The Real Impact of De-Leveraging
Consequences extend far beyond Wall Street.
Ultimately, de-leveraging will have vast consequences, but it's just getting started. For instance, we've been hearing about banks reducing leverage for nearly a year now so it would be natural to expect that banks today have less leverage than they did when the process began. Guess again!
Most recent figures for Citigroup (C), for instance, show a Tier 1 capital ratio (a measure of banks leverage used by the Federal Reserve which divides stockholder equity and other "irredeemable" capital by risk-adjusted assets) of 7.7%. As of last June, Citi had a Tier 1 capital ratio of 7.9%. So, after a year of de-leveraging and capital infusions, Citi is actually more levered than it was before the credit mess first surged into the headlines. Similarly, Wachovia's (WB) most recently disclosed Tier 1 capital ratio stands at 7.5%. Care to guess its ratio last June before it took steps to reduce its leverage? That's right: 7.5%!
Banks have made efforts to reduce exposure, of course, but even as they shed risk right and left, they've had to take new assets onto to their books. Busted SIV's, conduits, and other off-balance sheet loans have come home to roost; bridge loans and other forms of buyout financing have been reluctant to leave home; mortgages and other loans held for structured products are not getting structured, companies are drawing down previously unused revolvers, and on it goes, to the tune of $1 trillion and counting. And, of course, banks are also slowly writing down the value of the assets they hold on their books as both default rates and losses surge past expectations. Essentially, banks have been filling the tub with the drain open (to use a phrase that was originally applied to the Fed).
Rather than de-leveraging, what we've seen so far has been the forced acknowledgment of leverage that was there all along, but previously camouflaged by accounting sleight-of-hand, mark-to-model wishful thinking, and creative interpretations of "non-recourse," and "off balance sheet." What we're seeing is something more like Michael Jackson's classic "moonwalking" rather than real movement.
For insight into some of the forces driving de-leveraging, I recommend Minyan professor Das' post, The De-Leveraging Virus, from April 22. Rather than duplicate his excellent work, I'd like to put this de-leveraging process into a much larger perspective.
Simply put, leverage has been building in the U.S. economy for over 60 years. Coming out of the Depression and World War II, household debt was a bit more than 20% of GPD. By 2006, it was more than 90% of GDP, with the greatest surge since 1998. The increased leverage shows up everywhere, most notably in the declining equity in owner-occupied homes.
In 1952, the average homeowner had more than 80% of the equity in his or her home. By the end of March, 2008, that figure had dropped to about 47%. Considering that roughly 27% of homeowners have no mortgages at all, that means that many millions of American homeowners have virtually no equity in their own homes (and some bank estimates predict that 10 million homeowners will have negative equity in their homes by the end of next year). Most likely, these households have no pension or savings either.
We've learned about the leverage in the financial sector with thudding regularity, as each quarter brings new confessions in the form of unexpected write-downs and losses. Moreover, an extraordinarily high ratio of junk-rated debt belies all the talk about cash-flush American companies. When they were raking in the cash, many companies either bought back their shares at sky-high valuations, or were bought out by private equity groups, which promptly stripped the cash through dividend recapitalizations.
Even this cursory look at the context leads to one obvious point: a process of laying on leverage that was several decades in the making does not get unwound in one summer (as, unbelievable as it now seems, some on Wall Street were arguing last fall). Nor can it be sorted out in a year.
But at least it has begun.
Actually, the moonwalking of the banks, while it hasn't reduced leverage, has been both necessary and healthy. The sooner investors have confidence that a financial institution's assets are fairly and transparently valued, the sooner money will begin to flow again. On the other hand, we haven't even begun to see hurt the continuing de-leveraging will inflict on the economy and on consumers who have depending on access to credit to finance spending for several years.
One thing we can count on is that as consumers are forced to de-lever many will likely see a decline in living standards because so much of household cash flow has been financed by credit. That's when we will see the political and social reverberations of de-leveraging. For starters, take it as a given that most consumers won't blame themselves for the end of dream.
More likely, it will dawn on the beleaguered middle class that the main beneficiaries of this latest gilded age have been a tiny percentage of Americans who are owners and well-positioned intermediaries raking in what Tom Wolfe aptly called "golden crumbs" as money and products moved through the economy. There's an old saying that "over time money returns to its rightful owners." The trouble is that the question of who are the "rightful owners" of money has always been open to dispute, and there are now many times the number of Americans who've seen their net worth plummet than those who, for the moment, own the nation's wealth.
And, to finish the story, these Americans are voters. As dreams ebb of striking it rich in housing or the markets, many pension-deprived, house-poor, "right-sized" Americans may well discover a new found respect for government, regulations, safety nets, and unions (not to mention protectionism and xenophobia). Conversely, with diminished prospects and many grievances against those who ended up with their money, voters may also be more open to taxes on the rich.
It's consequences like this that show that the salience of dry academic terms like "de-leveraging" extend far beyond the insular world of finance.
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