Guest Post: The Many Faces Of Deleveraging
From the Contrary Investor
The Many Faces Of Deleveraging
Many Faces Of Deleveraging...Three
and one half years ago in March of 2007, we penned a discussion
entitled, "It's Delightful, It's Delovely, It's Deleverage".
Of course the upshot of that missive was that we suggested that
the whole idea of balance sheet deleveraging was to be a huge
investment theme to come. Little did we know, huh? You
already know this was well in advance of the ultimate systemic
credit cycle debacle that was to come and a year and a half in
front of Lehman as a singular event. Deleveraging
subsequently became a popular and virtually consensus theme in
late 2008 and early 2009. Associated with this headline
theme were tangential anecdotes such as "new normal",
etc. It's time to quickly revisit the subject of
deleveraging now as per the recently released 2Q Fed Flow of Funds
now why? Because believe it or not, a good two to three
years past what was the initiation of one of the greatest credit
debacles in US/global history that is still reconciling as we
speak, very little real world deleveraging has actually occurred.
Has the need to deleverage private sector and public sector
balance sheets suddenly disappeared amidst a miraculous macro
economic recovery? Not in the least. Has it been
negated by central bankers apparently under the impression that
printing unprecedented amounts of what most folks call money will
cure all ills? Nope. THE issue has been the ability to
deleverage, or inability as may be the more proper
characterization. Financial flexibility. It has
actually decreased in certain sectors of the economy as opposed to
recovered. So the question becomes, if the need to delever
private sector balance sheets is just as meaningful and important
today as it was three years ago, just what can we expect of the
character of the real economy ahead? What does this imply
for our investment activities and just how do we position in the
current environment given that this proverbial sword of Damacles
still hangs over our collective heads? Deleveraging is not a
pop culture term whose popularity has come and gone in 2008 and
2009. It remains a construct we will be dealing with for
years to come and absolutely must be integrated into thematic
decision making ahead.
try to take this in bullet point headline sector format. We
want to quickly review deleveraging at the household, public
sector and corporate levels. Where are we now? What
has happened over the past three years and where do we stand
relative to historical context. Let's get right to it.
the point, the top clip of the chart below is a look at the
quarter over quarter change in total household debt outstanding,
necessarily inclusive of credit card and mortgage debt.
Needless to say, we've never experienced anything like what we
have lived with over the last few years anywhere before in the
history of the data. As we wrote about long ago, thematic
household balance sheet deleveraging in action, no?
Actually, not in the manner most would assume.
the period highlighted by the red circle, household balance sheet
leverage has contracted by $492.6 billion. It just so
happens that on September 8th, a little over a month back, the
incredible folks at Moody's put out a piece estimating that in the
current cycle up to this point, US banks have taken $476 billion
in total write offs. They tell us they believe banks have
already taken 68% of the residential mortgage and 49% of the CRE
losses Moody's believe they will encounter over the entire cycle.
We'll reserve judgment for the final tally, but you can see that
bank write offs and the contraction in household debt numbers are
not too far off parity. Admittedly there is some apples and
oranges comparisons going on here as households are not CRE
holders per se. But we know intuitively that the bulk of
bank booked losses have related to residential real estate as so
much commercial property price damage occurred after the FASB
threw out mark-to-market accounting in early 2009. Plus, as
we have shown you in the past, the bulk of CRE loan maturities lie
in the years immediately ahead of us, not behind us. The
last data point we will throw into the mix is that as of August
2010 data, the drop in official US bank loans and leases
outstanding (very broad categorization) comes in at $454.3
billion. Again, you can see the macro numbers are converging
although the existing data does not allow us to pinpoint the
numbers exactly in terms of comparing household debt declines
directly with banking system write offs, we believe it is more
than very fair to say that the bulk of household balance sheet
deleveraging in the current cycle so far has come from defaults as
opposed to loan pay downs.
And to be
honest, this is not surprising in the least. Why?
Because the means by which to reconcile household balance sheet
leverage outside of outright default has been lacking, namely wage
growth. As of the latest data per the official 2Q period end
numbers to this point, the year over year change in US personal
income less US government transfer payments continues to rest in
negative territory. You can see the half century plus rhythm
of this data. It's not unusual to see personal income less
government transfer payments fall into negative territory during
prior recessions. We've just never gone as deep in any other
cycle but the most recent, and personal income growth excluding
transfer payments (think extended unemployment benefits) recovery
has been lacking. No big mystery as any semblance of new job
growth has been virtually non-existent. Last week we
received the personal income and consumption numbers for August of
this year. On a year over year basis they finally showed a
bit of rate of change growth. But as you know, we are
comping against very weak 2009 numbers. You can see as you
look at the absolute numbers in the chart below (the area in
black) that in nominal terms income exclusive of government
transfer payments remains well off the highs.
know the punch line here. At least up to this point,
household deleveraging has come "the hard way", via
default. Why? Because the means to delever via
savings/wages has been virtually non-existent. The important
issue is that the deleveraging process at least at the household
level hasn't even really begun in any type of organic sense.
