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On the Market A Transformational Era of DeleveragingLiz Ann SondersSenior Vice President, Chief Investment Strategist, Charles Schwab & Co., Inc. Updated November 5, 2008
Warren Buffett recently said this about leverage on The Charlie Rose Show: "Leverage is the only way a smart guy can go broke. You do smart things, you eventually get very rich. If you do smart things and use leverage and you do one wrong thing along the way, it could wipe you out, because anything times zero is zero. But it's reinforcing when the people around you are doing it successfully, you're doing it successfully, and it's a lot like Cinderella at the ball. The guys look better all the time, the music sounds better, it's more and more fun. You think, ‘Why the hell should I leave at quarter to 12? I'll leave at two minutes to 12.' But the trouble is, there are no clocks on the wall. And everybody thinks they're going to leave at two minutes to 12." A reversal of "fortune" on the horizon As you can see in the two charts below, whereas private sector debt has been on a tear for the past several decades, government sector debt is no higher than it was in the early 1990s and early 1950s, even with the increase during the past few years. We are likely facing a major reversal in these trends, with government debt accelerating while private-sector debt contracts.   For years, financial institutions were more than willing to extend credit far and wide to feed the insatiable spending and speculative appetites of consumers, investors and the financial firms themselves. This epic era is now ending with the government assuming the role of spender of last resort and the Fed assuming the role of lender of last resort. The rest of the world is wrapped up in this, as well. Imported capital has funded an increasing share of U.S. gross domestic product (GDP) growth. Since the beginning of this decade, the nation has experienced little growth in national income beyond that which was purchased by borrowing against the future. In other words, it's taken more and more debt to stimulate growth in GDP. Since 1981, GDP has increased by about $11 trillion, while private sector debt has ballooned by double that amount—about $22 trillion! This was clearly unsustainable. During the past 10 years, economic growth has averaged 2.7% per year—yet at the same time, the debt burden has increased at a much faster pace. Adding to the problem was a decline in real wages (net of inflation). Banks should have tightened their mortgage and consumer-credit lending facilities in a declining real wage environment—but we know they did just the opposite. Financial fitness = crisis' silver lining We've come to the end of the line on debt. It was inevitable, and it's a painful process. But if there's a silver lining to today's financial crisis and prolonged recession, it's that we're likely to come out of it a more financially fit nation—that includes consumers, financial institutions and maybe eventually the government. Behavior is changing and it's ultimately a blessing. The current crisis is a result of the bursting of the housing bubble at the end of a two-decade cycle of rampant profligacy and financial engineering/innovation run amok. It was an era of irrational exuberance and risk taking, fostered by a concoction of forces: Initially, we replaced wages and productive investment with debt and asset inflation as the economy's engines of growth. Then, the all-powerful force of greed and the dark side of free markets combined to promote excessive risk taking and lack of regulatory oversight. A vicious cycle We went into full-scale retreat mode in October—huge bank losses triggered ratings downgrades and margin/capital calls, which triggered more selling while crushing confidence and further constraining credit. This is the paradox of deleveraging. When it's just a single firm caught up in it, that's one thing (think Long-Term Capital Management in the late 1990s). When it's the entire system rushing for the exits at the same time, the door is simply not wide enough to allow for it without the kind of crisis we've experienced. Today, it's not only one financial firm that's deleveraging. Nor is it even one sector of the economy. It's every over-leveraged financial firm, both domestically and globally. It's every over-indebted consumer. At the same time, an already indebted government is coming to the rescue, incurring even more debt to boot. It too will need to deleverage at some point, but certainly not now. All of these forces are set to change the economic and investment landscape for a while to come. Consumers: entering an age of thrift Thanks to easy money and a tax system that has rewarded consumption over savings, Americans went on a binge during the past few decades. One example: The average family has 13 credit cards today, and carries a balance on 40% of them (up from 6% in 1970). We have been living well beyond our means. In the table below, you can already see the dramatic shift taking place from credit-induced consumption to credit-deprived thriftiness.  Looking closer, consumers have dramatically narrowed the gap between income and spending in recent months. Where their spending amounted to nearly double their labor income in the first half of 2008 (with credit filling the gap), in the past several months they have slashed spending well below their labor income. What makes this even more startling is that they did so even as income was rising! If incomes fall and/or unemployment rises, this spending deceleration will likely continue. Seen through another lens, household debt as a percentage of disposable personal income has just experienced a plunge of historic proportions, as you can see in the chart below.  