Has Deleveraging Even Begun? (Not For the Fainthearted)

It no doubt seems absurd to question the idea that deleveraging in underway. We’ve had three heroic central bank interventions, starting in August 2007, to reverse seize-ups in the money markets. The asset backed commercial paper market has been almost in run-off mode. Leveraged buyout loans have been scarce to non-existent. Banks have cut home equity credit lines and credit card borrowing limits. Commercial and industrial loans have fallen. The private mortgage securitization market is a shadow of its former self.

Yet the macro level data, at least as far as the US is concerned, tells a dramatically different, indeed troubling story (click to enlarge):

The chart is admittedly a bit hard to read, but it is prepared from Fed’s Funds Flows through the latest reporting date, which is March 31, 2008. The chart comes courtesy Frank Veneroso’s June 18 report, “Why a Second Wave is Inevitable.” (no online version, but if you ask nicely, I can e-mail you a pdf). The line is Total Credit Market Debt/GDP. As you can clearly see, the steepness of the vertical ascent of the has not eased in the last year or two. If anything, it may have gotten worse.

We will return to discuss the implications of how big the debt level is, but the graph itself should serve to focus the mind. The March 31 level was 350% of GDP. The previous peak occurred in 1933, during the Great Depression, at just under 270% of GDP. Note that the peak was reached due to the start of the rapid fall in GDP taking hold faster than debts were written off, a dynamic not in operation now. So the comparable level to our situation is in fact lower than the 270% peak.

An additional bit of cheery news comes from reader Bjomar: Japan’s total debt to GDP in 1990 was roughly 250% (it took some triangulating among this, this, and this source, his interpolation of corporate debt at 100-140% of GDP, household at 65%, and government at 60%). And unlike us, Japan had a very high saving rate, so its net debt would have been less alarming.

On my recent quick turnaround trip to the West Coast, I had the opportunity to read all sorts of interesting research various readers had sent me that I simply could not get to previously. All of it was useful, but the Veneroso discussion, and particularly his chart, seemed the most unrecognized, underappreciated element of the credit crunch.

Now the story in the first paragraph is not inaccurate. Private sector credit growth has slowed, in fact pretty dramatically in the first quarter. But “slowing growth” and “deleveraging” are two different conditions. Alejandro Neut at Banco Bilbao provides a good overview of the Fed’s funds flow data for the first quarter of 2008:

Credit continued to decelerate in the first quarter of 2008. Total debt of the domestic nonfinancial sectors grew at a seasonally adjusted annual rate of 6.5% (1 pp lower than in the previous quarter and the lowest rate since 2001). Even when the reduction in debt growth was not as pronounced as the one in 2007Q4, when debt eased from 9.1% to 7.5%, the decelerating trend shows no signs of abating. This bleak assertion is based in the yet strong deceleration of households’ debt, segment which remains the main driver of the current downtrend (households’ debt grew a meager 3.5% compared with the previously seasonally annualized growth of 6.1% in the previous quarter). Debt in almost all sectors grew at a lower pace than anytime during 2007. The only exception was the federal government’s debt, which grew at an impressive annualized rate of 9.5%.

Business debt continued to expand at a healthy pace Business’s debt grew 10.8% yoy. With interest payments at historical lows (relative to profits) debt growth in corporate America was robust. This explains why businesses have been shifting the means to finance itself, from bond issuance to bank loans. But risks are growing: the financial gap remains at a high level, indicating the need for external financing in order to keep current operations.

Note that even though the tone of the report is downbeat, credit is still growing, but at a slowing pace. While certain individuals and institutions might be reducing their borrowings, on an overall level, private debt is still increasing.

And, of course, the other reason that we haven’t seen deleveraging is that our friendly foreign funding sources have kept the credit spigots open and government debt has grown at a an accelerating pace, thanks in part to Iraq, but to a bigger degree due to various interventions. Tim Duy earlier focused on the role of foreign assistance in keeping a financial crisis from (yet) hitting the real economy to the same degree:

Perhaps most importantly, however, is the massive liquidity injections from the rest of the world, or what Brad Setser calls “the quiet bailout.” In the first half of this, global central banks accumulated $283.5 billion of Treasuries and Agencies, something around $1,000 per capita. This is real money – I outlined the likely implications in January. Foreign CBs are happily financing the first US stimulus package; will they be happy to finance a second? Do they have a choice? Their accumulation of Agency debt is also keeping the US mortgage market afloat. Do not underestimate the impact of these foreign capital inflows. If the rest of the world treated the US like we treated emerging Asia in 1997-1998, the US economy would experience a slowdown commensurate with the magnitude of the financial market crisis.

