Credit Crisis

What is Deleveraging?

Deleveraging, or degearing, is simply the opposite of leveraging, or borrowing.  It is the act of reducing the use of borrowed funds.  These borrowed funds can exist in the form of equity issued to stockholders, bonds issued to investors, issuance of commercial paper, and taking out syndicated bank loans to name a few.

Companies will utilize leverage to kickstart growth in their companies; however, if their plans do not go as expected, they will be forced to pay down their debts, or deleverage their balance sheet by selling their own assets.  Higher levels of leverage are often seen in startup companies in the small cap sector or even smaller.

Recent Example of Deleveraging

The term deleverage was made popular by investment banks on Wall Street.  Over the past decade, it has become increasingly more difficult for banks to produce profits for their clients in the stock market and therefore, they turned their attention to the housing market where home price were increasing at large clips every year.  Interest rates were cheap and mortgage backed securities were providing consistent returns.  They started borrowing, or leveraging, at incredibly high levels; 30 to 35 times their assets in some cases.  As you can see, the slightest move higher made them alot of money while even the slightest move lower could have serious negative implications.  This is exactly what happened when the housing market started to tumble.  Firms were forced to liquidate their assets, or deleverage, and did so almost in fire sale fashion.  Many banks were forced to file for bankrupcy protection while others forced to merge with other banks. 

The credit crisis of 2007 and 2008 explained in a 3 part series.  Fed funds futures and  money supply are discussed in part 1.

The speaker discusses the impacts of the credit crisis on the futures market.  He reviews the fed fund futures which tracks the movement of the fed funds interest and anticpates changes in this rate.  He talks about how this indicator is reflective of the economic condition.  As rates fall, the system is strengthened with new liquidity. 

He then moves on to discuss the aggregate reserves of depository institutions and the monetary base.  Banks need to keep a certain amount of reserves on deposit as part of the fractional reserve banking system.  It has been very effective in growing the economy for several decades.  He covers the two types of reserves held by banks; borrowed and non-borrowed.  Non borrowed represents the cash position that a bank has while borrowed represents the amount of money borrowed by the bank from the Fed.  The speaker discusses a trend of higher borrowed assets and lower non-borrowed assets.  He believes this is a warning sign of bad things ahead. 

The speaker discusses his prediction of dire economic news in the coming months to years and mentions a few fundamental drivers for this which cannot be ignored.  He cites a few reasons for this coming breakdown.  First, there is cheap overproduction in the world's marketplace which is occuring at viciously competitive prices.  He states that China, India, and the rest of Asia have become forces for cheap overproduction. 

Secondly, he suggests that over 2 billion workers have entered in the workforce and they work for 75 to 90% less than the workers in the United States.  To survive, US companies must move operations overseas and permanently move jobs.  The middle class is being eliminated. 

He suggests that the Fed has created two massive inflationary bubbles in stocks and real estate to compensate and are vulnerable to collapse even further.  He goes on to talk about the budget and trade deficits as well which are causing a run on the dollar.