Nuclear De-Leveraging

By: Satyajit Das

Equity markets believe the worst is over. Banks also seem to have convinced themselves that the worst is behind us. An alternative and, arguably, better view of the current state of the financial crisis is that stated by Winston Churchill: "...this is not the end. It is not even the beginning of the end. But it is, perhaps, the end of the beginning."

There is acknowledgement that an extraordinary level of debt and leverage precipitated the problems. However, there is limited recognition of the massive de-leveraging of the global financial system that is under way. Leverage amplifies returns but also accelerates de-leveraging.

 

The attached Exhibit shows how de-leveraging takes place in a highly levered world. Assume a hedge fund with $20 of unlevered capital. If a bank or prime broker allows it to leverage 5 times, then the hedge fund can acquire $100 of risky assets with $20 of equity and $80 of debt. Assume the asset falls $10 (10%) in value. The hedge fund leverage increases to 9 times ($10 of equity (the original amount less the loss) and $80 of debt supporting $90 of assets). If the permitted leverage stays constant at 5 times then the hedge fund must sell $50 of assets - 50% of its holdings ($10 of equity and $40 of debt funding $50 of the asset). If lenders (more realistically) reduce permissible leverage, say, to 3 times, then the hedge fund must then sell $70 of assets - 70% of its holdings ($10 of equity and $20 of debt funding $30 of the asset).

 

Exhibit

<h6>Impact of Losses on a Leveraged Investor</h6>

 

 

 

 

De-leveraging requires liquid markets and buyers with capital to purchase the assets. Ultimately, prices of risky assets must adjust to market clearing levels as the system reduces debt. The process described is now under way in the global economy.

 

The first phase of de-leveraging is focused on financial markets. Banks have suffered losses in excess of US$200 billion (with more possible). Approximately US$1 trillion of assets have returned onto bank balance sheets. This included warehoused assets that could not be securitised and assets previously parked in asset backed security commercial paper (ABSCP) conduits, structured investment vehicles (SIVs) and Collateralised Debt Obligations (CDOs). An additional unknown amount of assets will return onto bank balance sheets as hedge funds gradually de-leverage.

 

Banks require funding and capital to cover losses and returning assets (christened IAG (involuntary asset growth). High inter-bank rates and the deceleration in bank lending reflect, in part, banks husbanding their cash resources to accommodate the involuntary increase in assets.

 

They have been raising money both via helpful central banks and in the market. Major financial institutions have issued substantial volumes of term debt at very high credit spreads.  In one week in April 2008, financial institutions raised a record US$43.3 billion in debt at the highest credit spreads since 2001.

 

Banks will also need substantial new capital to cover losses and the regulatory capital required against returning assets as follows:

 

Losses:                        US$ 200 to 400 billion

Additional Capital:         US$ 100 to 300 billion (calculated as 10% (the Basel minimum is 8% but few banks operate at that level) of returning assets)

 

For bank’s operating under Basel 2, probabilities of default in credit models will increase resulting in regulatory capital increases. This is the pro-cyclical nature of the capital ratios in the current regulatory model.

 

The capital required is around 15-25% of total global bank capital. Banks have raised in excess of US$ 200 billion in new capital. The pace of new equity raisings is accelerating.

 

It is not clear how this capital requirement will be meet. Initially new capital was supplied by sovereign wealth funds (SWFs) and Chinese banks. Given that most investors have (sometimes) significant losses on their investment, this source of capital is less likely to be available in the near term. Banks have resorted to hybrid capital issues such as perpetual preference shares. The major attraction for investors has been the high income. Investors, especially retail investors, may not understand the equity risk in these structures. Rating agencies have expressed concern about the increasing level of hybrid securities in the capital structure of many banks.

 

Other sources of capital include asset sales. The current state of asset markets makes this problematic. Asset sales will put further pressure on available liquidity and prices.

 

One bright spot is investment in emerging market banks; for example, investments in Chinese State banks. For those lucky enough to have made these investments, there are still significant unrealised gains. Many banks see disposition of these shareholdings as an attractive source of capital. The recent decline in the Chinese stock market, the large size of many stakes and the unknown liquidity of the underlying stock remain issues.

