Deleveraging, Deflation and Debt: A Long and Painful Process

If you haven’t read this Barron’s interview with Ray Dalio, Chief Investment Officer, Bridgewater Associates, titled “Recession? No, It's a D-process, and It Will Be Long”, I would highly recommend it. I happen to hold many similar views to his.

Here are some excerpts from what Ray said, with my comments.

“The D-process is a disease of sorts that is going to run its course……This was the dynamic that occurred in Japan in the '90s, that occurred in Latin America in the '80s, and that occurred in the Great Depression in the '30s.”

I can't agree more. I think this process will take at least 10 more years, if not longer.

We will go through a giant debt-restructuring, because we either have to bring debt-service payments down so they are low relative to incomes -- the cash flows that are being produced to service them -- or we are going to have to raise incomes by printing a lot of money……If you think that restructuring the banks is going to get lending going again and you don't restructure the other pieces -- the mortgage piece, the corporate piece, the real-estate piece -- you are wrong, because they need financially sound entities to lend to, and that won't happen until there are restructurings…..The biggest issue is that if you look at the borrowers, you don't want to lend to them.

In today’s economic environment, even if the Fed has been fearlessly printing a lot of money these days, it still won’t be able to raise incomes enough to service our huge debt. Restructuring debt is the only option, not only just for our personal and corporation debt, but eventually for our national debt. This actually is a very familiar theme happening to a lot of emerging countries, only this time it happens to the U.S.

But the future of banking is going to be very, very different. The regulators have to decide how banks will operate. That means they will have to nationalize some in some form, but they are going to also have to decide who they protect: the bondholders or the depositors?

The key here is for government to stop making any ad hoc decisions. You can’t decide one day to protect Bear Stearns bondholders, upgrading them from junk to investment grade by forcing JPMorgan (JPM) to acquire them, and then the next day force Lehman into bankruptcy, letting their senior bondholders to receive pennies on the dollar. Who gave government the right to decide the fate of one bondholder over another? I think the political risk is too large not to protect depositors, so protection to bondholders has to be gone. However, no matter what happens, it is certain that the stockholders, both commons and preferreds, and unsecured subordinated debt holders, will get wiped out in this painful restructuring process, if they haven’t already. Just look at WaMu; the largest bank in the U.S. only paid back merely $1.9 billion to its most senior debtors, pennies to them, and everyone else got wiped out. As Bill Gross of Pimco has always urged his clients: move your investments up the capital structure hierarchy as high as possible. At least you get a chance to get something back on your dollar instead of total wipe-out.

Even government is trying to get private money to invest in banks, but the reality is it is likely for the next 10 years there won’t be much private money willing to invest in the banking sector anymore. Nationalizing banks is the only solution, regardless what the government has been telling us and whether they want to admit it or not.

Roughly speaking, most of commercial real estate and a good deal of private equity was bought on leverage of 3-to-1. Most of it is down by more than one-third, so therefore they have negative net worth. Most of them couldn't service their debt when the cash flows were up, and now the cash flows are a lot lower. If you shouldn't have lent to them before, how can you possibly lend to them now?

This is in line with several of my ten predictions for 2009, especially the one that half of the private equity firms will get wiped out this year. A few years down the road, the whole private equity sector will likely be gone, similar to the investment banking sector.

Comments

[morph366:]

Interesting piece that I would have thought would have provoked more comment. Not sure about making too many predictions in such uncertain times but I agree with the general point that the re-structuring process required is fundamental and likely to be long lasting

Feb 28 12:00 PM