Duy suggested that it might be possible for the US to rebalance and increase exports enough to reduce the need for more foreign funding. However, China has announced its plans to slow the pace of yuan appreciation, a negative for US export competitiveness. But even worse, the housing recession is far from over. Plenty of measures (prices relative to income and rents, duration of the late 1980s-early 1990s housing recession, comparisons to serious housing recessions in other developed economies) suggests that we are at best only halfway through in terms of duration and average house price declines. More housing losses means more trouble for the financial system, which means more interventions that depend on foreign support.

Frank Veneroso argues we have to get off the debt E-ticket ride, now. Referring to the chart above, he writes:

This chart shows something that has gone vertical, something that is on a moon shot. If it were the GDP of Argentina in pesos I would agree that the moon shot could go on and on. But it is not the Argentine economy in domestic money terms. It is a macroeconomic ratio of total debt to GDP. Macroeconomic ratios cannot go on unending moon shots. They are basically mean reverting series. In many cases, such as an economy’s investment ratio or its profit ratio, these values tend to be more or less the same on average over long periods of time. There are some such ratios that exhibit an upward bias or a downward bias; the ratio of service output to GDP and the ratio of industrial production to GDP are examples. But even though there may be a secular “tilt” to the mean, the shift in that mean is always gradual. Over short periods of time like a decade or so mean reversion tends to bring you close to where you came from.

For the above ratio of credit market debt to GDP there is no gradual tilt to this ratio over the last two decades…How can that be, given that it is a macroeconomic ratio? …If we look back in history, we see one prior vertical takeoff in this ratio – the period from 1930 to 1933. In that episode economic agents did not want to increase their aggregate debt to GDP….. A very bad recession from mid 1929 to mid 1930 started to take the denominator – nominal income – down rapidly….The resulting financial and economic carnage was so great that all economic agents wanted mean reversion. But debt is a stubborn thing to dislodge. It took a generation encompassing a wartime inflation to revert to the mean and eventually overshoot it to the downside.

Over the last year the U.S. has undergone the worst financial crisis in the three generations since that horrific episode of the 1930s. Even though we have had a severe financial crisis the ratio of total credit market debt to GDP keeps on rising. This could have occurred because government was socializing debt, but that has not happened yet.

Private debt to GDP rose as rapidly last year as it did before the onset of the financial crisis. It even rose in the first quarter of this year as the financial crisis intensified. But unlike the 1930s, when this ratio rose even though economic agents did not want it to rise because nominal income was falling, in this episode the private debt to GDP ratio has kept rising because fee hungry lenders continue to engage in expanding credit to profligate over-indebted borrowers. If one looks at this chart with a historic perspective it is clear that this ratio cannot keep on rising. But if you ask people in the market place whether we must go though a period in which credit falls sharply relative to income they will say that need not be. It is widely acknowledged that it has taken several units of debt to produce a unit of GDP in recent years. Most people strangely assume that will be the case in the next recovery. The same attitudes hold for our policy makers. They do not talk about an eventual reduction of credit relative to income. They talk about providing new channels of credit to offset constricting ones; for example, expanding the lending of the GSEs to offset the falloff in securitizations. Can the moon shot in the debt to GDP ratio keep going on, like so many assume? Or has something happened that makes at least a reversal, if not mean reversion, imperative now?

The answer is, reversal is imperative now. Why? It is widely understood that starting in the mid 1990s we entered into a historically novel path of serial bubblizations. Each asset bubble went hand-in-hand with an expansion of credit to the private sector….we can see why the reversal of the moon shot in the debt to GDP ratio is imperative. First, house prices now seem to be in an unstoppable downward spiral…..

It has been calculated from the flow of funds accounts that the ratio of aggregate mortgage debt to residential real estate value reached a peak of 50% when the home price and home finance bubbles reached their peak at the end of 2006. But the flow of funds accounts do not capture second and third mortgages. They do not capture the home equity loans that are in portfolios other than those of the commercial banks. There is a large “other” household debt item in the flow of funds accounts which includes various such claims against residential real estate collateral. I encountered one ratio calculated by the housing finance industry that suggested that, at the home price peak at the end of 2006, the aggregate loan to value ratio was 57%…..