 

The new capital noted above will merely restore bank balance sheets. Growth in lending and assets will require additional capital. The banking system’s ability to supply credit is significantly impaired and will remain so for the foreseeable future. Credit is clearly being rationed in the global financial system. If the banks are not able to re-capitalise, then the contraction in credit supply will be sharper.

 

In recent years, off-balance sheet vehicles – ABS CP conduits, SIVs, CDOs and hedge funds (collectively known as the shadow banking system) – provided additional leverage. These vehicles relied extensively on bank funding or support. The withdrawal of this support means that these vehicles are also de-leveraging rapidly.

 

ABS CP conduits, SIVs and CDOs are being gradually dismantled and the assets returning onto bank balance sheets. Hedge funds have been forced to reduce leverage by between a third and a half times. Prime brokers and banks have significantly tightened credit, increasing the level of collateral needed even against high quality assets. Each 1 times leverage reduction in hedge fund leverage represents in excess of US$2 trillion of assets. This accelerates the de-leveraging process.

 

The next phase of de-leveraging will focus on the real economy. The availability of debt has contracted sharply. The cost of funding has increased. This will force de-leveraging of corporate and personal balance sheets.

 

High quality corporations with maturing debt face face higher borrowing costs. For companies with less than stellar business outlook and credit quality, refinancing may prove difficult. Some US$150 billion + of leveraged loans comes due in 2008. A similar amount also must be refinanced in 2009.

 

Non-investment grade bond issuance over the last few years was concentrated in the weaker credit categories and is vulnerable to deterioration in economic conditions. Standard & Poor’s rating agency estimates that Two-thirds of non-financial debt issuing companies are junk-rated currently, compared with 50 per cent 10-years ago and 40 per cent 20 years ago. In recent years, around half of all high yield bonds issues were rated B- or below. These borrowers will face refinancing challenges.

 

Personal balance sheets will also de-leverage. Consumers in the USA and to a lesser degree in the UK, Ireland, Australia and New Zealand have used borrowings (against inflated real estate values) to offset a reduction in real incomes. Falling real estate prices and the reduced availability of easy credit will force de-leveraging.

 

Inflation is also a factor in the de-leveraging in personal balance sheets. Higher prices for the necessities of life reduce cash flow available to support debt. Higher food and energy cost, especially over a sustained period, may affect the degree of de-leveraging if income levels do not adjust.

 

An economic slowdown will exacerbate the de-leveraging. A fall in asset values can be sustained where the borrower has sufficient income and cash flow to service the debt.

 

In the US economy, the household, housing and financial sectors constitute over half of all economic activity. A (perhaps protracted) slowdown may be difficult to avoid. US demand is a significant driver of global activity. Recent reductions in global growth forecasts reflect these concerns.

 

Reduction in corporate cash flows as revenues slow down reduces the ability of companies to sustain leverage. Loan covenants (debt and interest coverage) will reinforce the de-leveraging.

 

There has been a systemic financialisation of corporate balance sheets. Changes in financial markets will have a significant impact on many companies that now rely on financial engineering rather than real engineering. The problems of GE may not be isolated.

 

For personal borrowers reduced personal income and unemployment will sharply accelerate the de-leveraging. Uncertainty about the future and market volatility will also accelerate the de-leveraging as companies and consumers reduce debt and aggressively save.

 

De-leveraging in the real economy may result in increasing defaults. Firms and individuals with unsustainable borrowings will fail. This will result in further losses to financial institutions setting off negative feedback loops as both asset prices and the level of aggregate leverage adjusts.

 

Central banks and governments actions have been directed at maintaining liquidity and (increasingly) directly supporting the financial sector. In the US and Spain, direct fiscal stimulus is already being administered.

 

These actions are designed to prevent a catastrophic collapse in the financial sector. They are also designed to help maintain a normal supply of credit to creditworthy business and individuals. These actions are designed to help the real economy from slowing down to a degree that the de-leveraging accelerates further. At best, these actions will smooth the inevitable de-leveraging and adjustment to financial asset prices.

 

 

 

© 2008 Satyajit Das All Rights reserved.

 

Satyajit Das is a risk consultant and author of Traders, Guns & Money: Knowns and Unknowns in the Dazzling World of Derivatives (2006, FT-Prentice Hall).

 

 

 

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