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“Debt and Deleveraging” -- McKinsey Research Report


JEast
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Sorry board members, but I am posting about debt deflation again because I am of the belief it is important.

 

In the link below, an interesting research paper from McKinsey on “Debt and De-leveraging”. If true, where is the growth going to come from? As some of us discussed recently, the grocery store industry is in slow death spiral. From memory, the CEO of Supervalu recently stated that pricing/discounting was the most stiff he has seen in nearly 30 years. In my own specific case, in over 20 years I have never seen the private chain of Publix promote their self advertised coupons. Anyway, enjoy.

 

http://www.mckinsey.com/mgi/reports/freepass_pdfs/debt_and_deleveraging/debt_and_deleveraging_full_report.pdf

 

Originally sent to McKinsey by the nice website of The Pragmatic Capitalist:

http://pragcap.com/must-read-debt-and-deleveraging

 

 

Cheers

JEast

 

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De-leveraging is not the same as deflation. A Central Bank that repays 20% of the national debt with newly printed notes will immediately de-lever, generate 20% inflation, & devalue its currency – all else being equal.

 

High residential mortgage leverage does not necessarily mean high risk. US mortgages are non-recourse, the borrower has an incentive to borrow 100% (or beyond), & gets a risk free tax break. A valuation collapse is the banks problem – not the borrowers.

 

De-leveraging doesn’t mean repay in cash & therefore have less $ to spend; you can repay in equity. A corporation can swap debt for equity. A government can swap debt for a % of the national assets (electric grid, water, sanitation, etc.)

 

This time it is different. 1930’s central bank responses assumed that the future would resemble the empirical past; the result was a nightmare until it was finally realized that the new world really was different. The unparallel 2009 central bank responses are a pretty clear indication that this IS again different; so why would you expect that the new world to exactly follow the rules of the old ?   

 

There will be de-leveraging, but it will be because of change in institutional & debt structure.

All we can do is make our best guesses.

 

EG: In any given year an investment gain is a zero sum game as someone had to lose for you to gain. Over successive years it is either positive/negative according to the total growth in global trade and/or innovation. An I-Bank could be hugely profitable today, pay all its gains out in bonus, & be bankrupt tomorrow - when it is on the losing end of a trade.

 

Collectively, the I-Banks are trading volatility relative to the stability of the global financial system, & the more volatility the better. Break the financial system (oops!), & the world goes into a global depression

 

If you have a bank parent you can use their stability to cover your loss. If you don’t have the parent you retain bonus to give you an equity cushion. Separate the functions (per Obama) & the I-bank is forced to either do less business, retain bonus, or both. De-leveraging is the consequence.

 

SD

 

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US mortgages are non-recourse     

 

Thanks for the rebuttal, but mortgages are surely recourse debt meaning the the creditor has recourse to repossess your house or your car. Non-recourse debt is similar to an option where the seller has no recourse to take it back, unless they buy it back.

 

so why would you expect that the new world to exactly follow the rules of the old ?

 

I don't and wouldn't expect it to be the same. However, I am looking at the world thru my own prism and what I see and experience is no one has any pricing power and the banks are not lending. True this may all change, but it is hard for me to see it changing this year or next with the middle class saving more and unemployment to stay at elevated levels.

 

Like your counter point though as you are more optimistic than I.

 

 

Cheers

JEast

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JEast,

 

Thanks for the rebuttal, but mortgages are surely recourse debt meaning the the creditor has recourse to repossess your house or your car. Non-recourse debt is similar to an option where the seller has no recourse to take it back, unless they buy it back.

 

You need to understand the definition of non-recourse I think.

 

http://en.wikipedia.org/wiki/Nonrecourse_debt

 

Non-recourse does not mean that there is no collateral backing, it means that there is ONLY collateral backing it (not your person, or corporate umbrella, etc).

 

 

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Non-recourse means that if the lender doesn't get enough on the sale of your house to repay the mortgage, the lender cannot come back on you for the shortfall.

 

On day-1 I buy a house at 500K & put in 200K as down-payment. I look like a great credit with a 40% (200/500) down-payment

 

4 years later the house is worth 800K. I see the light, & take out another mortgage for 450K (my 200K down-payment +250K profit) to drive the total mortgage to 750K

 

2 years later house value collapse, the house is worth 400K, & I choose to stop paying on the mortgage. The bank sells the property for 400K, but is still out 350K on the mortgage. Non-recourse means the banker has no legal claim on me for the remaining 350K, & is forced to take a write-off.

 

The banker will apply moral suasion (credit blemishment, community standing, etc.) to try to get me to keep paying at least 'something' - to keep the loan 'current' & avoid the write-off. If I really like the house I might counter with an unsolicited all cash offer of 375K - but I'm not obliged to.

