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.

Leverage

Leverage has leached into every corner of life.

• A young person buys a new television with no deposit, no interest and no repayments until 2010.
• A woman who inherited a house from her parents uses the equity to buy four more.
• A hedge fund uses bank credit to amplify the profit from trading in shares and commercial paper.
• A young man leases a new truck from General Motors for three years.
• A young woman maxes out four credit cards to spend $20,000 on a trip to Asia.
• A new married couple takes a 100 percent mortgage to buy their first house.
• A church pays for a new building with a mortgage, assuming that future tithes will pay the interest.

Leverage was everywhere. Everywhere that leverage went, pain is following close behind.

Financial Fuss (10) - Leverage

Modern banks are highly leveraged. This has been normal practice since central banks became normal last century. Central banks are supposed to protect depositors, so most governments have allowed capital asset ratios to fall dramatically. Modern banks have capital asset ratios less than 8 percent. Some European banks have ratios as low as 2 percent. This was great for profits during the boom years, but the chickens are now coming home to roost.

Capital or shareholders equity provides a buffer if things go wrong. If borrowers default on loans, the hit is on bank capital. If a bank faces defaults on loans that are greater than its capital, it becomes insolvent, with loans exceeding deposits. When loan defaults exceed bank capital, deposits are eroded and the bank collapses. Many modern banks simply do not have sufficient capital to absorb the losses that they currently face.

Banks prefer to be highly leveraged, because this boosts profits. High leverage amplifies profits. High leverage also amplifies the losses. Strong capital is the best protection for depositors, but that has been forgotten.

Leveraged Banking

I have just read an article by David Greenlaw (Morgan Stanley), Jan Hatzius (Goldman Sachs), Anil K Kashyap (University of Chicago), Hyun Song Shin (Princeton) called Leveraged Losses: Lessons from the Mortgage Market Meltdown. Their estimate that total mortgage credit losses will be about $US400 billlion has become the accepted wisdom. I was more interested in what they have to say about leverage.

The balance sheet perspective gives new insights into the nature of financial contagion in the modern, market-based financial system. Aggregate liquidity can be understood as the rate of growth of aggregate balance sheets. When financial intermediaries’ balance sheets are generally strong, their leverage is too low. The financial intermediaries hold surplus capital, and they will attempt to find ways in which they can employ their surplus capital. In a loose analogy with manufacturing firms, we may see the financial system as having “surplus capacity”. For such surplus capacity to be utilized, the intermediaries must expand their balance sheets. On the liabilities side, they take on more short-term debt. On the asset side, they search for potential borrowers that they can lend to. Aggregate liquidity is intimately tied to how hard the financial intermediaries search for borrowers. With regard to the subprime mortgage market in the United States, we have seen that when balance sheets are expanding fast enough, even borrowers who do not have the means to repay are granted credit - so intense is the urge to employ surplus capital. The seeds of the subsequent downturn in the credit cycle are thus sown.

I cannot understand why we want a financial system based on leverage. It does not have to be that way. See Money.

Superleverage

The problems faced by the US economy were mostly caused by “easy credit”, so they will not be resolved be resolved by more “easy credit”.

Sub-prime borrowers have bought houses that they cannot afford with borrowed money. Borrowing more money is not the solution to their problem. The only solution for those who cannot hang on where they are would be to sell up and move to housing that they can afford.

Easy credit has allowed US consumers to spend a large on their credit cards. If they have bought SUVS and LCD TVs that they cannot afford, they really need to learn to live with in their means. Easy credit will only encourage more unwise behaviour.

Easy credit allowed Investment Banks to wrap up mortgages into collateralized debt obligations (CDOs) and sell them to investors all round the world. The problem with these CDOs is that borrowers are defaulting on the mortgages and no one knows who is carrying the risks. Easy credit will not solve this problem. The only solution is for the investment banks is to unwind some of the links and decide who owes what to whom and establish who will bear the loss. May the bankers who have earned million dollar bonuses will bear some of the pain.

Easy credit has allowed hedge funds and others to undertake leveraged buy outs (LBOs) of large listed companies. If some of them have paid too much, more easy credit. They will just have to take their losses on the chin and the price for being in what has been a profitable.

Easy credit has allowed bond insurers like Ambac and MBIA to provide credit insurance way beyond the value of their capital. Insurers should be able to make good decisions about the size of risk. If they have been getting risk wrong, easy credit will just reward their mistakes. Taking their losses might be better education.

Easy credit has allowed business to expand without increasing their equity. They have been able to get the benefits without paying the price, but reality is now catching up. More easy credit will not strengthen their balance sheets.

George Soros says that the “era of superleverage” is coming to and end. He is probably right. Easy credit has allowed households, businesses and bankers to be heavily leveraged, without understanding the risk, but this is not the way of blessing.

You will lend to many nations but will borrow from none. The LORD will make you the head, not the tail. If you pay attention to the commands of the LORD your God that I give you this day and carefully follow them, you will always be at the top, never at the bottom (Deut 28:12-13).

Providing easy credit is like providing “another drink” to an alcoholic. It does not help them to get off the wagon. Banker Ben is the disease of the US economy, not the cure.

Of course, "Will it work?" is the wrong question (positive economics). The really important question is, "Is it morally right? (the normative issue). I will answer that question tomorrow.