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The Credit Crunch and the Pain of Deleveraging

We're currently experiencing a credit crunch: credit is not flowing. It isn't flowing because the banks are holding onto whatever cash they have. Banks are holding the cash, rather than lending, in order to be able to meet the unpleasant shock of debt deleveraging. The goal of last week's Treasury disbursement of $125 billion to the nine largest banks, and the additional $125 billion made available to other lending institutions was to help lenders do the business that they were set up to do - that is, lending. Yet, the lenders still appear to be very hesitant of letting loose any of their capital. Why?

Leveraging is a term for expanding the power of borrowing. Let's say you save up $1,000 in order to invest. While that's nothing to sneeze at, if you are able to borrow using your $1,000 as collateral then you expand your buying power. If you buy assets considered absolute solid, then you can borrow even more using what you just purchased as additional collateral. Borrowing on top of borrowing - that is the power of magnifying returns on investments.

Consider your initial $1,000. If you can leverage it up to $50,000 from borrowing on top of borrowing, then even a puny 1% return on a $50,000 bet will return a cool $500 on your initial bet. If the borrowing cost is cheap and if the return can be generated in a short time, the interest cost becomes a non-factor. As long as there is a positive return all is good. If this very high leveraging is legally prohibited, then simply do it off the balance-sheet, as was often done by many lending institutions.

But what happens if there is a negative shock and there is a loss in your investment? Your $50,000 bet turns a bit sour and is now worth $48,000. This modest decline in itself does not appear too worrying as it would occur under any normal market fluctuations. However, if the most of the $50,000 was borrowed, with you starting from only $1,000 as in the example above, then you are in a deep hole - not only losing all of your initial $1,000 but also unable to fully pay off all your creditors.

If you are able to borrow temporarily to rollover the debt, then you are fine - but only temporarily until the next debt rollover time. If the debt cannot be rolled-over as creditors have lost confidence in you, then you are wiped out with some of the counterparty lenders not getting paid. If these counterparty lenders had also borrowed on top of borrowing, then they would also be completely wiped out...with further parties not getting paid. This type of default shock wave can sound right up the line.

To lessen the default worry, the lenders also developed an insurance called credit default swaps. This insurance, which has rapidly and greatly surged since the turn of the decade from a $1 trillion market to a now-$60 trillion market, permitted people to be guaranteed payment if the original borrower were to go belly up. But what happens if the issuer of the credit default swap is also the one going belly up because they too had borrowed too much?

Not meeting any of the creditors means bankruptcy. Faced with that, would lending institutions hoard what remaining cash they have or give that capital up in the hopes that the next borrower can repay on quick notice? To raise the stakes further, what if the remaining cash was from the bank deposits or money market accounts of everyday people, who could panic over insolvency and start to withdraw? With lenders and Wall Street firms all entangled in the game of high leverage, a minor disruption in defaults had the potential to quickly snowball into a massive credit problem - and that is exactly what happened.

Warren Buffet has labeled the recent past Wall Street play of high leverage, derivative instruments, synthetic default swaps, and other hard to understand jargon as financial weapons of mass destruction. He stayed away from these complex investment vehicles because it was an accident waiting to unravel the whole financial system.

I also remember my conversation with Dr. Dewey Daane, who served as Fed Governor during the Paul Volker years. His greatest worry as relayed to me early this year was over the complexity of borrowing and outrageously high leverage that just defied any sensible economic logic.

The Treasury Department's $700 billion plan is to recapitalize banks and restore banking confidence. The current hoarding of cash by banks prevents profitable businesses from expanding and smart entrepreneurs from starting new businesses. We need to return to the normal business of lending. However, the lending must come with better oversight and with limits on leveraging so that small accidents do not cause a massive hemorrhaging of the financial system. Now that the lenders are getting cash from the Treasury, careful monitoring and the protection of taxpayers' money are a must.

Fortunately, there appears to be some market movement for improvement. The LIBOR rates remain elevated still, but have move down from last week. In addition, the Oracle of Omaha Mr. Buffet opined last Friday that he is now moving his money into the market. We are living in highly uncertain times, but perhaps the worst in the financial market disruptions is over or nearing their end.

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