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Thursday, October 16, 2008


the titanic power of deflationary deleveraging

this comment from the financial times regarding UBS and their overnight $60bn -- no typo, just for UBS -- bailout from the swiss national bank sums up the extraordinarily dire outlook for capital markets.

Put this latest broad sellof into context… and it’s pretty clear it’s a trend: UBS is deleveraging.

The “toxicity” of the assets it’s dumping are not linked necessarily to their likelihood of default or the way they’ve been structured, but rather, the fact that they are simply levered assets UBS cannot afford to have on its balance sheet.

The trend will be identical for all banks, and as the recession weighs significantly on consumer sentiment and spending, more and more asset classes will turn into unacceptable liabilities for banks.

It’s a debt-deflationary scenario. Which again will bring out comparison to the Great Depression.

From analysts at JPM this morning (highlights ours):

Our 29 selected Euro. banks are at 3.75% equity/asset ratio based on IFRS account. Reaching an eq./asset ratio of 4.5% would require €5.8tn of asset reductions. In total we estimate potential for reductions of €1.2tn from repos, €2.7tn from trading assets, €0.5tn of loan reductions and the balance of €1.5tn needed to come from other assets. The banks most exposed in our view are DB, UBS and BARC looking at current eq/asset ratio and the b/s maturity profile.

Those are figures against which all the Tarps in the world cannot protect the real economy.

As Citi’s European banking analysts said in a note on Wednesday:

If it feels like we are living through history at the moment, it’s probably because we are.

and one can compound that with further hedge fund delevering and liquidation, which still has a significant way to run.

this is depression, and i sincerely doubt any government action can impede its terrible momentum now short of global banking system nationalizations. the banks have taken a hand, and it is unsurprisingly every man for himself.

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Yikes, the unsustainable 350% total debt-to-GDP figure in the US is proving itself relevant with a force few were willing to contemplate. I wonder if and how far that ratio will spike above 350% if GDP crashes, as in the great depression... I also wonder how that number has been calculated previously and whether any source will provide a quarter-to-quarter estimate of how far we are through the deleveraging process?

I've also seen precious few debt-to-GDP ratios for other countries and currencies, save consumer debt in Britain and total debt in Australia (both very high!) Have you?

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hbl, the only other nation-state i've kept any eye on is japan -- where state debt is 170% of GDP in the aftermath of all their bailing and contracting post-1990 but corporate and individual borrowing is minimal.

it would be interesting data, but there is another factor (of course) to consider which makes the united states different.

american total debt, unlike that of any other nation-state, is large in relation to the absolute pool of global savings which can fund it. on an annual basis, the rate of increase in american debt has effectively consumed 100% of the rate of global savings -- in other words, the rest of the world is operating on a balanced budget.

given that, and given further that the american government is set to wildly expand its borrowing rate -- a deutsche bank report i saw excerpted by menzie chinn at RGE admitted the possibility of new issuance of treasury debt exceeding $3.3tn to fund government -- over the next fiscal year!

the float on gov't debt currently is just $5.9tn or something -- but (shockingly) it's not just that they're expanding the gov't debt by a thoroughly-argentinian 50% in one year.

they are talking about borrowing from global savings an amount that cannot be borrowed. it can not happen. if anything, the american current account deficit that would theoretically finance this will contract, not expand, as international trade slows with global recession.

so what is the consequence? as far as my meager reasoning can reveal, government will force the liquidation of domestic private debts, hoarding all domestic savings -- compelling savers not only to shun new corporate and individual credits in favor of treasuries, but to liquidate existing loans granted to corporate/individual parties to transfer assets to treasuries. and they'll end up paying whatever rate is required to get that done.

can you spot the flaw in that line of reasoning, hbl? anyone? because i certainly hope there is a flaw there.

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maybe all the above is part and parcel to popping the last bubble, as defined by marc faber.

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FYI, I've been frustrated at the lack of published quantifiable comparisons with Japan's credit bubble so I did some digging a few months back and emailed Yves Smith with my estimate -- roughly 250% credit-to-GDP around 1990. So the US credit bubble is bigger than japan's or the great depression, and even worse, it's concurrent with credit bubbles around the globe!. I have not yet done the digging to find out how big Sweden's was -- I think that would be valuable.

As to where the treasury borrowing will come from, as best as I can tell with my limited understanding, that is correct -- the new treasury debt will compete with other assets for funding, so these big government rescues will certainly have side effects. Based on what I've read, Japan at least has been able to get the funding and with low yields (I know there are many possible differences in their situation from ours depending on what you believe matters). The bottom line effect though seems to just be a conversion of private debt to public debt on a massive scale.

One point on which I seem to have a different understanding than most out there -- it seems to me that when it comes to asset prices (treasuries or private) that it doesn't really matter as much as is usually stated whether foreigners or domestic parties hold the debt. i.e., foreigners flight from US government debt to other currencies could crush the dollar but those dollars are still around to be invested in treasuries or private dollar funded asset classes. Dollars are dollars whoever holds them, and other than propensity to leverage, private asset choice decisions have no impact on aggregate broad money supply of dollars. Perhaps there's something I'm missing, or perhaps there's an unspoken assumption that foreigners will always have inherently a much higher propensity to hold treasuries as opposed to other dollar-funded asset classes, compared to domestic investors...

Perhaps you can clear up one other confusion for me also -- money creation only occurs when loans are created by banks, right? i.e., a better metric of total credit-to-GDP for the purposes of understanding systemic leverage should exclude government debt, because expansion/contraction of government debt does not expand/contract broad money supply -- right? And perhaps if the private debt measures in the credit-to-GDP ratios includes private bond issues also versus just bank loans then that would present another limitation to using these figures as representative of aggregate leverage?

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foreigners flight from US government debt to other currencies could crush the dollar but those dollars are still around to be invested in treasuries or private dollar funded asset classes.

hbl -- i think the real effect is the difficulty, as opposed to the nominal. dollars are actually destroyed only in deleveraging (using cash to pay down debt -- poof), but selling pressure on the dollar would (as you say) cheapen it vs other currencies, raise interest rates and import prices and -- voila -- you're some version of iceland and can neither borrow nor import.

there's too the question of who (for example) the chinese central bank would sell to. the answer in the absence of an obliterated market would probably end up being the fed, who could monetize the stuff to prevent a debt default.

iceland and its aftermath may be an interesting case study that gives something concrete to hang all this extemporizing on.

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What I am still trying to understand better is the persistent assumption of inevitably higher interest rates connected to any currency crash. It seems most past currency crises involved pegged currencies, with the pegs making the results worse -- however Iceland today is a good non-pegged example for me to study more closely if I can find good info. Thanks for the discussion...

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Wow, I haven't focused too closely on the statistics so far, but they are pretty scary. Roughly 528% debt-to-GDP ratio for private debt, plus between 500%-1000% external debt held by the banks. And credit was still growing at least in the first half of 2008.

I'm not up to speed on all the analysis on this but it seems more like an out of control version of what happened in a more mild way to the US and the dollar in the last 5 years or so -- credit expansion and currency decline.

I wonder if Iceland is now deleveraging internally like the US and Europe, and what that will do to the currency and interest rates? Maybe it's too far gone down the default path for that to matter... but more in depth comparisons with the US would be insightful.

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