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De-leveraging of Debt



February 19, 2008 – Comments (7)

Common Sense Forecaster has an well written post on de-leveraging.

"Call it what you like, but what you are seeing occurring at this time is the de-leveraging of the American consumer, the mortgage industry, and the banking system. It took us a long time to get to this point of debt and it will take a long time for this to unwind. The question is how quickly (violently) this unwinding will be. If you stop and think about it that is most of what is being discussed in the financial press and on the internet, the de-leveraging of America.

"Note that the various policies of cutting rates, putting a hold on foreclosures, or creating a stimulus package are not working. Those policies and that thinking were created to fight the last war, i.e. the Great Depression. That is why those policies are not working. We have a new war of excessive debt, causing credit losses, which ultimately is leading to insolvency in the banking system. How do you fight that war? From the WSJ:

My comment: Who has experience with a banking system that is dealing with insolvency?  Things are so different than previous experience.  

"The specter of deleveraging still haunts the financial markets. Rightly so, for the removal of credit from the global economy is a process that feeds on itself. That means that the credit crunch could easily turn into something much nastier.

"Before the deleveraging came the leveraging. Take the U.S. The ratio of all sorts of debt to gross domestic product rose to 342% at the end of September 2007 from 160% in 1975. Through 2000, debt increased by 2.4 percentage points a year faster than GDP. But after the turn of the millennium, the rate accelerated almost to 3.7 percentage points a year.

My comment:  This seems an understatement of the problem.  When you consider the population is aging there ought to be less debt, not more.  More debt simply seems like less ability to deal with increasing social programs.  Payments into social programs should be resulting in net gains when demographics are considered.  There should be a surplus, not a deficit.

"While it was happening, only a few sourpusses complained. Increasing debt was seen as a natural trend. As economies get richer, they have more need for debt-financed investments and inventories. But lending grew much faster after 2000 than even the most gifted apologist could explain away. It was a bubble, which has now been popped.

"In a credit bubble, one thing leads to another. You can bid more for a house because banks are willing to lend more. So house prices rise, giving the banks more confidence about lending yet more. So you build an addition or buy a new car.

"Multiply that by a few hundred million borrowers and presto, asset prices go up and economic growth is high. Banks rejoiced. They set up off-balance-sheet vehicles that piled on debt. Leveraged-buyout groups borrowed to take companies private; hedge funds borrowed to invest in assets. And so on.

"In deleveraging, too, one thing leads to another. Start with a bank that has lost a few billion dollars on subprime mortgages. The bosses are likely to decide that troubled times call for higher capital ratios. That means calling in lines of credit. Some borrowers are forced to sell assets, pulling down prices. The banks then look at the value of their collateral and think: "Oh my god, it's not worth what we thought." They then cut their credit again -- giving another turn of the deleveraging screw.

"The housing market was just the start. A series of debt mountains -- credit cards, car loans, LBO loans -- risk being leveled. The credit contraction strikes down financial arrangements that once looked solid -- from structured investment vehicles to auction-rate securities.

"If the original debt helped fuel consumption, deleveraging will feed into lower economic activity. If the original debt fueled asset purchases, the consequence will be lower asset prices. There could be a dual effect because lower asset prices can make people feel poorer and less willing to spend money. This is especially the case with people's homes.

"How far can this go? Historical parallels aren't terribly comforting. In Japan, a boom in the 1980s was followed by a painful deleveraging. Despite massive government borrowing and five years of a near-zero interest rate on overnight borrowing, the prices of shares and real estate declined by 40% to 70%. The U.K. did better in its deleveraging after 1990 -- house prices dropped by 40%, after taking inflation into account, but share prices rose.

My comment:  The 30 year average for house price to income was 2.8 to 2.9.  It got to 3.9.  House price should revert to the mean over time.  Last report showed it at 3.7.

"Politicians and central bankers are alarmed by the rapid shift to deleveraging. There are limits to what they can do. Sharp interest-rate cuts may not be enough to make banks abandon their newfound caution in lending, especially if loan losses are rising. Higher government deficits may not help either. In a deleveraging world, the government may borrow so much it crowds out private borrowers seeking funds.

"The deleveraging snowball will eventually reach the bottom of the mountain. Banks will start to see opportunities, and borrowers will become more courageous. But it could be a long and painful wait.



7 Comments – Post Your Own

#1) On February 20, 2008 at 12:18 AM, Bupp (27.89) wrote:

Debt is not necessarily a bad thing as long as it is being used to pay for assets which will provide long term value.

 Building railroads = good reason to take on debt

Building highways/hospitals = good reason to take on debt

Building Fiber-optic networks that cross the ocean floors = good reason to take on debt

Setting up WIFI networks that cover the entirety of our urban communities = good reason to take on debt

 The problem is when the debt is taken on and there is no increase in assets/the money is not invested in a pursuit that will provide a greater return then the interest rate on the debt.