If home prices fall nationwide by 35%, it follows that the average loan to value ratio will exceed 90%. About 30% of all residential real estate in value terms is without a mortgage. For all real estate with a mortgage, the distribution of mortgage indebtedness is very skewed. With the average loan to value ratio rising to almost 90%, a huge share of almost all mortgage debt will be deeply underwater. All studies show that when mortgages are well underwater there are defaults and foreclosures. This applies to the majority of mortgage debt classified as prime as well as the margin of mortgage debt classified as subprime. If home prices mean revert, the odds are high that in the shakeout that will follow the total credit market debt to GDP ratio will finally fall from its moon shot trajectory…..

There is another reason why. There are no more serial bubbles to be blown that are beneficial to income and output, even in the short run. The housing bubble was able to bailout the bursting of the tech bubble because it lifted household wealth and in turn employment, income, and output. Not so, the next new bubble now underway – the commodity bubble…..the effects on the economy from the commodity bubble are very different than those of the housing bubble. The public is not on board this bubble. They are not day trading tech stocks and feeling richer day by day. They are not buying second homes and investment homes, pyramiding their real estate wealth. The public’s involvement in the commodity bubble market is vestigial at most. Rather, the public is exposed to commodities primarily as goods which they must buy to use. This bubble – and in particular the oil bubble – is squeezing the bejesus out of everyman. Rather than being a new bubble that makes households feel richer, it is a bubble that is taxing them and thereby making them poorer.

The serial bubble solution to the problem of prior bubbles and the financial fragilities they spawn has come to a dead end with a third toxic oil bubble the financial authorities did not expect and do not want – the commodity bubble. Now the serial bubblization of the policy makers portends recession, not recovery…..The end of the moon shot in the debt to GDP would appear to be at hand.

Veneroso thinks the only way we might get a break is if the commodities bubble gets pricked and oil goes to $60. Since that is a wet dream for commodities bears, it looks likely that a grim scenario is not far from unfolding.

In case you view Veneroso as extreme, other analysts are leaning to a deflationary scenario, which presupposes deleveraging. Forbes cites the views of Merrill Lynch’s North American economist, David Rosenberg:

Rosenberg expects commodity markets, which have recently begun retreating from record highs, to continue their fall, easing inflationary pressures amid the U.S. housing market’s ongoing two-year decline.

“We do not see the prospective backdrop as inflationary,” he wrote. “All one has to do is pick up the newspaper to see that autos, housing, or practically anything you want to buy in a department store is experiencing ‘fire sale’ conditions.”

The next bubble that U.S. investors are likely to stoke will be in bonds, as commodities and stocks sell off during a painful economic period, comparable to the U.S. consumer recession of 1973-75, Rosenberg argues.

“Back then, collapsing earnings and price-earnings multiples triggered a 40 percent peak-to-trough decline in the S&P 500,” he recalled….

As consumers continue to cut back and equities remain under pressure, “if there is another bubble around the corner, it is likely to be in bonds, and this will be particularly apparent once the commodity explosion reverses course,” Rosenberg wrote.

U.S. households’ bond exposure is not much more than 5 percent of their total assets, after the past two decades scrambles into stocks and then real estate.

But a shift back toward the late 1980s and early 1990s level of between 7 percent and 8 percent of total assets “would imply the potential for $1.75 trillion of incremental demand,” Rosenberg expects, most of which would go to Treasuries and other higher-quality bonds as riskier corporate debt feels the pinch of a tough economy….

“The forces of deflation will outlast the cyclical inflation story,” Rosenberg wrote, adding that Japan’s experience in the 1990s of a lost decade of economic growth and deflationary pressures after equities and real estate bubbles there burst could mirror the unfolding situation in the United States more closely than many analysts reckon.

“Using the Japan post-bubble experience of the 1990s as a benchmark for comparison purposes may not be such a stretch as many people think it is because this is increasingly looking like a very similar secular bear market in equities,” he wrote.

Another lesson the United States now can draw from Japan’s earlier experience is that tax rebates may not free the economy up from the long lasting constraints of a credit crunch, he wrote.

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  1. ryb

    Interesting stuff. However, there may be a few more factors at work here:

    1.) The flow of fund data uses the carrying costs of the debt, i.e. the price banks companies etc. carry the debt on their balance sheets. I think that the carrying values of these debts is much higher than their “market” prices (without getting into a discussion of what market prices are, level III etc.). In other words, the value of these loans – mortgages, commercial credit whatever – will be written down further to reflect real values. Thus, the numerator is smaller and % of GDP is not as high as in that graph (although still high).

