How do you “de-leverage” – and why?

The story so far is easy to understand. Governments, central banks and banks got it wrong for five years, and allowed the western world to get too heavily into debt. Governments and individuals borrowed and borrowed at the attractive rates on offer.

Central banks then decided the party had to end and took the drinks away. Now we face the prospect that too many people will not be able to pay the interest on their borrowings and will not be able to repay them on time. Banks have too little money to lend, so house, property and vehicle prices are plunging. This means the banks are even more exposed, as they will not have enough money from the sale of an asset if and when someone hands back the keys and admits they cannot afford the interest.

It is now fashionable to say we need to “de leverage”. The main reason is to cure the inflation excess debt created. I have news for them. The future problem is deflation, not inflation. De leveraging was a good idea a couple of years ago, but today too much deleveraging will just turn a recession into a slump.

There are two ways banks can get their balance sheets into better shape. The first is to withdraw borrowing facilities from existing borrowers, and make very little or no new loans available to people and businesses that want to borrow. This is now happening on a dramatic scale, and will mean more bruising news from the rest of the economy.

The other way to do it is for the banks to raise new capital. If the main banks went out and doubled their share capital, raising new money from old and new shareholders, they would then have much stronger balance sheets and would be happier with the amount of lending they have already made.Some banks are reluctant to do this because their share prices are low. Unfortunately they have no choice. Their share prices are low because investors are worried about their lack of capital, so it is a circular argument. They also have the problem that if assets keep falling in value they can lose the money they raise, forcing them to write off more of their own assets. Again, they have no choice. They have to seek to replace the money they have lost. The shareholders have to pay up to keep their bank going.

It is now becoming popular to say that only the taxpayer can provide the capital the banks need. This is a dangerous argument. The taxpayer should not provide capital for the medium and longer term to help the private shareholders of these banks. Nor should the taxpayer nationalise them, as there is no evidence that nationalised management would be better. There are limits to what taxpayers can afford. Nationalising major banks is beyond their purses and their appettie for risk.In this downturn the governments are going to need all their credit worthiness to borrow to pay the running costs and to help the individual causualties of recession.

There is no substitute for major bank capital raising now. The sooner the better. They must just swallow hard and acept the low prices of the shares they can sell. It’s time for them to visit the Middle East and Asia, where the investment money is.

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17 Comments

  1. Kit
    Posted October 4, 2008 at 10:26 am | Permalink

    As for raising capital – that will happen only when the price is right. The sovereign funds will sit on their hands for at least another year when there will be bargain basement prices.

    • APL
      Posted October 4, 2008 at 7:58 pm | Permalink

      The sovereign funds have been burn already.

  2. Neil Craig
    Posted October 4, 2008 at 11:20 am | Permalink

    I assume that it is regulatory barriers to entry that prevent Banks of Singapore, China or Quatar buying up British or American banks or indeed Gazprom branching out into the banking industry. I don't know whether such restrictions are a necessary way of maintaining world leadership, immensely damaging to the real economy by preventing the solution to the credit crunch, or emulating King Canute. Perhaps all 3.

  3. Tony Makara
    Posted October 4, 2008 at 11:29 am | Permalink

    In the long term fixed lending rates across the world along with fixed exchange rates are the only way we can get back to, and retain, a level of financial stability. We also have to look very carefully at the role of interest, how it translates in terms of real and nominal, and how what we believe to be a hedge against inflation can actually become a contributory factor in inflation as interest has to be written into the final cost of goods and services, thereby excacerbating inflation in the long run. Compound interest has to be reigned in as a concept and as a practice.

    On the matter of liquidity each nation state could establish a state bank that can issue loans to lenders and later recall and destroy the issue of money, after all money, unlike commodities, has no intrinsic value as such, and, if properly understood, is only a promise to pay. So the creation of loans by the state, the recall and destruction of the said paper at a later date by the state, would provide liquidity and create values, without increasing the money supply in the long run. I don't believe the west should be looking to the east for investment, we need to remain autonomous in the creation of money and becoming dependent on the east would make us vulnerable economically and politically.

  4. oldtimer
    Posted October 4, 2008 at 11:30 am | Permalink

    Chinese takeaway will acquire a whole new meaning.

  5. Acorn
    Posted October 4, 2008 at 12:55 pm | Permalink

    You can lead a horse to water but you can't make it drink. Likewise, you can stuff cash into a bank but you can't make 'em lend it. These banks are in survival mode now and they know that the central banks are the people who are supplying the lifeboats; made by taxpayers who may or may not get paid for them sometime in the future. The US bailout has a lot of similarities to the 1990 Swedish property bubble implosion; it took the Swedes over twenty years – and some creative accounting – to get their money back.

    As an amateur economist, I am still not convinced that deflation is a more likely outcome than inflation. History tells us that in the long run excessive money supply that outruns the productive output of an economy always leads to inflation.

