Trading Online Markets LLC banner

Deleverage: What the Deleveraging Process Means for Investors


by Hans Wagner

After using substantial leverage to pay for a broad expansion of consumer spending, homeowners and banks continue to the deleveraging process. As the bank and household deleveraging continues, investors need to consider what affect this process will have on the market and the industry sectors.

Financial Leverage

By now we all know that 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 refinancing, they continued to spend more than they made, counting on the appreciation in their houses to make up the difference.

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, with many becoming less that the principal amount of their mortgages.

Many banks took advantage of these peoples desire to increase their life styles. However, when the value of the assets used to create this new found money stops rising and turns down, it starts the deleveraging process.


The vast build up of leverage 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.

As a result of the deleverage of balance sheets, foreclosures are up and the investors holding these collateralized 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.

Deleveraging Process

All the build up in the leverage is reversing course. That is the deleveraging process and it 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. As balance sheets become deleveraged, losses mount for the banks and for households.

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 deleverage 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 are curtailing the packaging 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 has driven rates to record low levels 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 deleveraging process is more likely to take longer than most investors believe.

What is an Investor to do

Deleveraging will affect all the consumer discretionary sector as families spend less and save more. Within the sector some companies will do better, especially those that offer lower priced goods such as Wal-Mart (WMT). In addition, companies that offer high value for the price should also benefit, such as Coach (COH).

As a consequence of the excess leverage, banks will be required to maintain higher capital levels. By reducing their leverage, it will hinder their ability to generate more profit. It also reduces the risk of incurring large losses. As a result most banks will experience lower earnings ratios. A few banks will be adroit enough to overcome this restriction such as Goldman Sachs (GS) and Morgan Stanley (MS). For many of the other banks, investors will do well to wait for the deleveraging process to come closer to completing itself.

Other industries will be less directly affected by deleveraging. However, they must deal with the affects of constrained consumer spending. Those with substantial amounts of cash and the ability to generate excess free cash flow will be better positioned to recover. Technology, materials and industrials are three sectors that should weather the deleveraging process the best.

Our Stock and Sector Portfolios for our Premium Members recognize the affect of deleveraging that continue to help us bear the market every year. If you are interested, we offer a no risk, free four-week trial. You have nothing to lose and money to make.