Has Deleveraging Even Begun? (Not for the Fainthearted)

Yves Smith, blogged at Naked Capitalism, www.nakedcapitalism.com  07/28/08

It no doubt seems absurd to question the idea that deleveraging in underway. We've had three heroic central bank interventions, starting in August 2007, to reverse seize-ups in the money markets. The asset backed commercial paper market has been almost in run-off mode. Leveraged buyout loans have been scarce to non-existent. Banks have cut home equity credit lines and credit card borrowing limits. Commercial and industrial loans have fallen. The private mortgage securitization market is a shadow of its former self.

Yet the macro level data, at least as far as the US is concerned, tells a dramatically different, indeed troubling story (click to enlarge):



The chart is admittedly a bit hard to read, but it is prepared from Fed's Funds Flows through the latest reporting date, which is March 31, 2008. The chart comes courtesy Frank Veneroso's June 18 report, "Why a Second Wave is Inevitable." The line is Total Credit Market Debt/GDP. As you can clearly see, the steepness of the vertical ascent of the [trend?] has not eased in the last year or two. If anything, it may have gotten worse.

We will return to discuss the implications of how big the debt level is, but the graph itself should serve to focus the mind. The March 31 level was 350% of GDP. The previous peak occurred in 1933, during the Great Depression, at just under 270% of GDP. Note that the peak was reached due to the start of the rapid fall in GDP taking hold faster than debts were written off, a dynamic not in operation now. So the comparable level to our situation is in fact lower than the 270% peak.

An additional bit of cheery news comes from reader Bjomar: Japan's total debt to GDP in 1990 was roughly 250% (it took some triangulating among this, this, and this source, his interpolation of corporate debt at 100-140% of GDP, household at 65%, and government at 60%). And unlike us, Japan had a very high saving rate, so its net debt would have been less alarming...

Frank Veneroso argues we have to get off the debt E-ticket ride, now. Referring to the chart above, he writes:

This chart shows something that has gone vertical, something that is on a moon shot. If it were the GDP of Argentina in pesos I would agree that the moon shot could go on and on. But it is not the Argentine economy in domestic money terms. It is a macroeconomic ratio of total debt to GDP. Macroeconomic ratios cannot go on unending moon shots. They are basically mean reverting series. In many cases, such as an economy’s investment ratio or its profit ratio, these values tend to be more or less the same on average over long periods of time. There are some such ratios that exhibit an upward bias or a downward bias; the ratio of service output to GDP and the ratio of industrial production to GDP are examples. But even though there may be a secular “tilt” to the mean, the shift in that mean is always gradual. Over short periods of time like a decade or so mean reversion tends to bring you close to where you came from.

For the above ratio of credit market debt to GDP there is no gradual tilt to this ratio over the last two decades...How can that be, given that it is a macroeconomic ratio? ...If we look back in history, we see one prior vertical takeoff in this ratio – the period from 1930 to 1933. In that episode economic agents did not want to increase their aggregate debt to GDP..... A very bad recession from mid 1929 to mid 1930 started to take the denominator – nominal income – down rapidly....The resulting financial and economic carnage was so great that all economic agents wanted mean reversion. But debt is a stubborn thing to dislodge. It took a generation encompassing a wartime inflation to revert to the mean and eventually overshoot it to the downside.

Over the last year the U.S. has undergone the worst financial crisis in the three generations since that horrific episode of the 1930s. Even though we have had a severe financial crisis the ratio of total credit market debt to GDP keeps on rising. This could have occurred because government was socializing debt, but that has not happened yet.

Private debt to GDP rose as rapidly last year as it did before the onset of the financial crisis. It even rose in the first quarter of this year as the financial crisis intensified. But unlike the 1930s, when this ratio rose even though economic agents did not want it to rise because nominal income was falling, in this episode the private debt to GDP ratio has kept rising because fee hungry lenders continue to engage in expanding credit to profligate over-indebted borrowers. If one looks at this chart with a historic perspective it is clear that this ratio cannot keep on rising. But if you ask people in the market place whether we must go though a period in which credit falls sharply relative to income they will say that need not be. It is widely acknowledged that it has taken several units of debt to produce a unit of GDP in recent years. Most people strangely assume that will be the case in the next recovery. The same attitudes hold for our policy makers. They do not talk about an eventual reduction of credit relative to income. They talk about providing new channels of credit to offset constricting ones; for example, expanding the lending of the GSEs to offset the falloff in securitizations. Can the moon shot in the debt to GDP ratio keep going on, like so many assume? Or has something happened that makes at least a reversal, if not mean reversion, imperative now?

The answer is, reversal is imperative now. Why? It is widely understood that starting in the mid 1990s we entered into a historically novel path of serial bubblizations. Each asset bubble went hand-in-hand with an expansion of credit to the private sector....we can see why the reversal of the moon shot in the debt to GDP ratio is imperative. First, house prices now seem to be in an unstoppable downward spiral.....

It has been calculated from the flow of funds accounts that the ratio of aggregate mortgage debt to residential real estate value reached a peak of 50% when the home price and home finance bubbles reached their peak at the end of 2006. But the flow of funds accounts do not capture second and third mortgages. They do not capture the home equity loans that are in portfolios other than those of the commercial banks. There is a large “other” household debt item in the flow of funds accounts which includes various such claims against residential real estate collateral. I encountered one ratio calculated by the housing finance industry that suggested that, at the home price peak at the end of 2006, the aggregate loan to value ratio was 57%.....

If home prices fall nationwide by 35%, it follows that the average loan to value ratio will exceed 90%. About 30% of all residential real estate in value terms is without a mortgage. For all real estate with a mortgage, the distribution of mortgage indebtedness is very skewed. With the average loan to value ratio rising to almost 90%, a huge share of almost all mortgage debt will be deeply underwater. All studies show that when mortgages are well underwater there are defaults and foreclosures. This applies to the majority of mortgage debt classified as prime as well as the margin of mortgage debt classified as subprime. If home prices mean revert, the odds are high that in the shakeout that will follow the total credit market debt to GDP ratio will finally fall from its moon shot trajectory.....

There is another reason why. There are no more serial bubbles to be blown that are beneficial to income and output, even in the short run. The housing bubble was able to bailout the bursting of the tech bubble because it lifted household wealth and in turn employment, income, and output. Not so, the next new bubble now underway – the commodity bubble.....the effects on the economy from the commodity bubble are very different than those of the housing bubble. The public is not on board this bubble. They are not day trading tech stocks and feeling richer day by day. They are not buying second homes and investment homes, pyramiding their real estate wealth. The public’s involvement in the commodity bubble market is vestigial at most. Rather, the public is exposed to commodities primarily as goods which they must buy to use. This bubble – and in particular the oil bubble – is squeezing the [xyz] out of everyman. Rather than being a new bubble that makes households feel richer, it is a bubble that is taxing them and thereby making them poorer.

The serial bubble solution to the problem of prior bubbles and the financial fragilities they spawn has come to a dead end with a third toxic oil bubble the financial authorities did not expect and do not want – the commodity bubble. Now the serial bubblization of the policy makers portends recession, not recovery.....The end of the moon shot in the debt to GDP would appear to be at hand...