22 October 2008

De-leveraging – Fairy Tale Endings

by Satyajit Das October 20, 2008

In the "Arabian Nights," the beautiful princess Scheherazade buys one day of life at a time by recounting fantastic fables that enchant the King who has condemned her to die. Investors and traders are currently telling each other fairy tales to buy one day at a time 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 lyrics of the Bruce Springsteen song - many have "debts that no honest man could pay".

The "cure" is the reduction of the level of debt (the great "de-leveraging"). In 1931, Treasury Secretary Andrew Mellon explained the process to President Herbert Hoover: "Liquidate labor, 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 taken progressively more aggressive actions to try to influence events.

Central banks have supplied liquidity to the money markets accepting an increasing range of collateral. Central banks may soon accept baseball cards and Lehman, 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").

Government and central banks have also "bailed out" a number of financial institutions using a variety of strategies to limit contagion. Lower interest rates and increased government spending has been used to try to reduce the effects of the financial crisis on economic activity.

In September, the US government’s plan du jour was a $700 billion package that was the latest magic potion. It is puzzling why this initiative was seen as the "silver bullet" that would "fix" the problems.

A cursory analysis of TARP (Troubled Asset Relief Program) revealed considerable confusion about even what problem it is addressing. The proposal to purchase up to $700 billion in "troubled" assets was not dissimilar to the existing liquidity support provisions in place. If assets were correctly valued in the books of the selling banks, then purchase at that fair value only provided funding to the bank. The difference is the risk of the securities was transferred to the government but so was any possible recovery in the price.

There are different views as to what price should be paid by the government for these assets. Under one approach, the government would pay a "hold-to-maturity" price that may be (perhaps significantly) higher than the "market" price or the value in the bank’s book. This would provide the bank with liquidity as well as capital (the gain between the price paid and the lower value to which the bank has written down the asset). The alternative approach would be to pay "market" values. This would provide liquidity to the selling banks but no capital. It may even trigger additional losses where the assets were carried at higher values creating incentives against participation. There was also a small problem that nobody, even the super bankers with super computers, seemed to have a clear idea what the securities are worth in any case.

Purchases of troubled assets were also conditional on (correctly) protecting the taxpayers against losses. This required banks to provide the government with equity or equity-like interests in exchange for participating in the program. Alternatively, the institutions selling the assets will need to enter into contingent arrangements to minimise the risk of loss to the taxpayer. Commentators have gone into rhapsodies about the ability of the taxpayer to "profit" from the program. This creates potential conflicts for financial institutions whose fiduciary duties require maximisation of returns for shareholders.

It is still not clear what securities will be eligible for purchase and exactly who will be allowed to participate. Amusingly, the recent short selling ban on financial institution stocks saw a curious array of companies claim that they were financial institutions! Gaming of the system will be practically difficult to control.

In fairness, the final form of TARP has not been settled and may provide greater clarity on these points.

By October 2008, TARP had receded into the background. A number of governments resorted to injecting equity into selected banks and providing extensive guarantees supporting bank borrowings. Consistent with this approach, the US government made the leading banks an "offer they couldn’t refuse" injecting $250 billion in equity directly into financial institutions.

The actions to stem the crisis have been increasingly directed at three areas. Banks are being forced to write-off bad loans without delay. Bank capital needs are being addressed by forced mergers and restructuring, new equity issues and (in the absence of other options) nationalisation or liquidation. Central bank guarantees of all major borrowings and other transactions to reduce solvency risk for banks are designed to enable normal transactions between parties in the financial markets to resume. The necessary coordinated global action appears at last to be under way.

The initiatives are sensible short-term measures to stablise markets. In the longer run, they transfer the problem onto the government and taxpayer balance sheet. For example, US Government support for financial institutions in this financial crisis is already approaching 6% of GDP (compared to less than 4% for the Savings and Loans crisis). The bailout of Federal National Mortgage Association (Fannie Mae) and the Federal Home Loan Mortgage Corporation (Freddie Mac) has almost doubled US national debt. This will ultimately place increasing pressure on the US sovereign debt rating and vitally the ability of US to finance its requirements from foreign creditors.