    If I was a central banker I would be engineering a large dose of inflation because inflation reduces your debts going forward. I would also engineer it to be more profitable to invest in my governments IOUs than in the likes of gold or commodities. It is starting to look like the US authorities are doing both these things. (selling physical gasoline and gold reserves, to push the price down)

    Joe Sixpack will be pleased when the "Price" of his house goes back up in dollars (or pounds). He will not discern that the "Value" it represents will have gone down relative to other prices.

    Can I recommend to Redwoodians that you read the articles dated October 3rd by Rob Kirby; Andy Sutton and Jennifer Barry at:-
    http://www.marketoracle.co.uk/

    I am starting to think there is a very clever "sting" going on here that Paul Newman would have been proud to star in. Can't wait for "The Sting 2". There has got to be a movie about this lot of crooks.

    • Robert
      Posted October 4, 2008 at 10:28 pm | Permalink

      I agree, they will try and inflate their way out, notionally it makes everyone feel better. John seems to believe that you can leverage and not de-leverage to get to get back into equilibrium not withstanding the fact that we will and have overshot on the upside and will do on the downside.

  6. Obnoxio The Clown
    Posted October 4, 2008 at 2:25 pm | Permalink

    John, while I agree with you that the taxpayer should not be held accountable, it's apparent to me that you are a member of a tiny minority of people in parliament (and congress and senate and especially Europarl) who feel this way. People are so desensitized to all the theft by the state that they just shrug their shoulders and accept it.

    Will this be any different under Call Me Dave? I can't see it: he pointedly rejected the rights of the individual for "social democracy" (what a oxymoron that is!)

    I despair, I really do. I can actually start to see a Britain that will end up as a communist dictatorship.

  7. michael, islington
    Posted October 4, 2008 at 2:53 pm | Permalink

    You make the assumption that British banks are viable businesses that could attract further capital through share offers.

    Surely, the "shorters", or more correctly, marketmakers began to take the opposite view. There was the danger at one stage, was there not, that banks' shares, and therefore the equity cover for their liabilities was becoming so depressed that they were in danger of breaching Basel rules, thereby triggering further limits on their activities, and inevitable bankruptcy.

    This is the potentially catastrophic position we are in at the present time. No British bank wants to lend to another British bank because it is not sure the money will be coming back. The Bank of England is currently supplying life-support to the whole of the British banking system (announcing on Friday it would be supplying cash in return for car loan collateral, for God's sake)

    Given this situation, why on earth would anyone want to lend money to them? Sovereign wealth funds – already burnt having been suckered into mug investments in US banks which have subsequently turned belly to the sky – are not going to be tempted into that game again.

    Reply: The big British banks are viable. Yes, there are many banks around the wrold that need new capital, where it would be possible to raise the money by share issues.

  8. Lola
    Posted October 4, 2008 at 7:06 pm | Permalink

    Mr. Redwood, agreed.

    Bank shares will fall further from now. Foreign investors will wait until this happens. I will also wait. They need teching a very big lesson.

  9. Blank Xavier
    Posted October 4, 2008 at 11:14 pm | Permalink

    The problem now in the US with bank attempts to raise capital is the fear of Government induced by the recent actions of(words left out) the FDIC.

    (The FDIC) has activty been using the powers of the State to force the sale of banks considered weak to other, larger banks – the problem being that in the process, the debt holders of the sold bank are being wiped out. If the bank had actually failed and liquidated, those debt holders would have been made partially whole or even whole (depending on which type of debt they hold).

    Given the uncertainty about which banks are truly weak and which not, providing capital is risky enough – but if you buy the right kind of debt you know, barring (the FDIC), that you're likely to get back most or even all of what you provide.

    (The FDIC) however has turned this on its head; for now if you invest in a weak bank, that bank may in fact be sold, and you will get *nothing*.

    There's plenty of money out there. The problem is confidence. Investors are not confident in banks. Anything which aids confidence will act to help solve the current problems; anything which acts to reduce confidence will make them worse.

    The FDICs actions are making this banking crisis significantly worse by scaring investors away from banks. It's all very well rescuing one or two banks; but if by doing so you make it all the more likely a whole bunch more will fail when they would otherwise have not, what have you achieved?

    If only the State would not involve itself in the market. None of this would have happened in the first place and now we would not be watching the State make a bad situation worse.

    • David Herr
      Posted October 5, 2008 at 7:44 pm | Permalink

      Blank Xavier,

      I disagree with your take on the FDIC. That agency is the only appropirate organization to clean things up; I would much prefer that the recent bailout had given $700 billion to the FDIC, than to Hank Paulson (words left out)

      The banks the FDIC takes over or arranges a shotgun marriage for are hopeless. Washington Mutual was headed to the dustbin, and its bondholders would have received nothing, because WAMU's loans far exceeded the value of the underlying property, and when people sense that they are hopelessly under water on their mortgage, they default, since it would be economically suicidal for them to keep paying 60% of their income to try to keep the house.