Coles Notes:  Debt is not always a bad thing.

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#2) On February 20, 2008 at 12:34 AM, dwot (28.84) wrote:

With a mature country there is little reason to take on debt other than fiscal irresponsiblity as a cultural belief.

On another point, there seems to be a run on Korean run Chinese businesses closing.  Something like 20,000 business have been operating at a loss.

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#3) On February 20, 2008 at 12:45 AM, Bupp (27.89) wrote:

One of the areas it would make sense to go into debt is in providing access to education.  Increasing your workforce's international competitiveness will definitely pay off in the long run.

 Also the key stat is definitely debt/GDP when this is trending upwards you are setting yourself up for failure.


In the case of the US you see a whole lot of debt and no assets to back in up.  Taking loans to buy homes at prices much higher then their fair value is not very wise.

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#4) On February 20, 2008 at 7:40 AM, CycleFreak7 (< 20) wrote:

Subprime loans defaulting before rates reset.

I am stunned at the level of lax lending practices. Other loans (ie, not subprime) are in the same boat. As everyone who knows anything has said, it is going to get much worse before it starts getting better.

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#5) On February 20, 2008 at 9:43 AM, dwot (28.84) wrote:

CycleFreak7, I was in Costa Rica in the summer and I went to the beach for 3 days with 2 women still acquiring their education.  One had 1-2 years of whatever it is you do before you are officially a doctor, another was at the very beginning of med school.

They both had over $100k of student loans.  What was interesting to me is that I had the tightest controls over spending.  Two of us took the public bus which cost only about $8, but the one decided she wanted air conditioning so she spent $50 on a private bus. 

They shopped quite a bit for useless trinkets.  I shopped as well; I got my xmas shopping done.  There was some nice things at a very good quality that you'd pay 3-4 times as much at home.  The types of things they were buying were things I didn't spend a dime on when I was in school.

And then going out to eat, they had no sense of eating out economically.  Granted, it was cheap eating out there.  You could have a fantastic meal, 5 star eating out quality, with a couple drinks and appetizer for under $20 and that would be including tip. But, you could also find a place to eat for under $5 with tip with good food.  I went from under $10/day for food to about $30/day.  

There is no question it was a really nice time, but my economic choices and desires were being driven by debt reduction desires and they had no thoughts of it what-so-ever.  They talked about several places they'd been on vacation while accumulating student load debt. 

That link that you have on the subprime defaulting before the resets is actually good news in my books.  If you've already got some of the this reset stuff in the data that means that there will be less of it in 2009-2010 when it was forecast to peak and perhaps we are closer to the peak of the losses than expected. 

I wonder how much of it is people just figuring they are economically better off by simply stopping paying and using the money to pay off other debts and live "rent" free until the foreclosure proceedings go through. 

Reading that article leaves me stunned as well.  They know it is a big problem, but as long as they can pass it on to a sucker they just keep it up.  There is no disclosure here.  I hope that there is sufficient legal power that the individuals that simply turned their backs on this problem for short term personal gain lose everything. 

This is simply fraud and it is high time there are penalties and legal consequence that are in balance with the seriousness of the crime.  

Developed countries with aging populations were already going to have some serious problems in adjusting to the changing social costs of an aging population.  I figured it would be 5-10 years before you'd see social program spending being cut back on a per person basis.  I figured those at the top of the baby boom would not be too bad off in terms of being able to collect at least for a while.

I suspect what has happened here with the housing bubble and costs to pay for it means that these social programs start getting cuts in the next five years.

rwilso01, at what point do you stop borrowing when you have young people forever needing an education?  We have a mature and aging population.  We have a smaller ratio of young people than we ever have had, and we should borrow?  I could perhaps see it if you had an age cohort bubble and there were so many going through that the ratio of tax payers to youth was temporarily out of wack, but right now we have fewer young people than ever relative to older people so there should be no problem in providing good education if we had fair allocation of resources and actually had fiscially sustainable policies.

We don't have fiscally sustainable policies and what you suggest is simply more unsustainable.

You need to take a closer look at some of the changes in Canada with respect to real estate and lending.  Canada will be dealing with this problem from our own real estate bubble as well, although we have better supports and policy in place, it is going to hurt. 

How much of the US problem we end up paying for will make a big difference in the level of hurt.  We've already got our banks writing off US losses.  Looking at historical data, I see Canada basically following the same economic cycle as the US, but off set by about 2 years.  So, we get to go into a down turn with already facing capital impairments from the US.

Canada's lending practices have deteriorated, but not to anything like the US.  It seems that most have at least 5% in the game, and the mortgage insurance for that low of a down payment is 2.5%.

