Why Deleveraging is so painful

Why a recovery is at least 7 years away: Economy Falling Years Behind Full Speed

6 Apr 2009. Louis Uchitelle. New York Times.

As the recession grinds on, more and more of the nation’s means of production — its workers, its factories, its retail outlets, its freight lines, its bank lending, even its new inventions — are being mothballed. This idled capacity, like baseball players after a winter off, takes time to bring back into robust use. The mathematics are daunting. The shortfall is running at more than $1 trillion in annual sales and other transactions. Only once since the Great Depression has there been such a severe loss of output — in the 1981-82 recession — and after that downturn, it was seven years before the economy regained the lost production.  Recovery from the current recession could be similarly sluggish.

[The downturn is FOREVER because energy makes everything happen, and peak world-wide production was reached in 2005, so 7 years is quite optimistic…]

A 10% price drop can lead to a loss of 50% or more

In 2008, money market funds stopped buying commercial paper issued by Structured Investment Vehicles.

This led to deleveraging:  less money and slow economic growth

Banking regulations require the structured investment vehicles to be brought their books, which in turn requires that they shore up their capital base by selling new shares or shedding other assets.

Every dollar that is used for this purpose is a dollar that can’t be used to make loans for corporate buybacks, commercial customers or hedge funds.

Without such loans, banks’ earnings and growth are very much reduced.

Worse yet, the buying power of the two main drivers of the last bull market — hedge funds and corporate Treasurys — is crippled because the leverage they’ve used to reap big profits has suddenly turned against them.

As hedge funds deleverage in fits and starts, much of their inventory is going back to bank balance sheets. This is known in the banking business as involuntary asset growth, and it isn’t good. It forces banks to issue more new equity to comply with international capitalization rules, further undermining current shareholders.

Deleveraging is going on among corporations and individuals as well, leading to less buying power for both. That leaves less money available for homes, cars, televisions and travel, further leading to the sort of buyers strike characteristic of long periods of slow or stagnant economic growth

How Deleveraging works

Assume a hedge fund has $20 of real capital.

If a bank allows it to leverage five times its capital, the fund can acquire $100 of risky assets with $20 of equity and $80 of debt.

Now the assets fall by 10% in value, or $10.

The hedge fund’s leverage suddenly increases to 9 times: $10 of equity (the original amount less the loss) and $80 of debt now supports $90 of assets.

If the permitted leverage stays constant at 5 times, the hedge fund must sell $50 of assets, or 50% of its holdings. If lenders reduce permissible leverage to 3 times the loss, then the hedge fund must then sell $70 of assets, or 70% of its holdings. This process is bad enough in normal markets, but when buyers are scarce, prices of these involuntary sales are knocked down to levels that can wipe out the fund.

[My comment: Quantitative Easing threw trillions at the 1% who’ve leveraged it into bubbles across the financial landscape in commodities, housing in select areas, stocks, and so on.  Consequently, in the next financial crash, the deleveraging will be even worse than the 2008 crash].

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