaults. They are only protected against defaults on a specified set of obligations in certain currencies. It is possible that there is a loan default but technical difficulties may make it difficult to trigger the CDS hedging that loan.

As a result, this will have widespread systemic implication:

A CDS protection buyer may have to put the reference entity into bankruptcy or Chapter 11 in order to be able to settle the contract.

As with most financial crisis and panic, decisions that make sense at an individual level will result in catastrophe if repeated en masse. If enough businesses are pushed into bankruptcies in order to fulfil the technical requirements of default, then losses will be exacerbated, triggering another around of credit deflation.

Then there is another problem. Since CDS is a derivative, the buyer of a CDS need not necessary owns the bond (debt asset). But in order to receive insurance payment for the debt payment, the bond has to be delivered. But what if there is more CDS than bonds (this may happen due to securitisation)? Then when the bond defaults, there will be a mad rush among the CDS holders to grab a slice of the defaulted bond (figuratively speaking), which pushes up the price of the bond. As a result, the CDS holder may not be as fully hedged as assumed to be.

If you think this is complex, this is because the murky world of derivatives is complex. Even central bankers do not understand it all.

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.