This drop has been accomplished by consumers moving quickly away from debt (to fund consumption) to savings. There's a rub though. Indeed, a four-percentage-point drop in household debt, as per the chart above, is historically significant, but the level from which it's retreating needs to be considered. The 50-year mean of household debt as a percentage of disposable personal income is 78%. Today it's just under 130%—having dropped from 134% at its recent high. So you can see we have a long way to go. Debt de-accumulation is in full force, as you can see in the chart below. This will be a theme for some time to come.  From 1960 to 1990, the average savings rate was about 9% of after-tax income. Recently, it's been bumping along around zero. Higher savings may mean more subdued GDP, but it also means a more financially fit consumer in the future. Corporate sector: The crowding-out effect We have written much about the relatively healthy corporate sector, given the post-tech bubble retrenchment and restrained hiring/debt accumulation phase that followed. But in a recession, sales—both domestic and foreign—will slow alongside the recent spike in corporate bond yields and reduced credit availability. If banks were healthier, the spike in yields would be less important to the corporate sector, because companies would simply shift their financing from the bond market back to bank financing. And that financing alternative would likely have kept corporate yields lower in the first place. But in an environment of massive deleveraging, banks no longer have sufficient capital to be an alternative source of financing for the corporate sector. This means a tough road ahead for businesses, particularly smaller ones, given that their access to the capital markets was limited all along. This could be one reason that, despite the liquidity efforts by the Treasury Department and the Fed, small-business confidence has failed to improve. Financial institutions: Exiting an age of power and engineering As markets rose and credit was both cheap and easily accessible, leverage was used to produce ever-greater profits for financial firms. This was supported by bold claims that mathematical models for the economy and markets plotted reality and successfully priced uncertainty, suggesting historical safeguards were unnecessary. Here's the math of what actually happened: Assume 30-to-1 leverage. A 10% gain on $1 million in capital grows from $100,000 to $3 million! Leverage allowed banks and hedge funds to squeeze more and more returns out of extremely thinly profitable investment strategies such as merger arbitrage. These institutions were juicing profits by plowing into complex instruments, such as credit default swaps (CDSs) and mortgage-backed securities (MBSs). The dark side of leverage My good friend Keith Hennessey, director of the U.S. National Economic Council, used these examples:
Derivatives: "Financial weapons of mass destruction" Warren Buffett has described credit derivatives as "financial weapons of mass destruction," and I've long expressed my concern surrounding their opacity. However, it's not derivatives per se that caused today's financial crisis, but the lack of transparency and the aggressive leverage attached to their use. As speculative investors—most notably hedge funds—increased their use of derivatives, they morphed into giant trading vehicles. Derivatives were initially intended to hedge risk against unexpected movements in asset prices, and were meant to be contracts between two investors. Once hedge funds and other speculators began trading them wildly, volatility skyrocketed. And they were doing this with leveraged money, trying to amplify their trading bets. Although retail investors are limited in how much debt they can take on to buy stocks, investment banks are not as constrained. Since 2004, they have been able to leverage at debt-to-equity ratios of 30 to 1. On top of that, unregulated hedge funds were coddled by their prime brokers with low margin rates, while money center banks used off-balance-sheet and highly leveraged structured investment funds to avoid otherwise tight capital limits. But then the markets imploded and leverage became a rapidly spreading disease. As markets fell, often dramatically, leveraged investors were forced to raise more capital, which forced them to sell what they could. That increased downward pressure on prices and triggered margin calls, which prompted more selling. When it was mortgage debt they were trying to unload in a "fire sale" environment, it was nearly impossible to find buyers at any price. Selling at those fire-sale prices forced firms to mark down the remainder of their portfolios. We've been experiencing this cycle in all its vicious glory. The U.S. dollar has benefited from this unwinding because banks around the globe are in desperate need of dollars. Many global bank credits are dollar-denominated, so demand for the dollar is up. We see this as a trend that has some legs during this deleveraging process. But an implication to consider is that a dollar reversal could coincide with an equity market reversal—in other words, a new bull market could come alongside a reversal in the dollar's recent rally. The hedge fund effect The instability unleashed by the great hedge fund unwind led to a vicious cycle of panic, further withdrawals and, in turn, more volatility. This has been further exacerbated by the limited trading being conducted by traditional investors—magnifying the hedge fund effect on short-term market movements (hence the wild last-hour swings). It's impossible to know with any measure of certainty how far along we are in the deleveraging process. Hedge funds, which are deleveraging at arguably the fastest pace, faced record-breaking redemption notices in the month of September, with more following in October. The anecdotal consensus is that these funds may be well through their deleveraging cycle. Although mutual funds have also sold to meet record-breaking redemptions, it's not traditional deleveraging—other than the fact that many investors are redeeming in order to deleverage themselves. For what it's worth, remember that record redemptions are often contrarian market indicators (the prior redemption record was in October 2002, right at the market low for that cycle). As a result of this relentless selling, hedge funds' levels of market exposure have decreased markedly during the past year, and their net long exposure is at historically low levels. Many funds are simply hoarding liquidity, possibly for three reasons:
