Finding a bottom

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As the writedowns at global financial institutions near $300 billion in capital lost as a result of the sub-prime crisis, the question as to when we reach a bottom is ever more urgent. Market history tells us that the severity of the bust after an economic upswing is usually related to the size of the original upswing. This mortgage and credit bubble being the mother of all bubbles requires a sustained and robust deleveraging to set things right. Therefore, the real economy in which we all live and breath should feel some very significant impacts for some time to come. My hope is this process will find a bottom late next year.

De-leveraging
We are now in the midst of a financial crisis after a large speculative bubble. As such, the real economy effects will tend to be larger than during a garden-variety recession. The problem is the deleveraging feedback loop that needs to work its way through the system. The Federal Reserve, The Bank of England and the European Central Bank are doing everything they can to make sure this process occurs without a systemic failure in the global financial system like what was suffered during the Great Depression.

De-leveraging begins when the speculatively financed investments go bust and writedowns occur. Normally, banks can handle these writedowns without having to de-leverage because they are well-capitalized. However, when banks writeoff unexpectedly large amounts of capital, this reduces their capital base and makes the bank look more leveraged and risky as a financial institution. $300 billion is a large amount. When the financial sector writes off $300 billion in equity capital in the span of one year, some institutions start to look pretty risky. In a fractional reserve banking system (in which only part of deposits are held in reserves), banks risk ruin if depositors lose trust in their stability. Therefore, it is important for institutions to re-capitalize after large writedowns.

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Re-capitalising can occur in one of three ways: the banks can increase their equity capital through paid-in capital, they can increase their equity base through profits or they can de-leverage. To date, banks have been forced to issue additional equity capital (often from sovereign wealth funds) in order to maintain strong balance sheets. However, the Federal Reserve has done all it can (and more — indeed, too much more) by lowering interest rates to banks in order to increase the spread between money lent and money borrowed, which will increase bank profits. This too will help banks — albeit slowly as the banks can only profit from these spreads over time.

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Nevertheless, banks will not be able to strengthen their balance sheets quickly enough through those two methods without significant deleveraging. They will need to sell assets and reduce future credit availability in order to gain the rock solid balance sheets that customers, counter-parties, and consumers will require in a more cautious economic environment.

The Feedback Loop
How much deleveraging will need to occur? That brings us back to market history, which tells us that deleveraging will be extensive given the size of the speculative run-up earlier this decade. Moreover, the feedback loop with the real economy suggests that many more writedowns are to come. As investments have soured and credit availability becomes scarce, individuals and companies have started to feel the pinch in the real economy. Layoffs have begun in earnest. As a result, consumers have cut back. This will cause more financial distress in other lending sectors of the economy. Top on the list are Alt-A Mortgages, some Prime Mortgages (especially zero percent, zero down and adjustable rate varieties), Construction and Development loans, Corporate Real Estate loans, Credit Cards, Auto Loans and High Yield Corporates. From here, the feedback loop will begin again with losses, writeoffs, and credit tightening in the new distressed sectors as well as in the previously distressed sub-prime market. The feedback loop continues with more deleveraging, layoffs, consumers tightening their belt, and reduced corporate profitability.

At some point, this whole feedback loop will end a we will find a bottom. The hope is that we can do this with a minimum of damage to the real economy, a minimum of personal financial distress and as quickly as possible. When we reach the bottom is anybody’s guess, but expect this deleveraging process to play out at least for the entirety of 2008 and through well into 2009. Let’s hope that we find a bottom then.

See also: Credit Crisis Timeline for a full list of writedowns and capital raising by institution and a timeline of the credit crunch.

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