How Much Longer Must This Deleveraging Process Go On? 12 comments
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To understand today's market you only needed information from 230 B.C.
For investing consumers of financial media there has been a parade of posturing pundits. All are happy to explain the same three things:
- Our financial system had excessive leverage;
- We are in the process of wringing it out of the system -- a "Great Unwind", if you will;
- This is going to take a lot longer and it will involve much pain.
Most of the pundits want to opine about who made the mistakes that caused this problem. The typical argument is that some politician was too stupid or too biased to act intelligently. For those interested in the public policy implications, there will be plenty of government hearings in the next year or so, and maybe a few criminal trials.
Meanwhile, the best and most balanced coverage has come from Barry Ritholtz at The Big Picture. This article, which I have already sent to a number of my friends from academic circles, is a good starting point.
What Is Missing?
While we are all interested in affixing blame and making the world a better place, there is an immediate question for investors: What should an investor do right now? Put another way, the key question is as follows:
How much further must this de-leveraging process go on?
The Significance
Leverage is the most important question. The punditry has plenty to say, but little understanding. Here is the acid test, which a reader should use every time the subject is raised.
Whenever you see the subject of leverage raised, ask two questions:
- What is the appropriate amount of leverage? How does it vary by type of institution? If the answer is "no leverage" or "match obligations to assets" the responder is dodging. The financial system has never worked that way, and it never will. Get real!!
- What is the right leverage ratio for various institutions, like regional banks? How close are we to that ratio? How long will it take to get there?
The Question of "Hoarding"
Every day seems to launch a new series of challenges to the "Rescue Plan." Today's message comes from financial media focused on financial institutions that were hitting the TARP plan, but not expanding lending. They were improving balance sheets or looking to buy other banks.
This variant of investigative reporting lacks objectivity. First, it relies on anecdotal evidence rather than data. Bill Rempel astutely notes some actual reporting of lending, which has not declined at the level suggested by the doomsayers.
These issues are significant because the markdowns in assets happen so quickly that some even challenge whether the Treasury can add enough capital to meet the write downs in mortgage securities.
The Biggest Variable You Do Not Already Know
The amount of leverage depends upon the amount of current assets. For a typical bank, if you force it to mark down assets by $10 million, you reduce lending power by $100 million. If the bank's assets are truly impaired, this is capitalism in action. If the write-down is not an accurate assessment, then the de-leveraging has already gone too far. Anyone who does not have a good answer to this, is dodging the key question.
What to Look For
The big story today will be the roundtable discussion sponsored by the SEC, working on their report about mark-to-market accounting. Colin Barr has been writing recently for the mother ship rather than his excellent blog, one of our featured sites. This nice article captures the key elements. Our only complaint is that he awarded our "trademarked" death spiral analysis to someone else! We were on this subject in January and before, using the Death Spiral terminology.
Colin points out the SEC meeting, the first of two, and the significance. It is something to watch today. If the SEC finds that the FAS 157 moves were, as we have suggested, a good idea that was implemented poorly, the game could change. The spiral might end.
We will not get the final Congressionally-mandated SEC report until January 2nd, but the discussion will highlight the issues. You can watch the webcast on the SEC site, or you can follow the coverage on CNBC.
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This article has 12 comments:
My sense is that there are a lot of players in the chain who could and now wish they had done things differently... the lower on the chain one goes, the better protected the player... because all the upstream types, the Mortgage Insurance companies writing coverage on the loans (down to 80% LTV) , the I-Banks bundling Alt-A and subprime credits into securitizations, the agencies rating the Asset Backed Securities, the AIGs providing credit enhancements, including with various other entities the writing of Collateral Default Swaps... and the hedge funds who took vast sums of capital from the very wealthy and leveraged it 50x, 70x and more to buy bad paper with a good yield... for a season.
