Tuesday, September 16, 2008

The Real Risks of Deleveraging

The deleveraging process that is dramatically impacting the economy and markets has two very serious consequences to it. One deals directly with the insane process of mark-to-market of illiquid, opaque assets. The other pertains to the effects deleveraging will have on the real economy. Allow me to highlight the key points of each.

In terms of the financial economy, the process of deleveraging can be characterized as feedback loops gone wild. Virtuous circles (and their accompanying animal spirits) give way to vicious cycles, in which lower prices beget write-downs, which beget lower prices. And on it goes. In the process, bad assets become toxic, especially for financial institutions who, unlike other entities, have capital requirements that must be met.

There is nothing new in all this. Bubbles and panics have been around for centuries. And bad behavior is always punished eventually. The larger macro economic issue is the fact that the global economy is in transition (listen to El-Erian’s comments below). The dominant question in such a macro economic environment is whether the transition will be an orderly or disorderly one (ex. a declining US dollar). What is new, however, is the impact that the rule change made last November that has turned a difficult situation into the disaster the financial markets are facing today.

Thanks to the well-intentioned actions of FASB last November and the updating of the accounting rule FAS 157, illiquid assets must now be marked to the current market price (mark-to-market) in an attempt to reflect the true value of the asset. This is all well and good were it not for the fact that marks in highly illiquid, opaque markets can produce a highly questionable reading as to what constitutes "fair value".

Moreover, when such marked-to-market assets are owned by financial institutions operating with high degrees of leverage often reliant on short-term financing with mandated capital requirements, you have a recipe for disaster. But don’t take my word for it. Listen to Paul Volker many months ago or Steve Forbes on Fox Business News last night*.

Lastly, so much of the current investment climate has been co-opted by short-term momentum players, many of which are aggressive short sellers. Does anyone seriously believe that these players are interested in what the "fair value" of an asset is?

All this creates a toxic climate for toxic assets.

The second risk re deleveraging is how it will impact the real economy. One effect is already being felt – fewer loans are being made. Gone are the days when credit cards, auto loans, and no-doc, no-income mortgages literally flew out the doors of financial institutions. Gone, also, are the very generous covenants attached to junk bonds. In their place is an austere environment where liquidity is abundant but the risk appetite in frozen with fear. This is all bad but what makes this situation highly dangerous is the state of the US consumer.

The US consumer, the spending workhorse of the world economy has a personal balance sheet that is in serious disrepair. In the current economic environment, the need to reduce debt and increase their personal equity will only come about through a process of savings out of income. Say goodbye to your personal (home) ATM. Say hello to a higher savings out-of-income rate.

But savings out of income coupled with extremely low levels of borrowing means that the US economy is on for a period of depressed economic activity. The shop-til-I-drop, I-must-sustain-my-unsustainable-lifestyle US consumer is toast. A weakened economic climate coupled with the negative wealth effect (from real and financial assets) and a looming retirement calendar will do that.

All is not lost. There are pockets of strength that can help alleviate the financial crisis and perhaps help avoid a worsening contagion to the real economy. For example, there is a segment of the world economy that appears to be poised to emerge as the source of demand – the emerging middle class of emerging economies. Growth in their economies should remain positive and, given their generally solid balance sheets (not to mention fairly good policy processes), should make a positive contribution to global growth and stability. Not quite 100% decoupling but more than the pessimists believe.

By the way, speaking of solid balance sheets, most investment grade corporations have very solid balance sheets. The ability to weather a financially-inspired storm is quite favorable.

Then there are the large pools of capital around the world that sit waiting for the crisis to resolve itself. From sovereign wealth funds to money market accounts to central banks, liquidity is more than ample.

Lastly, Americans have a great capacity to adapt, to innovate, and come together in common cause**. All these factors should not be ignored as they represent a path out of the credit crisis quicksand.

There is one final point that I wish to make.

Rule changes matter. FAS 157 is a well-intentioned rule that is rooted in an antiquated principle known as the Efficient Market Hypothesis. For while investors in the long run are rational and risk averse, in the short run they are anything but. Modifying FAS 157 would one very easy way to reduce the vicious cycle of mark-to-market.

Investment Strategy Implications

The technical damage done to the equity market is sufficiently bad (but interestingly not terrible) that aggressively adding to positions should be done with great care. However, a prudent portfolio management policy of sector tilting coupled with a mindful regard that stocks have an upward bias (see prior blog posting on this point) is always appropriate, made even more so when panicky selling rules the day.

*FYI - Little ole me has written on this topic on several occasions on this blog and in reports. I encourage you to use the topics link for credit related issues to your left to explore the writings further.

**This point is contingent on a less divisive political climate. Therefore: Memo to McCain’s advisors – cool it with the Karl Rove tactics. You may win the election just like W did, but you will cause severe damage to the country in the process, just like W did.)

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