Saturday, February 21, 2009
Credit Crisis 101 - Leverage
Pick up any business magazine or paper, or watch the business channels, you will find a plethora of information on the credit crisis. Sometimes, too much information overload will distract from the real issues and when we talk about the crisis, we have too many angles on the problem. Unless we zero in on the root cause (not not ascribing blame), we won't be able to get a handle on the crisis and its effects.
Let's get the blame out of the way. I have blogged about the blame game: mainly its the ratings agency, followed by Greenspan and then the Wall Street firms. If you have to describe the root of the current crisis in one word, that word has to be "leverage". If you take leverage out of the equation, if we didn't have the many new fangled acronyms, which were basically packaged loans supported by derivatives like capital platform, we would have a very mild recession. This recession is the severest we have seen since the Depression because of the leverage i.e. derivatives. Leverage implies very little capital outlay for a certain contract of service or product. If we have derivatives and leverage during the 1920s, the whole world might have collapse even more brutally.
Yes, we have more knowledge since then, we have a better understanding of fiscal and monetary policy, and some say better laws and regulation (well, there are regulators but they did not do a good job at all). Its the leverage which brought about such a recession that is much worse than any we have seen in modern times. If you want to take an account of the mess, the more reliant you were on that leverage, the more you fell as the values were nothing but book entries. The investment banks would not have been in so much trouble if they did not get greedy themselves and bought most of the instruments.
Naturally, the front line got hit the worst, the investment banks that parlayed capital up to 20x-30x leverage to issue these papers, and when they collapsed it very easy to see capital totally vanishing with just a minor drop in values. Now we are talking of properties (which these papers were based on) losing 30%-50%, hence the negative equity. Those who bought properties using these kind of easy and unchecked loans were the first to be foreclosed. Even if you did not participate in those loans, you might have benefited via rising housing values, and refinanced, you would have got hit as well. Generally the affected banks lost about 90% or more in share price while most of the broader equities lost about 50% and counting.
The rest of the world got hit because they got a corresponding inflow of liquidity emanating from these gains. Liquidity was ample. Related areas which practiced excessive leverage were hedge funds. If these funds bought emerging market shares and commodity, those prices got inflated as well, hence when it came time to de-leverage, the outflow was very severe. In particular commodity prices. Its not just a bull cycle, it was the leveraged funding which went looking for "liquid assets" to move into. Hence the very sharp rise in commodity prices in 2004-2008, and they came down just as fast. Related to commodities were the commodity ETFs which were coming out like fresh donuts. Every commodity ETF basically just fueled the rise and trend even further, causing many pension funds to specifically target a substantial weighting in commodity as a critical portfolio composition.
Unfortunately, the US consumers represents a significant engine for global demand. They are key to the US economy, and they need to buy crap from the rest of the world, so that the rest of the world have the funds to buy crap from other countries. The wealth destruction from falling share prices and more importantly, the losses from property, have caused the US consumers to tighten their consumption patterns. That has severe ramifications for the flow on effects to the rest of the world relying on exports for growth. Yes, it may not be the rest of the world that is at fault, but you still get swept up in the tsunami.
The curtailment of credit and loss in wealth from the deleveraging is what is bringing global demand to its knees. Every country has attempted to reflate, whether the sums are big enough is still debatable, I think it is, but more than just reflating you need to address the root problem. Has the deleveraging stopped? Well, banks are still holding the toxic assets, refusing to write down to a fairer market value, say twenty cents to the dollar, as that would wipe out the bank's equity. Hence NATIONALISATION is the best solution going forward. You are not going to do it, let the government do it. Nationalisation of banks = forced sale of these assets = investors have a good idea of the losses = shareholders will be wiped out but its necessary.
As big as the TARP is, it is insufficient to replace the writedowns. You want a bad bank, you need $2 trillion minimum. Already the lawmakers are balking over the TARP's $780bn, the amount for bad bank is humongous. By nationalising, you basically close a few big banks that shouldn't be allowed to continue. By propping them up, you will eventually have to pump close to $2 trillion anyway to get them on even keel.
The other major contention is that property has to stop falling in price because as it keeps down trending, investors have no idea how to put a fair value on those toxic asset losses. A better plan Obama should have included is to put a stop to the slide - put up an incentive for new home owners to buy, e.g. $25,000 for new homeowners that qualify. Its pointless to renegotiate mortgages if prices keep falling. You need genuine long term buying.
As for auto sector in the US, the crisis basically hasten their demise. Their business model does not work and is inflated. They must be bankrupted so that they can negotiate a reasonable business model with a very much reduced pension/healthcare liability overhanging the car makers. But the US auto sector is the least of global concerns.
Things are coming to a head, falling share prices will force the government's hand. Keep an eye on developments on these two front:
a) how they deal with the toxic assets properly
b) how to stop property prices from sliding further
To that end, the markets looks oversold as a lot of liquidity is on the sidelines. To activate the flow back, we need to see catalysts that would trigger (a) and (b) in the right way. Bank nationalisation would be one. Bad bank is still OK but the hurdles on raising $2 trillion will not be easy.
Things are so bleak now that it gives me room to be optimistic that certain things will happen when you are forced into a corner. These are very difficult decisions, do you have the political will to nationalise banks.
Another potential positive catalyst will be Geithner roping in private equity and hedge funds to start buying up the toxic assets. Pricing will be an issue but the government is keen to get these funds to take off some of these assets via special funding, which may be hard to come by for hedge funds and private equity funds now. Geithner has a strong hand now, by forcing banks to sell the toxic assets to these funds or else face nationalisation. Geithner has seen his credibility being eroded quickly with his conceptual plan that lacked details and a pricing mechanism for the toxic assets. He can restore much of it by moving fast to move the toxic assets. Yes, banks will have to do massive writedowns, and many may be barely solvent, but that's part and parcel of what needs to be done.
Despite all the bad news, I am more hopeful than most as things are coming to a head - and tough decisions are forthcoming, which will be good for the markets.
p/s photos: Natasha Hudson