Earn What You Spend

One point I keep repeating (over and over…) is that we still have too much leverage in our financial system.  Consumers, corporations and our government are all overleveraged.  What does that mean?  We need to deleverage.  But just because we need to do something doesn’t mean it will be easy; it just so happens that the process of deleveraging can be quite painful. 

David Roche from the WSJ argues that the question of whether this recession will lead to a depression is largely dependent upon “on the extent of deleveraging by financial institutions.”  

David notes that “despite these losses, the loan books of banks have grown, not shrunk during the credit crisis.”  That is an amazing fact -  banks are loaning more than they were before the crisis.  Why, then, is this deleveraging such an important necessity?  He continues: 

 

The first is that financial-sector leverage was too high before the credit crisis began, which is one good reason the credit bubble collapsed …

Second, the world economy has become accustomed to using $4 to $5 of credit for every $1 of GDP growth. Even if this profligate use of capital is halved, it still means credit expansion of 10%-15% is needed to achieve real GDP growth of 2%-3%. The recapitalization of financial institutions so far is only enough to maintain existing credit assets, but not expand them; ergo the credit crisis continues.

Third, the current bank-asset losses do not include any allowance for future losses which will result from global recession in (nonmortgage) consumer credit, leveraged buyouts and emerging-market, corporate foreign-currency debt. I estimate that, based on economic values, these losses will amount to a further $800 billion to $900 billion, putting total credit losses north of $1.7 trillion for the whole period of the crisis. Such future losses would eat up all the fresh capital contributions and reduce U.S. and EU financial institutions’ tier-one capital to around $2.3 trillion yet again. That implies a leverage ratio of more than 18 times.

 

So banks are giving out more than ever before, but it isn’t enough to satisfy the demand for credit.  A different perspective of the same phenomenon leads us to a corresponding fact: short-term debt and commercial paper markets have essentially frozen.  These have been the primary vehicles that corporations use to finance their day-to-day operations.  Take a look at the total amount of outstanding commercial paper and the dramatic drop-off: 

Source: Marcoblog

So those accustomed to using this commercial paper for their everyday financing needs had to turn somewhere, and they naturally turned to the banks and drew down their pre-existing credit lines.  So even with the capital injections made by the U.S. government, banks simply don’t have enough capital to make up for this precipitous fall in commercial paper.  

We’re deleveraging our system. And it isn’t very pretty.