I think the culprits are more toward the top than the politicians and the mortgage smoes and the home buyers. But... none of those three are innocent either... expecially the home buyers who were buying over thier heads and especially when they were buying over their heads for speculative purposes rather than housing... which returns us to the clip of Bush... I don't think he was advocating all minorities buy a house using cheap financing and sell before the teaser rate expired to make a bunch of money. No, he and other public policy types were trying to put people into homes that woud be shelter for their families... it is the top of the financial food chain that is looking at housing as a source of continued investment products upon which to profit... and that boys and girls is the disconnect... the perspective on one is housing... of the other it is ABS, CDS, CDO and other alphabetical buggers that have kilt the golden goose and ushered in a wave of anti-capitalism. Here endeth the opinion.
Thanks for the most unassuming and informational discussion. This is a topic that no one (at least no one that I have heard from) completely understands. My analogy is that the credit crisis problem is almost as complicated as trying to understand a haystack by analyzing the individual straws of hay. The analogy may be a stretch but it does give perspective.
The obvious answer to your question:
How Much Longer Must This De-leveraging Process Go On?
The Answer: Obviously, until our economy is de-leveraged. Until we stop lending to people that in no way can pay off their debts i.e. people/businesses that buy beyond their means. I guess they have to learn a hard lesson. Might take a long time because with this election, we might continue to give them something for nothing. Solving this debt problem with more debt. That makes a lot of sense.
famos
Globally, there exist $1,000 trillion - yep, a quadrillion - dollars of face value derivatives. How leveraged are they ? I doubt anybody knows. But consider the deleveraging of a quadrillion dollars of "assets".
Let's say, just for argument sake, that half of these derivatives are equal to their face value. The rest let's say are worth 15 - 65 cents on the dollar. And that they are only leveraged ten to one. Do the math.
Losses in the range of multiples of global GDP do not work themselves out of the economic system quickly.
What Benny and Hank are doing is analogous to the Dutch boy with a finger in the dike.
It's not just "how long" it's also "how big".
De-leveraging is detox. New stock market, housing and credit bubbles are relapses. The greedy person is just like the tweaker - neither can be cured of his/her addiction and almost everyone of them experiences numerous relapses and trips to rehab.
A tweaker's family usually will come to his/her rescue over and over again. Sometimes; sadly, he/she OD's.
Government regulation is meant to prevent greed from getting out of control. Lately, the regulations haven't been effective and detox is needed to fix the problem. Alan Greenspan decided the addicts could be trusted. Oops.
It's not possible to overdose on greed. Too bad.
I really liked and enjoyed reading your metaphor about greed and debt and especially the part about Greenspan trusting the addicts.
Just curious, are you inside or outside your metaphor?
famos
Leveraging by investment banks creates investment money at multiples of the "real money"--money that somebody had which they didn't have to pay back to someone else because it was "owned" money, not "owed" money--that is locked up in those banks' capital. If on average these banks leveraged at 20:1 then there is 20 times more 'investment bank dollars' in the system than there is "real" US dollars (capital) with which to redeem them. All the investment bank dollars are debt, and they cease to exist when the debts are repaid, and you can't pay redemptions with money that has ceased to exist.
The "leveraging" is "borrowing money", and the money has to be paid back sometime, so it's "temporary money", not real money that somebody has and doesn't owe back to anyone. You can't pay somebody back with money you borrowed and which you yourself have to pay back. Not indefinitely, anyway.
So if an investment bank at 20:1 is liquidated, all of its assets will only be able to collect 5% of their current inflated valuation in real money. It's fun to value your assets at 20 times what anyone with real money can actually pay for them, but it was only ever a bubble inflated by pumping the levers and creating temporary money more commonly called "debt". Once everyone repays their debt you have 100% deleveraging, and you find all that is left is the original amount of capital that you started with. The bubble money evaporated when principal balances on the investment banks loans were paid down to zero.
The same principle applies to inflated stock prices. If we assume people buy stocks with real money that they actually own, not loans which are creations of new money and which have to be repaid, there is only so much total "owned money" in the stock market or available to the market.
Somebody makes a high price trade of a few shares of every stock on the market and Poof! Every share of that stock is now "valued" at the high price. But as soon as all those owners of high-priced stock try to sell, they find there isn't enough money available for everyone to cash out at the higher prices. If stock buyers initially put $1 billion of real money into stocks, and a small fraction of high priced trades raises the total "valuation" of the market to $5 billion, that does not mean there is $5 billion of "money" to pay those prices.
