Tuesday, February 03, 2009

Leverage and Inflation

Banks, hedge funds, private equity firms and other businesses throughout the world have balance sheet problems. The market value of the financial instruments on the asset side of their balance sheets has plummeted. In many cases, their value cannot be determined, because there is no longer a market for them. The purchase of these assets was often leveraged by borrowing the credit that used to be so readily available.

The problem is that the value of the debt on the liabilities side of the balance sheet does not decline in value. The debt still has to be repaid in full when it fall due. This means that the decline in value on the assets side is a hit on the owners equity. In many cases the value of debt is greater than the value of the assets, so the owners equity has gone negative and the business is inherently worthless.

The solution to this fiasco that is preferred by the clever people is two or three years of inflation at a rate of 20% to 30%. During inflation, the market value of the assets on the assets side of the balance sheet increases, while the nominal value of the debt on the liabilities side remains fixed. This will increase the owner’s equity and restores the viability of the business.

This inflation should be opposed. Inflation wipes out the value of the savings of the people who have been responsible and rewards those who have used debt and leverage to speculate on property and other financial assets. A better solution would let those who have used debt and leverage reap what they have sown, and protect those who have been prudent.

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