Confronting the De-leveraging Spiral

By Satyajit Das

While it is well acknowledged that an extraordinary level of debt and leverage had precipitated the problems leading to the current global credit crunch – with the latest episode being that of the bailout of the mortgage agencies Fannie Mae and Freddie Mac in the US, there seems to be a lesser awareness of the potential fallout from the massive de-leveraging process currently underway in the global financial system.

Leverage is a two-day street: not only can it amplify returns; but on the flip side, it can also speed up the de-leveraging process, which unchecked can lead to ugly scenarios for not just for financial markets but also real economies.

For de-leveraging to take place, it requires liquid markets and buyers with capital and the 'stomach' to purchase the assets. Ultimately, prices of risky assets will have to adjust to market clearing levels as the system attempts to clear debt levels.

The initial focus of the global de-leveraging process will be within financial markets where global banks have suffered losses in excess of US$200 billion, with possibly more to follow.

Approximately US$1 trillion of assets have since reverted to bank balance sheets. These include warehoused assets that could not be securitised as well as those previously parked in asset backed security commercial paper (ABSCP), 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 by raising funds via both central banks and market sources. It is estimated that the global system will need at least fresh capital injections to the tune of US$100 to $300 billion, or about 15% to 25% of total global bank capital.

It is unclear how all these capital requirements will be met. While some of the initial funds have come from sovereign wealth funds, it's unlikely that most investors who had suffered significant losses would be able to plug the gap in the near term.

It should be noted that the injection of the new capital merely restores bank balance sheets, but is not enough to support growth in lending. The ability of the global banking system to supply credit is currently 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.

The next phase of de-leveraging will be on the real economy, which it this case would involve both corporate and personal balance sheets in the face of higher cost of debt funding due to shrinking availability of debt.

For companies with less than stellar business outlook and credit quality, refinancing may prove challenging. Some US$150 billion plus of leveraged loans comes due in 2008. A similar amount also must be refinanced in 2009.

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 adjustments.

So far, the fear of the de-leverage spiral have forced central banks and governments to act in order to maintain liquidity in the systems and hence enter the realm of moral hazard by supporting the financial sector in their actions. In the US and Spain, direct fiscal stimulus is already being administered.


What is to be Done?

A debate over the current state of the financial system may be akin to that of discussing lifestyle changes for a patient who has been admitted to ER with a full cardiac arrest. What is needed is the defibrillator paddles!

While it will need time for the de-leverage process to be sorted out, it is imperative that more immediate and drastic steps be taken to restore the normal functioning of banks and flows in credit supply.

The first step is to establish certainty that holdings and values of risky assets held by banks and investment banks are accurately determined. The need for greater certainty of values applies to sub-prime securities and leveraged loans as well as other risky assets.

Without certainty about what is held by whom and their values, it will be difficult to restore confidence in financial markets.

Market values or pricing models based on increasingly unreliable or meaningless indices or quotes should be abandoned. There is no current market for such risky assets. The models have not performed and are what got us here in the first place.

Capital levels should be set on a bank-by-bank basis by regulators rather than based on an inflexible formula that is frequently gamed by banks. Capital requirements should be eased, where appropriate. A desired long-term capital ratio for banks should be set.

Meanwhile, proposals to accelerate Basel II requirements to raise capital ratios will have to play second fiddle, as they are ill-considered in the light of present market conditions. The banking system needs significant amounts of capital to cover losses. It also needs additional capital to cover assets returning onto balance sheet. Increased capital ratios would only exacerbate the de-leveraging already under way, making the contraction in economic activities worse.

The final step would be the need for government guarantees of major bank liabilities. It is not as radical as it appears. The US Federal Reserve (Bear Stearns), the Bank of England (Northern Rock) and Germany (Landesbanks) have already done this. The current de facto nationalisation of Fannie Mae and Freddie Mac is a further step along this interventionist path by sovereign governments.

Term lending through the support facilities means that central banks are doing more than providing liquidity. They are also underwriting the solvency of banks. If at maturity, the bank cannot repay the advance, the central bank will be forced to continue to fund the borrowing bank to avoid triggering default. Banks generally fail due to liquidity risk. It is sobering to consider that Bear Stearns was still technically solvent when a withdrawal of liquidity brought it to its knees.

An explicit guarantee has many advantages. It avoids inflationary money supply expansion and the need for money market sterilisation operations. It would help restore confidence in banks and in the interbank market.

Support of the global banking system will be needed. The originate-to-distribute and risk transfer models did not – as we now know – distribute risk through the financial markets. Instead, it linked the financial solvency of all financial market participants in a complex web.

Hence, government underwriting of the banking system is now critical to resuscitate normal financial activity since credit markets have by themselves become dysfunctional. Vital life signs have to be restored before longer-term lifestyle changes can be contemplated. Implementation of the steps outlined above allows monetary policy, interest rates and fiscal policy to be directed to ameliorate any economic slowdown.

The proposed actions are contrary to free market orthodoxy and raise familiar concerns about moral hazard and rewarding greed. There seems to be no choice. As Charles Kindleberger noted in his history of financial crisis: "Today wins over tomorrow."

The defibrillator shocks must be accompanied by far reaching and fundamental changes in financial architecture and global capital flows. Regulation of banks, capital regimes, risk transfer, asset valuation, risk management, use of collateral, counterparty risk, model risk, rating agencies and financial accounting – all these need radical surgery.

Fundamental economic imbalances such as an excessive reliance on US consumption and excessive savings by other nations – must be addressed.

Failure to deal with the major structural problems of financial architecture and global economic imbalances may mean that any improvement will be short-lived. It may also sow the seeds of future, and perhaps spawn more serious financial crises.

Resolution of the crisis requires brave and decisive steps that transcend geography, jurisdiction, regulatory silos, nationalism and rigid economic formalism. As John Maynard Keynes once put it well, "The difficulty lies not so much in developing new ideas as in escaping from old ones."

© 2008 Satyajit Das

Satyajit Das is a risk consultant and author of Traders, Guns & Money: Knowns and Unknowns in the Dazzling World of Derivatives.