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The Pernicious Dynamics of Debt, Deleveraging, and Deflation

Developing an understanding of the "Three Ds"
Tuesday, June 5, 2012, 1:27 PM

At this moment, the news media is constantly clamoring about the "Three Ds" that are buffeting the markets: debt, deleveraging, and deflation. We intuitively sense that they're linked -- but how, exactly?

Understanding this linking is critical; as debt has fueled the global expansion, it will also dominate its contraction.

Debt and Deleveraging

To illustrate the forces of debt and deleveraging, let’s consider a home mortgage.

Suppose a buyer of a $100,000 home qualifies for a mortgage that requires only a 3% down payment in cash. The buyer ponies up $3,000 in cash and obtains a $97,000 mortgage. The cash collateral is thus leveraged about 33-to-1: Each $1 in cash has been leveraged into $33 of borrowed money.

Let’s say the owner wants to refinance at a later date, and to qualify for the new loan he must have 20% collateral for the new loan. (This is a simplified scenario; we will consider more complex examples later.) If the house value remains around $100,000, then the owner must boost collateral by paying down the mortgage $17,000. This boosts collateral to $20,000 (20%) while reducing the mortgage to $80,000.

The leverage has been slashed from 33-to-1 to 4-to-1: now each $1 of collateral leverages $4 of borrowed money. This is deleveraging.

Another common example is a margin stock-trading account. J.Q. Speculator can leverage his cash collateral 2-to-1 via margin: If he has $100,000 cash in his account, he can buy $200,000 of stocks. If (heaven forbid) the stocks he purchased decline in value by $50,000, then his collateral has shrunk to $50,000. Since margin accounts cannot exceed a 2-to-1 leverage, he must either sell enough of his portfolio to return the leverage to 2-to-1 (that is, $50,000 in cash value and $100,000 in stocks), or he must deposit another $25,000 in cash (that is, $75,000 in cash/cash value) to collateralize the $150,000 in stocks he owns.

When credit is cheap and abundant, prices of assets tend to rise in self-reinforcing bubbles. If J.Q. Speculator’s portfolio of $200,000 rises by 50% to $300,000, then his collateral increases to $200,000. This expansion of collateral enables him to buy another $100,000 of stocks, as $200,000 in cash value can leverage $400,000 in stocks.

The same mechanism enabled home owners to leverage up their rising equity to buy additional homes.

When the debt cycle turns and asset bubbles pop, collateral declines and lenders are stuck with losses as over-extended borrowers hand the keys to underwater houses back to the lenders. These losses are subtracted right off the bank’s own equity (cash reserves), which are typically a modest 4% of loans outstanding. That is, the bank leveraged each $1 of cash collateral into $25 of mortgages.

If mortgage losses eat away that 4% of cash, then the bank is technically insolvent. As a result, banks become wary of extending risky loans in eras of credit contraction: Their fiscal survival focuses their attention on dumping liabilities and building cash reserves (collateral). The credit spigot is turned off, and all those down the line who were counting on easy abundant credit to bankroll their leverage are left high and dry. As credit contracts, demand for assets and commodities contract, and a wave of selling begins as cash is desperately in demand.

Leverage and Derivatives

In an extreme example, if a bank has $1 million in outstanding loans and has suffered losses such that its cash has declined to $1, it is leveraged 1-to-1-million. It must liquidate enough liabilities and concurrently raise enough cash to restore its 1-to-25 leverage (i.e., 4% of the outstanding loans are in cash reserves). 

The problem is that liquidating liabilities requires the bank to absorb any losses generated by the sale/write-down of loans. If the bank sells a house for $50,000 that carried a $100,000 mortgage, the $50,000 loss is subtracted from its cash reserve.

The bank has a difficult mandate: Get rid of as many liabilities as possible without incurring losses that will bankrupt the bank. The alternative strategy is to sell unleveraged assets to raise cash or slowly build cash by earning interest.

To restore the 1-to-25 leverage of its $1 million in loans, the bank needs to raise at least $40,000 in cash. It has two basic ways to reach this goal: Either keep all of the impaired loans it owns on the books at full value—in other words, ignore the declining market value of the homes underlying the mortgages—and slowly accumulate cash from deposits and interest, or sell non-leveraged assets such as gold, bonds, or property it owns free and clear to raise the $40,000. (Again, this is a simplified example.)

