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Deleveraging: How Will It End?


No fairytale conclusion for this crisis.

In the Arabian Nights, the beautiful princess Scheherazade buys one day of life at a time by recounting fantastic fables that entrance the King who has condemned her to die, and now investors and traders are telling each other fairytales to buy one day at a time in an attempt to stave off the inevitable.

The drama and tumult of recent events are not symptoms of the disease but the cure. The "disease" is the excessive debt and leverage in the financial system, especially in the US, Great Britain, Spain and Australia. In the words of a Bruce Springsteen song, many have "debts that no honest man could pay".

The "cure" is the reduction of the level of debt (the great "deleveraging"). In 1931, Treasury Secretary Andrew Mellon explained the process to President Herbert Hoover:

"Liquidate labour, liquidate stocks, liquidate the farmers, liquidate real estate. Purge the rottenness out of the system. High costs of living and high living will come down... enterprising people will pick up the wrecks from less competent people."

The initial phase of the cure is the reduction in debt within the financial system. The overall losses to the financial institutions (net of re-capitalisation via new equity issues) are $400 to $600 billion and may well go higher. This requires reduction in financial sector balance sheets (assuming bank system leverage of around 10 times) of around $4 to $6 trillion through reduction in lending and asset sales.

For example, the bankruptcy of Lehman Brothers resulted in $600 billion of debt being eliminated. In turn, this inflicts losses on holders of Lehman debt that in turn flows through the chain of capital. The destruction of Lehman Brothers' capital (around $20 billion) also permanently diminishes the capacity for further credit creation in the future.

The second phase of the cure is the higher cost and lower availability of debt to the real economy. This forces corporations to reduce leverage by selling assets, reducing investment and raising equity (for example, as GE has done). This also forces consumers to reduce debt by selling assets (where available) and reducing consumption.

Feedback loops mean reduction in investment and consumption lowers economic activity, placing stresses on corporations and individuals setting off defaults that trigger losses for the financial system that further reduces lending capacity. De-leveraging continues through these iterations until overall levels of debt reach a sustainable level determined by lower asset prices and cash flows available to service the debt.

The process of destruction echoes W.B.Yeats' words: "All changed, changed utterly: A terrible beauty is born."

Within the financial sector, de-leveraging is well advanced. In the real economy it is in the early stages. Fairy tales in financial markets focus on the "superhuman" abilities of regulators and governments to avoid the de-leveraging under way.

Central banks and governments have aggressively supplied liquidity to the money markets accepting an increasing range of collateral. Central banks may soon accept baseball cards and Lehman Brothers, Bear Stearns and Washington Mutual ("WaMu"), Fortis and Dexia
memorabilia (mugs, stress balls, desk-decoration cubes that open up to reveal Lehman Brothers' key operating principles - "demonstrating smart risk management").

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No positions in stocks mentioned.

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