Government and central bank initiatives to date have been ineffective. Money markets remain dysfunctional and inter-bank lending rates have reached record levels relative to government rates. The failures are unsurprising.

At the height of the boom, banks used a variety of techniques to increase the velocity of money. As the system de-leverages, the velocity of money has sharply decreased.

Money being supplied to the banks is not being lent through. Banks are parking the money in short dated government securities in anticipation of their own funding requirements. Around $3-4 trillion of assets are returning to bank balance sheets from the "shadow" banking system - off-balance sheet structures - that can no longer finance themselves. In addition, banks have large amount of maturing debt (estimates suggest $1.5 trillion by the end of 2008) that they must fund. Fear of bank failure (especially after the bankruptcy of Lehman and restructuring of WaMu) and shortages of capital also limit ability of banks to on-lend.

It remains to be seen whether the most recent global initiatives achieve the required re-capitalisation of banks improves the normal supply of credit to sound borrowers and also reduces fear of default allowing normal activity between institutions to resume.

The key issues remain availability of capital and liquidity. The perceived abundance of liquidity was, in reality, merely an illusion created by high levels of debt and leverage. As the system de-leverages, it is becoming clear unsurprisingly that available capital is more limited than previously estimated.

Central bank reserves and sovereign wealth funds are often cited as evidence of the amount of available capital. These reserves are invested in US dollar denominated US Treasury bonds, GSE paper and highly rated securities. It will be difficult to mobilise the funds and convert them into the home currencies of the investors without large losses.

The risk of a severe dislocation in global capital flows remains a real risk in the present environment. Some have called for a global conference (along the lines of Bretton Woods) under a respected chairman (Paul Volcker is the obvious choice) bringing together all the major players to address key structural issues within the global financial system. Any such conference would focus on economic reforms (capital flows, currency policies, fiscal disciplines, trade barriers) necessary to find a resolution to the crisis.

A principal objective of this conference would be ensuring supply of funding for the US in the transition period. Recent comments by China about US responsibility for the crisis and its resolution miss the point. As China’s Premier Wen Jiabao observed the U.S. financial crisis may "affect the whole world". As Wen noted: "If anything goes wrong in the U.S. financial sector, we are anxious about the safety and security of Chinese capital…" All creditors have much to lose if the de-leveraging process becomes dis-orderly.

Ultimately, "all the king’s horses and king’s men" cannot prevent the de-leveraging of the financial system under way. The extent of de-leveraging is substantial and likely to take time. In recent years, money was cheap and other assets were expensive. As each of the global economy’s credit creation engines breaks down and systemic leverage reduces, money becomes scarce and more expensive triggering substantial adjustments in asset prices in a reversal of the process.

David Roche of Independent Strategy, a consulting firm, estimates that $4 to $5 of debt is now required to generate $1 of economic growth. As credit creation slows and debt levels fall, the sustainable level of global economic growth may fall as well.

At best, the government and central bank actions can smooth the transition and reduce the disruption to economic activity in the transition to a lower debt world. The risk is that well-intentioned steps prevent the required adjustments from taking place, delay recognition of problems and discourage action that must be taken by financial institutions, corporations and consumers.

Like a giant forest fire the de-leveraging process cannot be extinguished. Thoughtful actions can create firebreaks that limit preventable damage to the economy and the international financial system until the fire burns itself out.

The Arabian Nights had a happy ending. The King after 1,001 night of enchantment and three sons pardons the beautiful Princess Scheherazade who becomes his queen. Despite the fairy tales that investors are putting their faith in currently, the de-leveraging that is at the heart of the current financial crisis may not have such a happy ending.

Satyajit Das is a risk consultant and author of Traders, Guns & Money: Knowns and Unknowns in the Dazzling World of Derivatives (2006, FT-Prentice Hall).

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