      I am a real estate agent in the San Francisco Bay Area, and I saw WAMU and Wachovia's loans. They were atrocious, and it was obvious at the time that absent 15% annual house price appreciation, those loans would default.

      Capital that would go to those institutions destined to fail would be better used on institutions likely to succeed. The way for investors to get in on that action, is for the US to fund its bank bailout with Treasury debt, which will be one of the only instruments out there that will be reliable in the coming deflation, which is now underway and cannot be stopped by any desperation move by the government.

  10. Bazman
    Posted October 4, 2008 at 11:40 pm | Permalink

    It's all very interesting. The truth is that many of the people involved in this farce are just riding the crest of any financial strife. If you are rich its just cards. I suspect politicians build their careers on it. Look at Mandy returning.

  11. mikestallard
    Posted October 5, 2008 at 6:42 pm | Permalink

    1. How much is the EU to blame here? What, exactly, is the effect of Basel II? It has been mentioned a lot in the blogs recently on this site. Christopher Booker blames it for the entire crunch and he is usually right.
    2. Is Iceland pointing the way for us, where the Icelandic government is proven completely powerless before the collapse of their banks. Why? Small country, no money.
    Erm…..

    BAsel II is recent. Basel I is the system of banking regulaiton that had most effect on the build up of excessive debt. It was a permissive regulatory framework which meant banks thought they were behaving sensibly when gearing.

  12. RobertD
    Posted October 5, 2008 at 7:11 pm | Permalink

    The fundamental problem is that for the last 5 to 10 years productivity in western economies has fallen relative to the asian economies, and that profligate use of energy has put them in thrall to the countries with major oil and gas reserves. This fundamental reduction in relative income has been hidden from people in the west by allowing them to borrow to maintain living standards, and by allowing governements to borrow to build a large unproductive body of public servants and welfare dependants.

    The chickens are coming home to roost. The honest answer is that if the people of the west want to restore their living standards they are going to have to get people out of welfare and non-productive public sector jobs, to upgrade education and training, and to start working a whole lot harder and smarter.

    Nobody in any western government has yet been ready to level with people. Osborne "the cupboard is bare" falls a long way short, and Brown and Bush are in total denial.

    The wealth of the world has not been destroyed, but far more of it is now controlled by the Chinese, Russians, Saudis et al. They will recaptialise western banks eventually because they need the western consumer to keep on consuming, but they will do it in ways which make a permanent change in the distribution of power in the world.

    To minimise the damage western governments need to stop wasting time with the blame games, level with people, and start to put together a regulatory environment that encourages current shareholders to put the banks back on their feet. Thye need to get government out of the way of companies trying to remain competitive in world markets. That means slashing non-jobs and long term benefits to balance the governments books, encouraging retraining, and gettting the cost of compliance with government regulation by companies and individuals back to affordable levels.

  13. RobertD
    Posted October 5, 2008 at 7:33 pm | Permalink

    A further comment. As part of the move to get western economies back to level competiton with Asia a full restructuring of the finanical services sector will be required.

    Much like the recessions of 1974, 1981 and 1991 were driven by the need to cut obsolete capacity from manufacturing the recession of 2008-9 will be driven by the need to cut out surplus capacity from the finance sector.

    As an indicator of how much the financial sector has been sucking out of the real economy is the startling estimate that the fees and margins for bankers in producing and trading CDO's and CDS's (the toxic stuff that is imploding) over the last three years is in excess of $1.5 trillion. That is more than the likely losses on the US mortgage market. ($12 trillion total mortgages outstanding at 10% bad and only 50% recovery = $1.2 trillion). Bankers fees are as much a cause of the loss as the imparirment of the underlying assets.

    However if we redeploy the mathematicians and physicists from investment banks to teaching and engineering maybe we can restore competitiveness in the things that make life possible.

  14. Promise of Avalon
    Posted October 6, 2008 at 1:22 pm | Permalink

    And there it is. To pay for our debt fuelled living standards we must sell off assets. But when we have sold off all the family silver, and even the clothes on our backs we will find ourselves in the poverty we pity other nations for.

    The cause of this problem was unsound money so the only solution is sound money. If people want something they must pay for it up front, and that includes governments.

  • About John Redwood


    John Redwood won a free place at Kent College, Canterbury, and graduated from Magdalen College Oxford. He is a Distinguished fellow of All Souls, Oxford. A businessman by background, he has set up an investment management business, was both executive and non executive chairman of a quoted industrial PLC, and chaired a manufacturing company with factories in Birmingham, Chicago, India and China. He is the MP for Wokingham, first elected in 1987.

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