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Leverage and Deleveraging
When, however, the economy suffers from Post Bubble Disorder,
characterised by private sector deleveraging and a fat-tail risk of deflation
In such a liquidity trap, private sector demand for credit is, axiomatically, very inelastic to low interest rates,
as evidenced by contracting private sector debt footings, even when the central bank’s policy rate is pinned against zero.
In such circumstances, the central bank has a profound duty to act unconventionally
Paul McCulley August 2010
ballooning its balance sheet by monetising assets, either government or private, or both. Put differently, the central bank has a profound duty to meld itself with the fiscal authority, until the fat-tail risk of deflation is cut off (and then killed, in the famous words of General Colin Powell).
Indeed, this very idea is what gave Chairman Bernanke his nickname of Helicopter Ben back in November 2002, when discussing possible remedies to deflation in the United States were it to unfold.
Here’s what he said:
To generate increased growth in aggregate demand, some sector of the economy must be willing to proactively lever its balance sheet. And that must be the fiscal authority, if the private sector is intent on delevering.
Yes, I know all about the perils of long-term fiscal unsustainability. But I also know that in the long run, we are all dead. I see no reason to die young from fiscal-orthodoxy-imposed anorexia.
Full textAggregate consumer debt continued to decline in the second quarter,
continuing its trend of the previous six quarters.
As of June 30, 2010, total consumer indebtedness was $11.7 trillion,
a reduction of $812 billion (6.5%) from its peak level at the close of 2008Q3
Calculated Risk with nice chart 17/8 2010
Whatever you think about fractional reserve banking the truth is that we no longer have it.
Reserve requirements apply only to transaction accounts, which are components of M1, a narrowly defined measure of money. Deposits that are components of M2 and M3 (but not M1), such as savings accounts and time deposits, have no reserve requirements and therefore can expand without regard to reserve levels.
Washingtons blog 21/3 2010
With the repeal of Glass-Steagall, deposits have been used to speculate in every type of investment under the sun, using insane amounts of leverage. Instead of the traditional 10-to-1 ratio, the giant banks and hedge funds were using much higher levels of leverage.
For example, Congresswoman Kaptur told Bill Moyers that while - on paper - there are 10-to-1 reserve requirements, banks like JP Morgan were using 100 to 1 leverage. She said that, with derivatives, leverage might be much higher.
And remember that most of the credit in our economy is actually through the shadow banking system, not through traditional depository banking.
This U.S. debt to GDP started accelerating in the 1960s (with the Vietnam War, Space Race and continuation of the Cold War) when it took $1.53 to generate an additional $1 of GDP.
Then during the 1970s, with the continuation of the Vietnam War, it took $1.68 to generate $1 of GDP.
In the 1980s (including Leveraged Buyouts and Star Wars) it took $2.93.
In the 1990s (with the internet bubble) the debt it took to generate $1 of GDP climbed to $3.12.
However, the most incredible of all was the first decade of this century when it took over $6 to generate an additional $1 of GDP.
That decade included the war on terror, two wars, private equity firms (new name for leveraged buyouts) and housing and another stock market bubble, as well as promises of entitlements that we have no possibility of being able to keep.
Clearly, needing over $6 to generate $1 of GDP is unsustainable.
Comstock January 25, 2010
Eurozone credit contraction accelerates
Bank loans and the M3 money supply in the eurozone contracted at an accelerating pace in November, raising the risk that a lending squeeze will choke the region's fragile recovery next year.
Ambrose Evans-Pritchard, 30 Dec 2009
Banks have chosen to restrict lending as they struggle to meet tougher capital rules rather than dilute shares by raising fresh equity or accepting the onerous terms of state support schemes. This has prompted harsh criticism from finance ministers, but Professor Tim Congdon from International Monetary Research said the authorities themselves are to blame.
"This is becoming ridiculous. How can banks raise capital asset ratios and lend more at the same time? These people are barmy," he said, comparing the new rules with policy mistakes in the early 1930s.
Barmy
1. stupid, bizarre, foolish, silly, daft (informal), irresponsible, irrational, senseless, preposterous, impractical, idiotic, inane, fatuous, dumb-ass (slang) This policy is absolutely barmy.
2. insane, odd, crazy, stupid, silly, nuts (slang), loony (slang), nutty (slang), goofy (informal), idiotic, loopy (informal), crackpot (informal), out to lunch (informal), dippy, out of your mind, gonzo (slang), doolally (slang), off your trolley (slang), round the twist (Brit. slang), up the pole (informal), off your rocker (slang), wacko or whacko (informal), a sausage short of a fry-up (slang) He used to say I was barmy, and that really got to me.
insane reasonable, sensible, rational, all there (informal), sane, of sound mind, in your right mind
www.thefreedictionary.com
The Age of Deleveraging
Total consumer debt is shrinking for the first time on 60 years.