If the bank’s management is dominated by wise-guy “operators,” then it might pursue another strategy, selling derivatives against assets it doesn’t own. The derivatives are sold for cash and hedged against losses by buying derivatives covering the other side of the trade from another institution. The difference between the revenues from selling the derivative contract and the cost of the hedging contract is pure profit that bolsters the bank’s collateral.

If the derivative contract expires or executes as planned, the cash earned from the sale of the derivatives is pure gravy.

If the derivative contracts trigger losses, then the bank turns to the other institution that it bought the hedge from to make good the losses. If that institution fails to make good, or the losses of the bank’s derivatives are not fully covered by the hedge, then the bank must raise enough cash to pay the buyer of the derivative.

The need to raise cash by selling assets leads back to the original problem. Liquidating liabilities, such as mortgages, by selling the underlying assets (houses) forces the bank to book losses it is ill-prepared to absorb.

Deleveraging and Deflation

This example illustrates the pernicious dynamics of debt and deleveraging. The bank cannot declare the true value of its assets (houses that have fallen in value), nor can it sell the houses and take the resulting huge losses, as its cash reserve (collateral) is already at dangerously high levels of leverage (or even negative -- i.e., the bank has no real collateral at all and is insolvent).

Ascertaining the true collateral of any household or enterprise is straightforward. Sell all of the assets on the open market and pay off all of the liabilities. The cash remaining is the collateral.

In highly-leveraged households and enterprises, the impaired assets are held, as the sale of the underlying asset would force the entity to declare its insolvency. So homeowners who are “underwater,” i.e., their mortgage exceeds the value of their home, continue paying the mortgage because selling the house would require them to come up with the difference between the value and the loan in cash. The alternative is to declare bankruptcy and give up any hope of leveraging future income into new loans.

The same basic mechanism is at work in companies and banks.

Ironically, perhaps, the process of raising cash by selling assets inevitably places a premium on unleveraged assets such as precious metals, collectibles, Grandma’s house that is now owned free-and-clear by her heirs, etc. Everything that has been leveraged is held, lest its true value be disclosed by the market, while everything that has retained some measure of its cash value is unloaded to raise cash—either to pay the interest on debt or to recollateralize the entity’s shaky finances.

The key point here is that the outstanding debts far exceed the cash value of the underlying asset; selling everything including the kitchen sink doesn’t even come close to paying off the entire debt. Selling everything that isn’t nailed down simply maintains the much-valued illusion of solvency and puts the reckoning off for another day. The hope of course is that assets will reinflate to their old bubble valuations, but the forces of deleveraging outlined above power relentless selling that eventually overwhelms supply.

The market “discovers” price as demand transparently interacts with supply. When supply exceeds demand, prices fall. And since price is set at the margin, even modest imbalances of supply and demand can lead to cascading declines in prices.

For example, the value of a neighborhood of 100 houses is not set by the sale of all 100 homes; it is set by the last few sales. Thus the last five sales determine the value of the other 95 homes.

Deflation is simple to define: Cash buys more real goods and services than it did last year. Cash is what’s in demand, and assets that depend on credit are not in demand. Rather, they are being sold to raise cash. It’s simple supply and demand: Cash rises in value as it’s in demand, and assets decline as the demand is lower than the supply.

In Part II: The Deleveraging Pain Is Just Beginning, we look at how much longer the U.S. might need to recover from its long deleveraging hangover from multiple global asset bubbles, and why building cash (and cash equivalents) at this time is especially prudent.

Click here to access Part II of this report (free executive summary; paid enrollment required for full access)

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8 Comments

mrobinson's picture
mrobinson
Status: Bronze Member (Offline)
Joined: Jan 13 2009
Posts: 71
Prof Steve Keen

I haven’t visited this site for about a year now and was the first site to introduce me to the 3 ‘E’s’ back in 2008.

Oz was on a different economic trajectory to the US at the time.

Interestingly to note article on deflation and debt deleveraging which in the past would have been against the views of many here from the hyperinflation camp. Wondering if the outlook on the “flations” have changed?

The master of economics and PRIVATE debt deleveraging, Mr Steve Keen.  Definitely a 3E economist.

http://www.debtdeflation.com/blogs/2012/01/03/the-debtwatch-manifesto/

http://www.debtdeflation.com/blogs/2012/01/28/economics-in-the-age-of-deleveraging/

 http://www.debtdeflation.com/blogs/2009/01/31/therovingcavaliersofcredit/

Also, have the views on Gold changed?

