Tuesday, January 19, 2010

Debt and Debtors: A Global Picture of Deleveraging (Part 1) - Alpha

“And forgive us our debts, as we forgive our debtors.”
-The Lord’s Prayer in the English Bible

Debt is the poisoned root for the global economy and financial markets. It is the big substructure that all investors must weigh, the deflationary gravity that will push down equity, commodity, and all risk-asset prices (despite the current sugar rush from unsustainable monetary policies). Deleveraging means paying off debts; and mind you, risk-taking and economic growth cannot occur if debts are too high. We go into the visual details in this post.

The McKinsey Global Institute (MGI) has come out with a superb report on global debt and deleveraging, available here (very long and detailed):

McKinsey Debt and Deleveraging Report (2010)

See shorter text summaries from Gillian Tett of the FT and the Economist.

See also the masterful Rogoff/Reinhart study (which we also refer to), presenting centuries of history on debt and defaults:
This Time is Different: A Panoramic View of Eight Centuries of
Financial Crises (2008/2009)


MGI looked at the facts on the ground and analyzed 45 historic episodes of deleveraging, in which an economy significantly reduced its total debt-to-GDP ratio, that have occurred since 1930. Below is our analysis of their conclusions, heavy on visuals and light on text.

1) US total debt at highest levels since 1929 (before the Great Depression):
This reached its highest level in 2008 in the last 110 years, only once before seen in 1929/1930. In that instance, deleveraging took 20 years. (Note: This is a Morgan Stanley slide)


2) All “rich” countries are in deep debt: The US wasn’t alone in the cancerous debt growth. All rich Western countries, along with Japan and S. Korea, were part of this foolish debt binge. Empirically, after a credit-based expansion and major financial crisis, every country nearly always has a long period of deleveraging.


3) Emerging market stars are light on debt: Countries like the BRICS, took on much less debt in comparison. Russia, of all countries, was a responsible Hetty.


4) Debt varies greatly by sector - households and CRE are the sickest: A heat map shows that the two areas most needing deleveraging are households and commercial real estate. Households are getting a massive savings penalty in low rates, whereas commercial real estate (CRE) lenders are pushing back doomsday with a “pretend and extend” approach to maturing debt. Surprisingly, many governments and corporate borrowers are much healthier than investors realize.


These are McKinsey’s metrics in coming up with the heat map:


5) The UK and Japan were hogs, Russia was a minnow: Interestingly, government debt is the biggest problem for Japan, but it’s the least problematic for the UK (where everything else, household, corporate, and financial hurts equally). The US and Germany are close in the level and near-equal composition of their debts. Russian financial institutions and corporations were relative hogs; its government and household were the most frugal in the world.


6) Sovereign debt crises (a hardy perennial): For a sovereign crisis to occur, total debt must be high, deficits must be trending higher, debt service must come close to unbearable bounds, and the bond buyers must be twitchy. Japan has high total debt and bad deficits, but its debt is mostly owned by Japanese savers who are forced to own government debt through institutions like Japan Post. But as Japanese savers eventually need to fund their retirements, this could get nasty for Japanese rates. For a deep, fascinating analysis of Japan, see some SG research here: SG on Japan's Sovereign Crisis


By this measure, the US is in a pretty safe place in the short run, but the trend is not sustainable. The million-dollar question is who implodes first: Japan, the UK, Greece, and some of the PIIGs (Portugal, Ireland, Italy, Greece, Spain) seem to be top contenders.


Sovereign crises seem to happen in waves, with defaults occurring every 20 to 40 years. (Rogoff/Reinhart)


Also, the hotter or more mobile that capital is, the greater is the incidence of a banking crisis. (Rogoff/Reinhart)


7) Only 4 ways to get out of the debt mess:

i) belt-tightening,
ii) high inflation,
iii) massive default,
iv) high GDP growth/productivity.


The rich world will have to decide between options 1 and 2, as option 3 has a very high long-term cost and option 4 is illusory (even though I’m a “tech optimist”, even I’m not that optimistic given the debt loads – Silicon Valley, seen from the ground, seems to be in a nasty, secular contraction for innovation/startups despite the health of the big companies like Intel, Oracle, Google, etc.).


Inflation will certainly be part of the solution – in the long-run, no paper currency is worth the pulp it’s printed on. That’s why investors turn to the “hard” currencies of gold and silver – they can’t be printed/duplicated but must be slowly mined over decades. (Rogoff/Reinhart)


8) GDP growth depends on the policy path taken: Depending on the road taken, GDP growth could recover faster or slower. In the short-run, belt tightening is the best strategy, but strangely, in the long-run default seems to lead to the best outcome! (I would question that with the examples of Argentina and Thailand, but Russia survived 1998 quite well). As McKinsey puts it: “Deleveraging episodes are painful, lasting six to seven years on average and reducing the ratio of debt to GDP by 25 percent. GDP typically contracts during the first several years and then recovers.”


9) CRE, GSEs, and Big Banks are the worst offenders: Digging down into micro details, commercial real estate and the US broker-dealers (the Big Banks, the “Banksters”) went completely bonkers. But craziest of all were the government-sponsored entities (GSEs) of Fannie and Freddie, where it was “tails shareholders win, and heads the government/taxpayers lose” on their massively levered bets. Two problems from the GSEs and Banksters: i) insanely high debt/equity ratios, ii) liquidity mismatches, meaning borrowing money short and lending it long. Congress, the Fed, and the feckless GSE regulators take much of the blame here.




10) Governments have dealt with hard times before: The two fascinating charts below show how the US and UK governments borrowed too much after previous wars and then had to pay back the debt. For the US, recent high borrowings came with Reagan to finish the Cold War (1980-1988) and then with George W. Bush for the Middle Eastern Wars (Iraq 2, Afghanistan). George H.W. Bush and Bill Clinton should get credit for being the responsible, “fiscal clean-up” Presidents. In the end, debt must come down and debtors must be forgiven. But many paths lead to that eventual conclusion.




11) Historic deleveraging episodes: Below is the dataset that McKinsey used in their study.

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