I think our resource based economy lets Canada recover sooner, but I also think all of the emerging markets are going to have serious slow downs.  20,000 Koreans shutting down businesses over the Chinese holidays because of running those businesses at losses for a while now would be a hint that all is not well in China either. 

I think long term China sees the improvements in lifestyle because they have so much business investment that has essentially cannibalized the countries that lost that investment, but I think they will have a significant slow down as their economy goes through the changes from reduced exports and how business gets built domestically.


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#6) On February 20, 2008 at 9:33 PM, Bupp (27.89) wrote:

In terms of education you can continue to borrow indefinitely because the spending is an investment in human capital that will increase lifetime earnings of the individual who got access to education.  More earnings ---> greater GDP -----> less debt/gdp.

 Looking at it from another perspective, I don't mind a company taking on debt as long as it results in a greater return on equity.


I agree that canada will follow behind the US (as usual) and you are also right in saying that the problems will not be as severe in Canada.

In other news, Stanford University now offers free undergraduate education to any student whose parents combined income is below $100 000.

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#7) On February 22, 2008 at 12:21 AM, TheGarcipian (34.37) wrote:

Government spending, especially under this Bush Administration, is out of control. Good ol' Dumbya started with a surplus, which he quickly squandered before 9/11 with unnecessary kickbacks, and how now pushed us to a record $9 TRILLION debt load. Congratulations, Yale grad, you bested your Reaganesque goal by double what the Gipper did for us. And you did it with less American jobs too! Wow, marvelous feat. Just peachy. I'm so glad you were elected to your office; don't know what I would've done without you -- oh yeah, retire early...

But it's not just the reckless spending habits of the current Administration and its Congress. All the bureau-cats in Washington are out of touch, not so much with their constituents, but with reality. Except for 2 years of the Clinton Administration, we have run a deficit since 1973. How many people reading this blog can say they even remember hearing about balanced budgets, much less knowing how many years we've actually achieved that coveted status? Not very many, that's for sure.

Anyone who believes that the next President can get by with handing out (idiotic) tax cuts or (stupid) stimulus packages, without raising taxes, or without serious cutbacks on major services (Social Security, Medicare, etc.) needs to be smacked very hard in order to wake up. McCain is talking about "No New Taxes" and Obama & Clinton are talking about increasing services -- both camps are playing to the average American who is clueless of how bad a financial shape we are in. Estimates are now placing Social Security to start running in deficit (for those clueless, "deficit" meaning "paying out more money than you're taking in") by 2017 (or was it 2014?). Either way, that's not very far away at all.

Someone with bold leadership skills needs to take the bullcrap by the horns and toss out the pleasantries; just tell us how it is so that we can fix it in the next 10 years, and not continue to pass this live hand-grenade to our children (if not to ourselves!). We as a culture will be facing serious financial problems if we do not demand that our Nero-tic politicians (Repubs and Dems and Independents) put down the fiddle and face our collective problems now. The house is on fire; let's do something about it.

All cultures rise and fall. Perhaps we did hit our apex in the 1950's with our financial acumen, our tough-earned world-war-inspired pride, and our hard-working long-visioned goal-setting mentalities of the individual as well as the collective nation. In our current quarterly-guided, borrow-money-to-pay-myself-first mentality, that most certainly is NOT the case. I pity whoever is the next President; his/her job is not going to an easy one.

In the meantime, we can help in our little ways much as The Motley Fool does: educate. Learn about and discuss with your brothers, sisters, families and friends the budget crisis that has been brewing to an F5 hurricane over the last 35 years. Teach your children about saving (a 0.8% savings rate is horrible!), about budgeting, about putting off those loans unless you really need them and can pay them back long before they come due. Teach them about the real value of money. Everything doesn't have to be from Abercrombie & Bitch or Neidless Markup or NerdStorm in a hollow attempt to placate your bored children because you're hard at work trying to put food on the table and not being able to show as much interest in their lives (or worse, having no such interest beyond doling out an buy-off-my-guilt allowance). A nice trick my dad always used was to ask us (ahem, before we got to the sales counter) how long we thought it would take us to earn the money we were about to spend based on our hourly wage at the time, and whether the pleasure we derived from this purchase would surpass the pain we endured for the equivalent hours worked. The time-value of money is so hard to grasp, unless you can put it in terms like this. Talk about an eye-opener!

So, I'm with you, dwot, on not living cheap but on living below your means. Good luck to all you Clueless out there. Please don't drag the rest of us down when your Titanic sinks... 


P.S. Didn't mean to write so much, but I got fervent the more that I did. Pardon the rant, but I hope it will help wake some people up (like your med school AC-bus-riding friend). Live modestly, or at least within your means, because the hard times, they are a'comin'...  

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