A near-term impact has been on the liquidity profile of equity performance rankings. Russell Investments studied the third-quarter performance of its Russell 2500™ Index (the top 2,500 stocks by market cap). Overall, the index fell by 6.7% in the quarter. But the most liquid stocks—the top 20%—plunged 22%, with average declines falling along with liquidity. In fact, the most illiquid stocks actually rose 3.6%. Liquidity will likely continue to be important in a deleveraging cycle. Failure of the 5%, not the 95% John Hussman of Hussman Investment Trust wrote in a note in September: "These institutions are not failing because 95% of the assets have gone bad—they're failing because 5% of the assets have gone bad, and they over-stretched their capital." We believe that the most obvious implication is tighter lending standards by the banks. Lenders have been in retreat, pulling back on credit lines for mortgages, home equity loans, business loans, credit card offers—and increasingly for commercial real estate (potentially a "next shoe" to drop). This trend is unlikely to reverse meaningfully, even with the government's money via the Emergency Economic Stabilization Act of 2008, also known as the Troubled Asset Relief Program (TARP). The market is certainly sensitive about that capital being put to work to leverage the system again. Best guess is that it will be quarters, not weeks or months, before that happens. And this says nothing about the demand for credit, which is likely to be subdued for quite some time. Government: releveraging So, the government is coming to the "rescue." One of my favorite (though depressing) New York City sites is the National Debt Clock, which has "real time" constant movement showing the growth in the nation's debt. Are you aware that they recently ran out of digits? In 1990, the national debt was $3 trillion—by 2001 it had doubled, and it is currently approaching $11 trillion following the passage of the TARP. This doesn't even include the more than $5 trillion in Freddie Mac and Fannie Mae debt that the Treasury now explicitly guarantees. With national debt having moved into 14-digit territory, the National Debt Clock had to remove the dollar sign ($) in order to accommodate the 14th digit. A new clock is on order—let's hope they don't add a space for a 15th digit! In the 1920s, prior to the Great Depression, U.S. government spending as a percentage of GDP was about 3%, but today it's 20%. The percentage of GDP driven by consumer spending is now just off an all-time high of nearly 72%, well up from the long-term average of about two-thirds. You can see the trends in the charts below. A near-certain force gathering steam will be private-sector deleveraging leading to waning private-sector consumption, with the government sector stepping in to fill some, though not all, of the void. There is already talk of another fiscal stimulus plan, but it's more likely to be a broad plan rather than just rebate checks, as was the case this past summer.    This year will be the first since World War II that both financial and housing assets are declining simultaneously—taking a big bite out of household net worth. Federal Reserve studies estimate that for every dollar lost (or gained) on an asset, consumer spending decreases (or increases) by four to seven cents. The total drag so far, since asset prices began declining, is estimated at more than 2% of consumer spending. That's lower than the trough experienced during the last recession in 2001. How much worse does it get from here? There are examples of housing busts/deleveraging periods in other developed nations (Scandinavia and the United Kingdom between 1987 and 1995). According to BCA Research, in those episodes, consumer spending dropped by 6.5% on average over two years from peak to trough, and the savings rate rose significantly. Bottom line? The era of cheap and easy money is over. Credit will cost more for consumers and businesses, even with debt holdings pruned. Unseizing the credit markets remains a must, but government interest rates are already low (and likely going lower) and banks will want to operate with more normal interest-rate spreads than they did during the easy money years. The transition to prudence is painful but necessary, and if financial fitness is the end result, we'll all be better off—eventually. Important Disclosures The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. All expressions of opinion are subject to change without notice in reaction to shifting market conditions. Examples provided are for illustrative purposes only and are not intended to imply future results. Data contained herein from third party providers is obtained from what are considered reliable sources. However, its accuracy, completeness or reliability cannot be guaranteed. The Schwab Center for Financial Research is a division of Charles Schwab & Co., Inc. (1008-8922) Return to Top |
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