The term deleveraging is one bandied about a lot in the press recently. But, what does it actually mean? De-leveraging is the process by which financial institutions and investors reduce the relative size of their assets to equity ratio. Generally, it means shedding assets in the financial sector, thus reducing credit and slowing the economy.
The basis of my having started this blog site was to bring greater attention to the issue of deleveraging, credit writedowns, and the likely consequences. Therefore, the issue of deleveraging is central to this blog. Now, when I talk about deleveraging, I am talking about the process whereby anyone, whether individual, institutional investor or financial intermediary, cuts one’s debt load relative to one’s asset base. Let me give an example. In this example, forget about Tier 1 capital requirements and all the other esoteric stuff; let’s focus just on assets and total capital (equity)
Let’s look at Citigroup. According to Google Finance, they had assets of 2.2 trillion and equity of $128 billion as of 31 March 2008. For any enterprise, the balance sheet shows that assets equal liabilities (debts) plus equity (capital). (See Wikipedia’s Balance Sheet entry for more)
Basically, it means that if you were to liquidate all Citigroup’s $2.2 trillion in assets and pay down all their liabilities in full at the values presented on their balance sheets, shareholders would be left with $128 billion to divvy up. So, that’s the book value of Citigroup: $128 billion.
As time goes along, Citigroup makes money and its capital base grows accordingly. Now, every quarter Citigroup presents its balance sheet to investors, allowing investors to assess basic levels of financial health. One basic check is leverage (or gearing).With $2.2 trillion in assets and $128 billion in capital, that’s a ratio of 17x leverage, assets to equity for Citigroup.
Leverage basically is about other people’s money. It means you cough up some of your own money (equity capital) and borrow the rest (liabilities). This allows you to buy all sorts of assets: Treasury bills and notes, gilts, corporate debt, Emerging market sovereign bonds, muni bonds, CDOs, RMBSs, CDOs of CDOs, Swaps, Puts, Forward contracts, equity shares. You will hold lots of cash too. So, in Citigroup’s case, the company contributed $1 for every $17 of other people’s money it borrowed. This is typical of most major financial institutions.
What that 17x ratio tells you is a basic sense of the riskiness of the enterprise. The gearing or leverage means that for every 1% loss of total asset value, you lose 17% of your equity capital. You lose 6% of your total asset value and you’re wiped out, bankrupt. The higher the gearing, the easier it is to get wiped out when you lose money. So why do people gear up? (Long Term Capital Management (LTCM), infamously, is said to have been levered 100-to-1). You gear up because leverage magnifies gains as well as losses. If your assets gain 1%, you have just made a 17% return. If your assets are up 10% in total value, you’ve made a 170% return. Nice. Now, that’s intoxicating.
And just in case you thought only companies and investors gear, you should know that’s what mortgages are all about. Anyone who’s bought a piece of property knows, when house prices fluctuate, the less equity you put in, the more money you make on that equity (or the more you lose depending on circumstances).
Financial institution leverage
That’s all fine and dandy for investors and individuals, but not a good thing for banks. Banks are the bedrock of our economic system and must be safe and stable institutions. Why do you think they are called Northern Rock, Security Pacific, Standard Chartered, and Fidelity Trust and so on. Would you put your money in ‘Fly by night’ Bank. I think not.
So, banks are strictly regulated regardless of country of origin. They have minimum capital ratios and there are various deposit insurance schemes to insure their stability. When investors (and depositors), as the source of a banks debts and liabilities, get the sense that the institution is unstable, they take action before their money goes down a rat hole. So, if you saw your bank levering up 100x like LTCM, you would get your money back as soon as you could.
This is where writedowns come into play. Now, normally, banks make money — lots of it, HSBC made $22 billion in 2006, as did Citigroup. However, when banks suffer losses on assets that they do not expect, they make less money. Sometimes, they even lose money.
And so it is with the credit crisis. The U.S. subprime crisis caught the global financial world unawares. The losses in this sector were both unexpected and large. In fact, they were so large that the likes of Citigroup, UBS and Merrill Lynch have each written off over $37 billion of equity each.
Now, when you’re a large global financial institution and you write off $37 million, no problem. $37 BILLION? Now you have a problem. These are extraordinary amounts that mean losses and writedowns. This means less capital and higher gearing. Less capital and higher leverage automatically mean risky. You might as well slap a sign on your forehead that shouts “I am a risky financial institution. Please come get your money now before it goes down another rat hole like the U.S. subprime market.” What to do?
So deleveraging is where we are today. Many financial institutions (and investors like hedge funds, for that matter) have suffered massive losses in the credit crisis. Their capital is impaired and their resultant leverage makes them risky. Therefore, they have been forced to de-leverage in order to regain a less risky profile. In April, I wrote a post called “Finding a bottom” that said this about deleveraging:
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 write down unexpectedly large amounts of capital, this reduces their capital base, and makes the banks 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.
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.
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.
This sums up the need for banks to shed assets in order to re-gain security as lending institutions. Shedding assets is by its very nature a deflationary event. It means the bank is not lending money; it’s doing the exact opposite. Credit is the lifeblood of a fractional reserve banking system. When banks do not lend, the economy contracts.
My fear is that the need to de-leverage will cause banks to take a vacation from lending for some time. This is to be expected after the credit binge of the last five years; as with a partygoer, first comes the binge, then comes the hangover. But, this is no normal hangover — because if institutions do not start lending more soon, the global economy will suffer and unrelated credits will start to sour in turn. Leveraged loans for LBOs, Alt-A mortgages in the US, commercial property, credit card loans, auto loans, and so on down the line.
Given the highly leveraged nature of the U.S. and British economies in particular, this sort of downward spiral must be avoided at all costs. This is one reason America’s central banker Helicopter Ben has been very busy indeed. We still can’t know if he has been successful as his policies have stoked inflation, limiting their effectiveness. And, now it’s Mervyn King’s turn at the Bank of England. Will he have the ability to stop this train from derailing in the UK? Let’s hope so.
See the Credit Crisis Timeline for a full list of writedowns by institution.