And that tells us the road to true economic recovery is going to
be long. Very long. This process still needs to happen
as we'll see in just a moment. Doesn't this say something
about the longer term fundamentals of domestic consumption?
If you believe, as we do, that true household balance sheet
deleveraging must indeed take place before a sustainable new
domestic economic growth cycle can take hold, we have not yet even
left the starting gate.
few quick tangential comments and then a quick summary, and we'll
move forward. Importantly, the bulk of household
deleveraging in the current cycle has been achieved by loan
default, not proactive savings or wage based balance sheet actual
debt pay down. In spite of the economy being back in
recovery mode as per the headline economic stats, the real tale of
financial pressure at the household level is being told in the
data of US personal income less government transfer payments.
We believe it's very fair to say that what little sustainability
in consumption we have seen in the recovery cycle so far has in
very good part been supported by the government (actually the
taxpayers). As you'll see below, we've never seen levels of
the current magnitude of government transfer payments as a
percentage of personal disposable income. Just what would
happen if the government were to stop extending unemployment
benefits or cut back on household transfer benefits in any other
manner? Don't worry, they will not, especially with the
relationship you see below.
In one sense,
the government has very much put itself into a box as never have
government social payments as a percentage of
personal consumption risen to such a level as you see below.
Never. How does the government cut back without very much
negatively impacting a consumption based
economy? We do not have an answer. It can't
until jobs and wage growth reappear. How does the government
cut back and not negatively impact the household deleveraging
process that is absolutely a must do prior to true domestic
economic healing taking place, to say nothing of the potential for
a restart of the household credit cycle? Again, we have no
So just where
are households in this whole process of deleveraging considering
the fact that excluding the influence of the government their
incomes have not risen over the past few years? For that we
like to look at household liabilities as a percentage of
disposable personal income. Again, remember that a lot of
the already seen contraction in household liabilities up to this
point has been through default, not repayment.
ratio of household liabilities today relative to disposable income
stands much higher than the longer term average. Will we get
back to the average as part of total cycle reconciliation in the
years ahead? To be honest, we do not expect that to happen
because quite simply the public does not have the financial
resources for that type of an outcome. But we do believe
this ratio must and will continue to contract ahead. The
bottom clip of the chart is data we've not shown you in a while,
but repeatedly reviewed regularly a number of years ago.
Remember, we define cash in the bottom chart clip as all
household financial assets less equities. Savings, bank
deposits and products, bond holdings (taxable and tax free), as
well as bond funds. It was only in the prior decade that
this relationship fell into negative territory for the first time
in the entire history of the data. A "tipping
point" as we have described in other discussions. After
all, who needed cash when credit inclusive of HELOC's, lines of
credit, cards, etc. was so readily available to households?
Again, we have a hard time seeing this reconcile back to zero any
time soon as we are looking at a $2 trillion mismatch here.
BUT, the path of current reconciliation will continue because it
of banging on the household data. THE key important point
being, although deleveraging remains a very valid construct and
investment theme, when it comes to the current reality of the
household balance sheet the deleveraging process has only been
achieved up to this point primarily by household debt default.
It's not enough as per the history of the numbers you see above.
We have a very long way to go in terms of household balance sheet
reconciliation still yet to come. Income generation at the
household level is the key to the timing and rhythm of this
process. Interest income is dead. Small business
(proprietors income) literally just recorded its first positive
year over year number with the August personal income report, but
it's comping against weak prior year numbers. In absolute
terms it's not a factor. Jobs and wages are the key to the
inevitable household deleveraging process and so far both are MIA.
Consumption in the domestic economy remains at risk until this
deleveraging process is ultimately completed. And finally,
again as is clear per the numbers relationships above, the
government is the current wild card in this process as they have
acted to hold up nominal headline personal consumption (via
income) with transfer payments up to this point. Of course
the sarcastic question becomes, can we have a
economic recovery built on government transfer payments? Of
course not. QE will do the trick in terms of making that
very much consensus thinking these days that corporations are
"flush with cash". We will not debate that for a
minute. You can see the deals that have been done in tech
land as of late for cash, and also cross border deals that are
heating up. In fact since 2006, total corporate financial
assets (the broadest definition of cash we can think of) are up
close to $2.5 trillion. That's a lot. And by the way,
this is the number for non-financial
corporate business. But what gets little to no attention,
and mostly no attention, is that in aggregate over exactly the
same time period non-financial sector corporate liabilities have
likewise increased close to $2.7 trillion as we detail in the
we're nitpicking, but just where is the corporate deleveraging?