The gains are illusory, except for the fortunate few who manage to sell high. But everybody cannot sell high, which is why all Ponzis have to deflate. You can't get more "money" out of a market than the amount of money you put in.
Another great comment.
I'd like to expand your comments in the following regard: using debt to increase production can, in fact, increase the the amount of "money" above the amount initially put in. If you produce things that have utility, they have a real monetary value. If this utility further increases production of goods for which there is demand, you have, in fact increased the monetary base. This argument remains logical until there is over-production. Once demand is exceeded, there is no increase in value. If the excess continues, value per unit of production goes down. Absent any modification of production (cutbacks), the entire value structure of the product collapses.
As long as production remains in balance with demand, goods can be exchanged for currency and vice versa. We have had a production facility for debt and equity and there was no effective mechanism for keeping production and demand balanced. The root of the problem is that the initial production (paper - stock and debt) became unlinked from further production of useful items. It became production for its own sake, without further utility.
What I am trying to describe is the concept of wealth creation and economic expansion. It is often accompanied with inflation (fiat currency devaluation), but, as long as supply/demand imbalances remain subdued, growth (wealth) often increases over long periods of time. This growth is in excess of inflation, i.e. real growth. The entire growth process is virtuous. However, with any good thing excesses diminish the good. Sustained excesses destroy the good.
We are living through yet another example of the desecration of the virtuous.
Outside.
My inspiration -- I just read "beautiful boy" - a story of a father's struggle (the author) with his son's meth addiction. It in are the three 'C's. It's advice Al-anon gives to the family members of alcohol and drug addicts to help them cope.
The three 'C's probably apply to those of us trying to cope with the financial mess caused by the greedy among us while we responsible ones did our best to live within our means and not over-leverage ourselves.
You didn't ---CAUSE--it.
You can't---CONTROL--it.
You can't---CURE---it.
You are talking about production of real economic wealth: goods, services and physical capital (machinery, etc.). There is no doubt that investing money in productive processes increases supplies of real wealth. You input $1 million worth of capital, material and labor and you output $1.2 million of goods-for-sale.
The problem is that producing real wealth does not produce "money". It produces economic values that are denominated in monetary values, but the industrial economy does not produce any "money" at all (aside from the banknotes and coins--the physical forms of money--that are printed or minted on behalf of the central bank: printing and minting are "industrial" activities).
The creation of financial credit--"money"--is an entirely separate process from the production of real wealth and from the availability of real credit. In our system only banks are allowed to literally "make money". Banks create money as loans. That's where money comes from in the first place. That's where ALL money comes from in the first place.
When a bank makes a loan it creates a deposit in the account of the borrower and an asset in the account of the bank. A bank's "assets" are its loans customers' "debts". When the principal balance of the loan is repaid both the asset and the deposit are written down to zero.
The "money" was created out of nothing and after it went into the economy and activated economic activity the money returns to the bank and ceases to exist. That's just the simple truth about the life cycle of money which is clearly explained in any introductory financial economics textbook. Incredible as that might seem to people who are used to thinking of money as something "real". But money is essentially just numbers.
The institution of "banking" creates and manages an economy's financial credit. Banking is called an "industry" because it is operated as private-for-profit, but I think it is more properly recognized as an institution along with government, the courts, etc. because bankers decide what kinds of economic potentials will be actualized and what kinds will not; and they decide who will be given the privilege of buying something they have not earned yet.
These are "fiduciary" duties. There is a public trust involved. Banks make loans on behalf of "society" and it will be society who has to make good on that money by producing economic efforts or goods that are bought by the person who borrowed from the bank. There are social and moral elements to those decisions as well as purely economic or financial elements.
"We", society, people, provide the real credit to redeem the financial credit that banks give borrowers. If "we" don't respond to offers of bank-money payments, the money is worthless because it cannot "command" real credit. The 1913 Bank Act that made US dollars "legal tender" means that we are legally required to accept those dollars as payment.
We don't necessarily have to accept any particular "form" of the money--we don't have to take checks or debit cards--except for Federal Reserve notes which are "cash", $20 and $100 bills that you put in your wallet and that have "legal tender" printed on them.