My position has changed. When the day comes we pay taxes in gold,(as per our history)  i’ll start buying gold. But then again if we start paying taxes in coke tops, i’ll buy coke tops.

Interested to read the feedback.

mobius's picture
mobius
Status: Silver Member (Offline)
Joined: May 18 2009
Posts: 153
at mrobinson

Hi mrobinson,

I've found Edward Harris's site quite helpful in explaining the relationship dynamics between private and public debt :

Any person’s, any household’s, any business’s, any group’s, any government’s debt is someone else’s asset. Any person’s, any household’s, any business’s, any group’s, any government’s deficit is someone else’s surplus. Again, it’s basic accounting.

...

The same is true for national accounts. At the end of any accounting period, then, the sum of the sectoral financial balances must net to zero. The government balance – the private balance – capital account balance = 0. The government balance = the private balance + the capital account balance. See my post Economics 101 on government budget deficits for the full write-up. I credit British economist Wynne Godley for making this identity relevant to macro economics.

What does all this mean then? Put simply, the financial sector balances framework means that when the government sector runs a deficit, the non-government sector runs a surplus of equivalent size. So, to move any sector balance in an open economy, you need to move the other two balances exactly opposite in equivalent measure. To reduce the government deficit in any period, the private balance and the capital balance must increase by the exact same amount in that period.

Thinking about government deficits this way opens a whole new understanding of what cutting deficits means for the economy. What it should mean to you is that deficits are the effect and not the cause. Budget deficits are the result of the ex-post accounting identity between the sectoral balances and should not be a primary goal of public policy.

www.creditwritedowns.com/2012/05/why-cant-people-understand-national-accounting.html

I suppose the problem here is that there isn't enough paper to contain a balance sheet this big!  More reason to live by the KISS premise, just keep it simple.

take care! Jo

theisland's picture
theisland
Status: Bronze Member (Offline)
Joined: Mar 16 2012
Posts: 62
I second Steve Keen

I couldn't agree more with mrobinson. As well as those links Google "Steve Keen vs Paul Krugman". Hes also written "Debunking Economics" which has left me with the belief that economics is least understood by economists. His conclusions on the role of banks and credit are backed by pretty hard evidence and pretty much reinforce much of what CM has written on the economy E.

Adam Taggart's picture
Adam Taggart
Status: Peak Prosperity Co-founder (Offline)
Joined: May 26 2009
Posts: 1930
Steve Keen next podcast guest

mrobinson & bowskill -

Given your respect for Steve Keen, I imagine you'll be pleased to learn that he'll be the featured guest on our next podcast (to be released Friday).

cheers,

A

ChiRho's picture
ChiRho
Status: Member (Offline)
Joined: Mar 30 2012
Posts: 1
Clarification

The latest Martenson Report (June 5th),  says to stay in cash.  

Under take action tab on home page it talks about buying gold/silver.

Is it just a matter of different time frames, inflation vs deflation? Or the perspective of metals as cash equivalents?

Thanks in advance,

CR

mobius's picture
mobius
Status: Silver Member (Offline)
Joined: May 18 2009
Posts: 153
Podcast - Steve Keen

Great news Adam.  Can't wait to hear this interview.  Hopefully it will be "accessible" and not to high-level academic talk.

Greets! Joanne.

mammamia's picture
mammamia
Status: Bronze Member (Offline)
Joined: Nov 9 2011
Posts: 32
 Good question! Any taker

Good question!

Any taker to try to answer?

lastboyscout's picture
lastboyscout
Status: Member (Offline)
Joined: Jun 3 2010
Posts: 9
I have to question

Mobius,

I agree with this "someone's deficit is someone else’s surplus". I can not agree that you can seperate the government from the taxpayer. 

Government debt is private (US citizens, US business). The US Government is the US citizen and business. The govt. debt is our debt. Govt assets are our assets. Ultimately, the taxpaying citizens must pay on debt accumulated by the govt. because the govt and the citizens are one in the same.

World governments has been transfering debt (through bailouts, low intrest loans, T-bill intrest) from individual businnesses (banks and others) to the whole. Re-allocation of wealth has been being transfered from the many to the few ( most obvious banking institutions), where as we are more apt to believe a government will realocate wealth from the few to the many. The tax payer  eventually pays, trust me.

Govt debt is the forward spending of future tax revenue, pure and simple.

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