In academic terms, it has not happened at all. And yet
corporate debt relative to GDP is much nearer record highs as of
now than not.
not trying to create the impression that corporations are somehow
in trouble due to leverage. They face a completely different
set of dynamics than do US households. The source of
"income", per se, for US households is derived in the
domestic economy. For so many
corporations, that's not true at all, especially in the current
environment of continued strong emerging economic activity.
Moreover, although a certain segment of US households has been
able to participate in the benefits of lower interest rates (the
solvent ones, that is), US corporations have been given the debt
cost of capital gift of a lifetime. So it's not so much the
level of liabilities that is the issue, but rather the cost of
carrying the liabilities. Big plus for the corporate sector
for now. We just wanted to point out the facts here.
Yes, corporations are flush with cash/financial assets. But
their liabilities have actually risen more in the last four years
than have their cash assets. Although we do not expect
dramatic and life changing balance sheet reconciliation ahead, we
do expect some debt pay down to come in the current cycle.
Although we'll be the first to admit that when IBM can issue three
year paper at 1% and have it be oversubscribed (the exact terms of
a recent deal), who the heck wants to pay down debt? In
fact, any CFO not issuing paper at these mind boggling interest
rate levels should be shown the front door.
a final comment, we do need to keep in mind that a lot of
corporate cash is being kept very safe and warm...off shore.
We hear the number is close to $1 trillion, so that puts the total
financial asset number in perspective. So as we think about
the bigger picture macro of the need for domestic jobs and wage
growth that would indeed facilitate household deleveraging, could
corporations use that cash for capital spending and expansion that
would potentially create jobs and income? Sure, but probably
not in the
. Taxation is going to keep this cash hoard offshore unless
something dramatic changes. That means the cap and equipment
spending, and resulting job expansion, will happen in higher
growth rate areas of the world. Again, where is the spark
for household deleveraging we know has to happen ahead?
Probably not in the corporate sector, at least not for now.
SECTOR VERSUS PRIVATE SECTOR DEBT
simply a toss away comment to say that the government has borrowed
a lot of money over the last two to three years. Everyone
and their brother already knows that. And there is plenty
more borrowing to come where that came from. But a bit
analogous to the comments about household debt contraction and
bank write offs above, what about the relationship of private
sector debt contraction and public sector leverage acceleration?
Is there a similarity or mismatch here? As of the Fed Flow
of Funds statement for 2Q, the following table delineates the
change in public and private sector debt outstanding since the end
of 2007. Have a peek.
we're not going to dwell on this or drag you through a series of
charts. We've done all of that before. The numbers
tell their own story in rather dramatic fashion. In nominal
dollars total public sector debt has expanded over twice as much
as private sector debt contraction over the last two and one half
years. Not only have we academically offloaded private
sector debt onto the public sector, the public sector as doubled
the number in terms of additional leverage assumption. So as
we look at the public and private sector from a birds eye
viewpoint, again the question becomes what deleveraging
systemically? Just how does the public sector delever when
the private sector is contracting? It can't.
Academically the public sector has the means (taxes and spending
cut backs) but never the will. The perception is out there
that public sector debt accumulation has simply offset private
sector debt contraction. Not true. It has more than
offset private sector debt contraction. And still households
have not been able to achieve organic balance sheet deleveraging?
Again, the process of total cycle deleverage remains in its
charts and numbers and all that other stuff. We think the
summation messages are very clear and certainly have implications
for at least a domestic economy thatis suffering primarily from a
lack of aggregate demand, let alone a global economy in part
suffering from the same. As hard as this may be to hear,
deleveraging is still barely out of the total cycle starting
gates. At the household level we have not yet even seen
organic deleveraging, but rather deleverageing through defaults.
Jobs and income growth are the keys to the deleveraging process at
the household level, but they are for all intents and purposes
missing in action in the current cycle. And that speaks to
time. Time for true balance sheet healing and ultimately a
recovery in aggregate demand. The very means for households
to delever independent of default are not visible. Not yet.
And so we need to expect 1) a stop-start real world domestic
economic recovery, 2) Fed QE that does nothing to reinvigorate the
real economy, but has the real potential to create yet more
unproductive asset bubbles, 3) continued volatility in financial
asset and commodity prices based on investor perceptions of Fed
and global central banker sponsored liquidity and the
effectiveness or not of liquidity injections at any point in time.
In reality, this is nothing we have not already been dealing with
up to this point. But for our investment activities
specifically, we believe it all comes down to just how far the Fed
and their global central banking brethren are willing to push the
envelope in terms of money printing, currency intervention, etc.
For now, investors still view these activities as virtuous.
But at some point unless we do indeed see true real world economic
reinvigoration, we believe the markets will come to view further
Fed and global central banker monetary "experiments"
quite negatively. All part of the psychology of a financial
market and economic cycle.