A legitimate reason for refusing to accept legal tender is that you lack real credit: "Sorry, we are out of that item." or "I'm too booked up to do your job." When our supply of real credit is fully expended we cannot respond to offers to activate our real credit: it's already activated and fully committed.
There are many opinions about our "methods" of banking (for or against fiat money, fractional reserves, central banking), but nobody is denying that banking as an institution is an essential element of any economy that has evolved much beyond barter.
In the example above the $1 million was "invested", which means it was spent as the "costs" of production. So the company spent $1 million into the economy, but the company created $1.2 million worth of economic values which it charges as the "prices" of the goods it made for sale.
Every other company is in the same boat. They all spend an amount of money into the economy as their costs "C", but they all need to take out of the economy a greater amount of money to make profits "P". They put in C of money and they need to take out C + P of money.
Where does the "money"--not the economic value but the "money"-- come from to make P possible?
Industrial activity only distributes an amount of money C into the economy. Knowing as we do that the only source of money is bank loans, the only possible source of new money to make P is from somebody else taking out loans and distributing the money into the economy.
But loans have to be repaid, and a borrower can't repay his loan with money he already spent buying goods from our industrial producer. He no longer owns that money. The producer now owns the money.
The borrower must earn income by working for some other industrial producer and this borrower's "income" is part of his employer's "costs". His income is part of somebody's C. The ONLY money that is put into this system is C.
Bank's can make "consumer loans". Money is created to finance consumption, not production. But you can't earn money to repay your consumer loan just by consuming something. You need to earn the money so you "own" it. You must repay "owed" money with "owned" money. You must repay borrowed money with earned money.
This is the main fiduciary duty of banking, to ensure that those to whom we lent our real credit have paid it back in kind, by "earning" the repayment money.
We are seeing what ends up happening if you pay one credit card with another; if you try to repay owed money with more owed money. Eventually the jig is up. The banks want their money (which, properly understood as the activator of "our" real credit, is "our" money) and they won't lend you any more.
In order for companies to make P there must be an escalating increase in new money coming into the system. The only source of this money is new loans. To the borrowers, these loans are their debts. P is only possible with escalating debt.
Eventually the music stops and there aren't enough chairs for everyone and we see widespread defaults, foreclosures and bankruptcies that result in the kind of large scale asset/debt writedowns that are happening now. This had to happen. There was never enough "owned" money in the system for everyone to pay all their monetary debts.
That's because loan money is created at interest. Just like industrial producers who put C of money into the economy and need to collect C + P back out of it, banks put C into the economy as their loan principal but have to get C + I (interest) back out of the economy. Bankers are in business to earn money so just like the business who needs to earn profits, banks' interest is their P.
But the banks, alone or collectively, never created the money to pay I, the interest. They only created the money to pay C, the loan principal.
It is argued, by people who don't want to accept this arithmetic absurdity of our financial system, that because loan terms cover different timeframes there will always be enough money in the system for borrowers to repay principal plus interest.
So okay, let's take all money that was created by banks as loans from 1913 when the Bank Act made US dollars the only legal tender up until now.
The arithmetic doesn't change by adjusting the timeframe.
ALL banks over ALL that time created an amount of money C as loan principal, and an additional amount of monetary debt I as interest on all those loans. If every borrower has repaid all of their principal the amount of money left in the system today would be zero: C - C = 0. You put in C as loans, you take out C as loan repayments. There is no "money" left in the system.
In our G10 central banking system governments don't get "free" money from the Fed either. It must all be accounted and charged interest. Like a private bank manages its customers' accounts, the Fed manages the "country" account according to basically the same rules as private bank accounts.
There is no "external" source of MONEY to resolve the arithmetic impossibility of paying principal plus interest when the only money that can exist is the principal.
The same arithmetic applies to stock markets and financial markets. You can increase "economic" values all you want. But you cannot increase "money" because money is just numbers and numbers don't multiply themselves to become bigger numbers. Whatever number you put in, that's the number that is available to take out. Everything else is smoke and mirrors and confusion, escalating debt and financial meltdown with asset/debt writedowns, and start all over again.