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The De-Leveraging Virus


Financials were first, but no sector is immune.

Equity markets believe the worst is over. Despite begrudging acknowledgment that an extraordinary level of debt and leverage precipitated the problems, there is limited recognition of the de-leveraging of the global financial system that is under way. Leverage amplifies returns but also accelerates de-leveraging.

The Exhibit below shows how de-leveraging takes place in a levered world. Imagine a hedge fund with $20 of unlevered capital. If a bank or prime broker allows it to leverage five 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 nine times ($10 of equity - the original amount less the loss - and $80 of debt supporting $90 of assets). If the leverage stays constant at five 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 three 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).

Exhibit: Impact of Losses on a Leveraged Investor

Click to enlarge

De-leveraging requires liquid markets and buyers with capital to purchase the assets. Prices of risky assets must fall to market clearing levels as the system adjusts debt levels. The process described is now underway in financial markets.

The initial phase of de-leveraging, currently underway, is focused on financial markets. Banks have suffered losses in excess of $200 billion (with more possible). Approximately $1 trillion of assets have returned onto bank balance sheets. This included "warehoused" assets that were not able to be securitized and assets previously "parked" in asset backed security commercial paper ("ABSCP") conduits, structured investment vehicles ("SIVs") and Collateralized Debt Obligations ("CDOs"). An additional unknown amount of assets will return onto bank balance sheets as hedge funds gradually de-leverage.

Banks require funding and capital to cover losses and returning assets (christened IAG, or involuntary asset growth). High inter-bank rates reflect, in part, banks husbanding their cash resources to accommodate the increase in assets. Banks will also need in excess of $500 billion in new capital to cover losses and the regulatory capital required against returning assets. The capital required is around 20-25% of total global bank capital. Banks have raised in excess of $100 billion in new capital and the number of new equity raisings is accelerating. It is not clear how this capital requirement will be meet.

The additional capital will merely restore bank balance sheets. Growth in lending and assets will require additional capital. The banking system's ability to supply credit will be significantly impaired for the foreseeable future. If the banks are not able to re-capitalize, then the contraction in credit supply will be sharper.

In recent years, off-balance sheet vehicles – ABS CP conduits, SIVs, CDOs and hedge funds (collectively known as the "shadow banking" system – have provided additional leverage. These vehicles relied extensively on bank funding or support. The withdrawal of this support means that these vehicles are also de-leveraging rapidly. Hedge funds have reduced leverage from an average 5/6 times to around 3/4 times as the supply of credit tightens. Each one time leverage reduction in hedge fund leverage represents in excess of $2 trillion of assets. This accelerates the de-leveraging process.

The next phase of de-leveraging will focus on the real economy. Availability and cost of funding has already adjusted. Corporations with maturing debt face refinancing difficulties. This will force de-leveraging of corporate balance sheets.

Personal balance sheets will also de-leverage. 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.

An economic slowdown will exacerbate the de-leveraging. A fall in asset values can be sustained where the borrower has sufficient income and cash flow to service the debt. Reduction in corporate cash flows and reduced personal income (via unemployment) will sharply accelerate the de-leveraging. Uncertainty about the future and market volatility will also accelerate the de-leveraging as companies and consumers reduce debt and aggressively save.

De-leveraging in the real economy may result in increasing defaults. Firms and individuals with unsustainable amounts of debt will fail. This will result in further losses to financial institutions setting off negative feedback loops as both asset prices and the level of aggregate leverage adjusts.

Central banks and governments actions have been directed on maintaining liquidity and (increasingly) directly supporting the financial sector. In the US and Spain, direct fiscal stimulus is already being administered. These actions are designed to prevent a catastrophic collapse in the financial sector and maintain a normal supply of credit to creditworthy business and individuals. They are also designed to help the real economy from slowing down to a degree that the de-leveraging accelerates further. At best, these actions will smooth the inevitable de-leveraging and adjustment to financial asset prices.

Perhaps the 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."
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