Sunday, September 28, 2008

Bailout and Deleveraging

Unless you live in a cave, you have heard a ton about the $700 billion bailout of so-called "toxic" mortgages that Wall Street firms hold. Poor risk controls, lack of regulation and easy credit are all mentioned as reasons for this. They all have their elements in this, but essentially the US has been living on credit. The government has been borrowing to the tune of $500 billion this year alone. Wall Street, insurance companies and banks have used derivatives to lever themselves up to deliver on ever greater profit expectations. Families used inflated equity and easy credit to renovate and expand their homes and buy all sorts of goods. Americans were told to spend post-9/11, not sacrifice to pursue a war on terror. Don't worry, we'll just issue more debt and everything will work out. Our trading partners bought US debt supplying the capital necessary to keep up with ever increasing budget and trade deficits.

The music has stopped and everyone is looking to grab their chair. Unlike when a stock moves, when real estate drops, no one is betting on the other side. Credit movement has halted, causing intense fear in the financial community.

We are now in a very difficult period of deleveraging. It will be painful. Credit access will not be easy. People will not be able to tack on to growing home equity lines to buy whatever they want. Mortgages will have equity requirements. Companies will need strong fundamentals to get access to debt capital. It will not be as easy to hit profitability targets by levering up. Foreign governments are starting to shift away from pumping money in the US (Has anyone noticed that financial plans are completed before the opening of Asian markets?). Confidence has diminished.

The question is will the $700 billion in cost to buy mortgages + the $5 trillion in Fannie/Freddie debt + $120 billion debt in AIG & Bear Sterns + $9 trillion in existing US debt serve as a tipping point?

Or will this begin a period of stabilization?

It is not sustainable to run $500 billion fiscal deficits + $700 billion trade deficits year after year without having an impact. Forget the fact that the fiscal deficit is much higher if you include Medicare and Social Security obligations.

The process of deleveraging is akin to a drug addict quitting cold turkey. It is visceral. It is physical. In the end, it is the best thing that could ever happen.

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