3/14/2008

De-leveraging is a term being used by many economists and market analysts. What is de-leveraging and why should investors care?

Excess Inventories and Recessions

Past recessions have been characterized by excess inventories of manufactured goods. These excess inventories build up as consumers cut their spending faster than businesses can respond by cutting their production. To help reduce these inventories, companies cut the price of their products to encourage consumers to buy them. They also cut their production to levels below current sales to help work off the excess inventories. Eventually, these inventories are sold and the economy starts its recovery. Such has been the nature of past recessions.

The recession of 2008 has not yet experienced excess inventories in most manufactured products. Perhaps, it is the improvements in the supply chains that more closely align production with demand. Perhaps, demand has not yet fallen off.

However, there is an excess inventory in housing that has built up that needs to be worked off. The backlog of unsold homes continues to grow. As of January 2008, at the current sales rate, it would take 10.3 months to sell off the inventory of unsold homes. That is without adding any more homes coming on the market from builders, new foreclosures and current owners looking to sell for any number of reasons.

Housing inventory was 9.7 months in December, and 4.5 months in 2005. Not surprising, the median home prices also fell nationwide. The median price of a home sold in January slid to $201,100, a drop of 4.6 percent from a year ago. Some analysts expect it will take until 2010 to work off this excess inventory so the market can return to normal.

This continuing rise in inventories of houses and the fall in home prices directly affect the balance sheets of banks, investment houses and hedge funds that hold mortgage backed securities. Hedge funds have used significant leverage to extract higher returns from these investments. Since these funds do not have to report to authorities or the public, most people do not know how much leverage they use. Merrrill Lynch, the most leveraged of the investment banks sports a 37 to 1 leverage ratio. A 1 percent loss on assets of $1.02 trillion would wipe out a third of the equity. Pretty scary stuff.

As of Sunday evening March 16, 2008, there are reports that JP Morgan will be buying Bear Stearns for $2 per share. It was trading early Friday for $57 a share. As late as a week ago the firm confirmed that its book value was $84 per share. A lot of people lost a lot of money.

In the U.S., commercial banks are normally required to maintain capital ratios that are no more than 8 to 1.

Financial Leverage

In the U.S., home owners have relied on the appreciation in their houses to provide them additional spending money above what they earned from their employment. Using home equity loans and lines as well as cash-out refinancings, they continued to spend more than they made, counting on the appreciation in their houses to make up the difference.

Moreover, many first time homeowners took advantage of the less than appropriate lending terms and rates to buy more house than they could afford. These sub-prime loans are now the focus of almost everyone, yet they are not the entire picture. Many people are just now realizing that the value of their homes is falling, getting closer to or perhaps becoming less that the principal amount of their mortgages. How many of them will walk away from their homes and mortgage commitments is any body’s guess. But I best it will be more than many expect.

All this was driven by investors seeking assets to place the mountains of cash moving around the world, looking for high rates of return. The mortgage backed securities that the banks created and sold were the answer to their quest, especially if they could borrow money at low rates to acquire them.

The investment funds added more and more leverage to buy up these collectivized securities, helping to fuel the housing values. It was a wonderful story and everyone was satisfied with the situation. Bankers were making more money; homeowners were spending more than their incomes could support. All the cash found a home. Speculators bought homes expecting that the price would go up and they could sell it for more. Government officials were pleased that there were many new homeowners achieving the American dream.

Then evitable happened. Some people could not sell their houses for more than they just paid. Others could not make the payments when they were due. The housing piggybank developed a leak. Bankers started to worry that their loans might not be repaid. The investment houses and hedge funds started to try to sell off some of their assets to help pay for calls for cash. However, no one was willing to pay the asking price for these assets.

The leak developed into the implosion we are now experiencing. Investors are discovering that the collateral underlying these loans is suspect. Many more borrowers cannot make the payments, especially as the rates rise. Others realize that they are paying on a mortgage(s) that are worth more than the house. Why should they keep making the payments?

As a result, foreclosures are up and the investors holding the collateralized back securities realize that their highly leveraged assets are now losing value. The banks and other lenders are worried that their loans will go into default, so they are asking for more security. If they do not get it, the bankers are issuing margin calls. But many institutions cannot make the calls without a way to sell off all the highly leveraged assets.

De-leveraging

All the build up in the leverage is reversing course. That is de-leveraging and is has a lot more to go. There are likely going to be losses on commercial real estate, student loans, auto loans and credit card-related derivatives, all of which are beginning to crumble. De-leveraging of the financial structure is contracting derivative-created liquidity much faster than central banks could create it, even under the best of conditions.

Banks used to make loans and keep them on their books. However, the big banks found that this type of business was not capable of generating the growth they wanted. Their strategy was to sell off loans, transfer them to off-balance sheet entities, securitize them and otherwise moved them out to make room for more.

Now the banks, investment firms and hedge funds are faced with massive write-downs of their assets. As a result, they are causing all the related entities to sell off their assets to generate the necessary cash to meet the margin calls. The de-leveraging of the financial system continues.

With the credit debacle, these banks are going back to lending their deposits and only creating money to the extent permitted by the central bank under the fractional reserve system (the 8 to 1 capital ratio). They no longer are packaging up the various loans and selling them to other investing entities.

This process is limiting the availability of credit that was available in earlier times. Everyone is now worried about risk, likely more than necessary. No one wants to be the one that writes a loan that goes bad. To help offset the risk rates are rising, even as the Fed tries to lower rates to help the economy.

Since no one knows how much leverage was created (remember the hedge funds are private), it is difficult to tell how long this must go on to correct the situation. Like so many other situations, it will take longer than the optimistic analysts’ think. Anyone holding these securities realize they do not know which mortgages are going bad now nor which ones will go bad in the future. The same holds for many other collectivized loan securities.

When Standard & Poor’s says we are half way through, they are only guessing. In addition, they have guessed wrong before. This de-leveraging process is more likely to take longer than most investors believe.

What is an Investor to do

First, the recession now underway is going to be more severe as consumers retrench, and the financial crises spreads to corporations. Martin Feldstein of the National Bureau of Economic Research, believes the U.S. will have a more sever recession than most expect, lasting throughout 2008 and possibly into part of 2009. By the way, the NBER are the ones who say whether the U.S. has had a recession about 12 months after the fact.

The risk is clearly to the down side, especially for the financial sector. One of the best ways to take advantage of this risk is to invest part of your portfolio in funds that short the financial sector. The Financial sector Proshares Ultrashort Exchange Traded Fund (SKF) would be one way to provide a nice return if the financials continue to melt down.

Shares of this ETF will be volatile reflecting the risks most investors have with the financial sector. However, the potential returns can be worth the risk if properly managed.

Otherwise, you can use the Proshares Ultrashort S&P 500 (SDS0 that includes about 20% financial stocks. The Proshares Short S&P 500 (SH) is also a possibility.

Finally, you can just avoid the sector, either selling all the financial shares you now own, or avoid buying any until this de-leveraging process is over.

De-leveraging is causing a significant realignment of the financial sector in the U.S. it will be violent and several firms will disappear. This process will last longer than most people expect.