 

SD    

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Just want to point out that whether one's home mortgage is nonrecourse or recourse depends on what state one is in.  In some states you can just walk away and not worry about being personally liable for a deficiency.  However, in other states you can be personally liable for a deficiency.  Additionally, whether the mortgage is nonrecourse can also depend on whether it is a purchase mortgage or a mortgage resulting from refinancing.  

 

It's all very state specific.  

 

---

 

JEast, I believe you are referring to Fisher's theory on debt-deflation being the cause of great depressions.  I think that before the government took the action it did, we were indeed going down the great depression route.  Fisher's detailing of his proposed debt-deflationary spiral is remarkably similar to what happened in the last two years.  We were at the edge of the precipice, and we luckily got pulled away before we fell into the void.  We should thank Ben Bernanke and the Treasury for saving us despite all the criticisms that can  justifiably be thrown at them (such as, why did they let us get here in the first place?).

 

I believe that the government took the necessary steps to prevent us from being in a severe depression resulting from a deflationary spiral.  However, escaping a depression does not mean that things will be great going forward.  Instead of stag-deflation, we might have stagnation plus mild inflation.  Or we could have stagflation, as many on this board have suggested.  Hopefully, we don't get to a point where we have economic stagnation and hyperinflation.  

 

We will definitely have high unemployment and underemployment relative to previous years for a while.  Our currency is destined to be devalued, which will reduce our standard of living (but not by as much as some people seem to think).  Much of the paper wealth that people believed they had has evaporated, which makes everyone feel less secure, which results in further deleveraging (of personal balance sheets).  At this time, very few people and businesses can take advantage of the record low interest rates because they need to de-lever.  When interest rates go up -- and they will go up -- it's going to be very tough for people to have the same standard of living that they were used to.  Now, that standard of living was perhaps unsustainable, but it's gonna feel horrible for those who thought that that was the norm (having things taken away from us feels disproportionately worse than the good feeling we get from getting an equal amount of stuff).  The financing issues we will have could also translate into less entrepreneurial vigor, especially when tax rates go up.

 

My hope is that some systemic reforms (i.e., health care reform) will mitigate the way that the middle class has been hit over the last decade or so and will continue to be hit due to this need to de-lever across the board.  Because it ain't looking that great for us in the short to medium term.  :-\

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At times during the day we/I sometimes get busy and type too fast meaning that there are some sharp cats on the board to point it out.

 

As 'benhacker' points out, yes, mortgage is by definition non-recourse meaning that the collateral is the backing. However, that does not mean that the bank or mortgage lender does not have some recourse. From where I sit in my house, if the bank forecloses and kicks me out - well, I have just been recoursed out of my house and are now on the street.

 

List of Non-Recourse Mortgage States and Anti-Deficiency Statutes

http://www.helocbasics.com/list-of-non-recourse-mortgage-states-and-anti-deficiency-statutes/

 

txlaw,

 

You are spot on and I am with you on that the global governments have done what they could to prevent another potential depression. The following is the direct steps circa 1935 from Fisher on debt-deflation.

 

Assuming a state of over-indebtedness exists (meaning corporate and private), this will lead to liquidation, through the alarm either of debtors or creditors or both. Then we may deduce the following chain of consequences 1) Debt liquidation leads to distress selling, 2) Contraction of deposit currency, as bank loans are paid off which leads to the slowing of the velocity of money which precipitates more selling, 3) A fall in the level of prices, causing, 4) A still greater fall in net worth of businesses, precipitating bankruptcies, 5) A like fall in profits, curtails employment and production, 6) A reduction in output, trade, and employment, lead to, 7) Pessimism and loss of confidence, which in turn leads to, #8) Hoarding and more slowing down the velocity of circulation, and the above eight cause, 9) Complicated disturbances in the rates of interest, or the fall in money rates and the rise in the real, or commodity, rates of interest.

 

Does any of the above sound familiar?

 

Irrespective of non-recourse, recourse, inflation, or deflation - good comments by all.

 

 

Cheers

JEast

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The U.S dollar has devalued by 98% over the last century, yet the standard of living is up quite a bit. 

 

Devalued relative to what numeraire?  The pound sterling?  Gold? 

 

Or do you mean relative to "real goods" like apples or eggs?

 

I was actually paraphrasing Charlie Munger, you obviously get a heck of a lot more computing power for your dollar today so its all relative!

 

 

according to this site which uses some PPP calculations

http://www.measuringworth.com/ppowerus/?redirurl=calculators/ppowerus/

1$ in 1900 was worth 26$ in 2008. 

 

http://usa.usembassy.de/etexts/his/e_prices1.htm

according to this the average Teacher made 328$ a year, average annual income was 438$ so roughly 100:1

 

 

 

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