And the decline shows no sign of abating.
John Mauldin 19/12 2009
This recession was caused not by too much inventory but by too much credit and leverage in the system. And now we are in the process of deleveraging.
And this is true in Europe as well, and maybe more so; but today we will look at some data in the US.
Credit card companies have reduced available credit by $1.6 trillion dollars. And for good reason.
The coming debacle in commercial real estate loans is well-documented.
Past post-recession expansions have been built on growing credit and leverage. That will not be the case this time. We are going to see reduced lending and borrowing. Even though the federal government is running massive deficits, the stimulus portion of the debt will be running down in the latter half of 2010. There will be little political will to continue with massive stimulus and deficits.
While this is good in the long run, in the short run it will reduce GDP.
We know that the current driving force behind this downturn is “deleveraging”.
Overindebted households and undercapitalised banks are adjusting their balance sheets, building up savings in the first case and restricting lending in the latter.
There is no chance of a sustained economic recovery until that process is almost complete.
Wolfgang Münchau, Financial Times, December 28 2008
We are still some way from that point. For example, on my calculations it will take a total peak-to-trough decline in real US house prices of some 40-50 per cent to get back towards long-term price trends and for price-rent ratios to return to more sustainable levels. We are about half-way through this process.
I arrive at three policy priorities for 2009. The first is for central banks to avoid deflation.
If ever there has been a need for a central bank to target price stability, it is now.
I mean this in the European sense of the term, meaning a small but distinctly positive rate of inflation, say 2 or 3 per cent annually.
I worry, though, that the US will try to raise inflation afterwards, which would reduce the real level of US debt but create massive distortions in exchange rates and financial flows and produce another global financial and economic crisis.
The second priority is to shrink the financial sector. A disorderly collapse would be catastrophic, but it is neither desirable, nor possible, to maintain the financial sector at its current excessive size. Take the market for credit default swaps, an unregulated $50,000-$60,000bn casino that serves no economic purpose except to enrich its participants at massive risk to global financial stability.
We are living through the painful end of an age of leverage which saw total private and public debt in the US rise from about 155 per cent of gross domestic product in the early 1980s to something like 342 per cent by the middle of this year
Once, monetarism and Keynesianism were considered mutually exclusive economic theories. So severe is this crisis that governments all over the world are trying both simultaneously.
Niall Ferguson,Financial Times, December 18 2008
Every tumultuous period of financial boom and bust comes to be defined by a word or catchphrase.
Tulipmania. The Great Depression. The dotcom bubble.
The word that could define the financial times we are now living through — and the economic pain that has begun — is leverage.
Bill Powell, Time Magazine, October 23 2008
Leverage Is an 8 Letter Word
John Mauldin, Nov 21 2008
Leverage is an eight-letter word, which the markets now regard as twice as bad as the two four-letter words debt and pain (or fill in your own four-letter words).
As I have written for a very long time, there are two aspects to the current recession and financial crisis.
The first is the fallout from the subprime crisis, which has morphed into a full-blown credit crisis. That coupled with a housing crisis has sent the nation into what looks like it will be the worst recession since 1974.
The second phase to hit banks and lending institutions is the normal recession problem of increased losses on all sorts of loans. Credit cards, home equity loans, residential mortgages, and especially commercial property mortgages all suffer during a recession.
Every tumultuous period of financial boom and bust comes to be defined by a word or catchphrase.
Tulipmania. The Great Depression. The dotcom bubble.
The word that could define the financial times we are now living through — and the economic pain that has begun — is leverage.
Bill Powell, Time Magazine, October 23 2008
Leverage was the mother's milk of Wall Street — and of Main Street — for the past 20 years. Leverage meant debt, specifically the number of dollars you could borrow for every dollar of wealth you had.
On Wall Street, debt funded investments in pretty much everything a financial firm could bet on, including the toxic mortgage-backed securities that led the way into this crisis.
On Main Street, it meant borrowing to buy a house or a condo — maybe two — then perhaps borrowing again off the increasing value of that property to pay for something else: a flat-screen TV, a new set of golf clubs, your daughter's braces.
The debt binge was fueled by easy money and the belief that prices of assets — those of houses in particular — never went down; only interest rates did.
That era is over.
It will be replaced by what will be one of the more painful, and consequential, economic chapters in our history:
the great deleveraging of America.