    2.) As the economy in general and real estate in particular continue to deteriorate, the process described above should accelerate.

    3.) Many corporates that have access to liquidity, like lines of credit, are drawing on them, not because they need the funds per se, but are willing to eat a small spread to make sure the funds will be available in the future. (As far as I understand, total debt here is gross, not net of cash or ST investments.)

    4.) The same is true for households, although the numbers are smaller.

    5.) The same is true for those banks that have access to liquidity, either from Central Banks or interbank/commercial paper. Much of the liquidity they receive they hoard, fearing demands from their best clients, or expenses associated with bring off-balance sheet back on balance.

    In general, I think destruction of credit has already led to deleveraging. It’s just that the data does not reflect it, due to accounting standards and perverse economic incentives. But I agree with the article (& Rosenberg): real deleveraging is coming soon, and it won’t be pretty.

  2. dano

    I think we are seeing the deleveraging in commodities already. Certainly their run-up was a moon-shot, and they fall is far less graceful than a shuttle landing — unless you count Challeneger.

    I see a lot of the loss in ALL markets as the various unwindings of hedge funds et al looking to free up cash to meet withdrawals. Let;s face it, Main Street does not have that kind of pull in the markets anymore.

    My own take is that housing is dead for 5 years or so (leat till 2012), China;s growth slows, and that in the next 3-8 years we are forced to increase our interest rates significantly by our trading partners.

    as to inflation or deflation, we get both. deflation in asset classes like houses and commercial, cars & boats, et al, but inflation does not significantly abate in foodstuffs.

    Gold is a toss-up in my book at present. Oil will rise again, and sooner than some thnk, as will nat gas.

  3. Anonymous

    Dano’s comment leads me to another question:

    What is the role/share of leveraged financial montages in this debt run-up? Hedge-funds, pseudo-private equity funds, LBOs, etc?

  4. peterthepainter

    March 11 2008…

    from the financial ninja…

    “Repeat After Me; All Bubbles Are The Same! Always. Forever.”

    “Risky assets will continue to lose value. Not necessarily because they all deserve to, but because they must. The entire financial system is de-leveraging. Yes, that means that even commodities will face the wrath of the margin clerks… Eventually. They’ve all gone parabolic. That NEVER ends well. EVER… and it ALWAYS signals the beginning of the end.”

    from me – Yo post today is well right on bro. an ryb above is good too.

    I been lookin inta this here flation stuff an this floats my boat man! amen.

  5. a

    Accurate scholarship someday may explain what has driven American culture mad.

    Let it be noted that the change in the slope of the curve began under Reagan.

    For over a quarter century I have lived in exile. When when I have my country back?

  6. wintermute

    Alarming stuff. Good research.

    One thing screams out. Fiat currency meltdown.
    1972 – closing of gold window. All constraint on government printing gone. A US dollar not worth the paper it is printed on. And the whole irresponsible fractional lending/ govt debt financing / negative real interest rate situation – has gone on far too long simply because the US was fortunate to inherit the world’s reserve currency status from sterling.
    What a waste of a once-in-a-century opportunity…

  7. Richard Kline

    “Alan built de Tower o’ Babylon,
    Babylon, Babylon.
    Alan built de Tower o’ Babylon,
    And the bills come a-tumblin’ doowwwwwnnn!”

    Actually, a, you’ve got the time frame better. We’ve been bloating out debt since 80 at least. Arguably, we never really paid out the Vietnam war in real terms, but started to ‘fund’ our way forward from the mid-60s. When will we have our country back?: When we take it back. And that takes organization and a plan. Waiting for compromised politicos to do it gets more of the same shilling, in both senses of the word.

    I don’t think the deleveraging has started in earnest. Citigroup, to take an example, is insolvent if its assets and its capital are matched in real terms—but they are still issuing ‘credit’,’ “saying yes every day,” thanks to the largess of the Fed, whose auctions give them ‘capital’ to back ‘new lending’ so as to ‘grow their way back to health.’ That doesn’t look like deleveraging or deflation, yet. One other point to bear in mind, though, is that all our friendly foreign sovereign creditors are running neg real rates, too. Perhaps the US _can’t_ deleverage as long as the rest of the world is inflating like mad around us. What gasket is going to blow in all this, and where, and when I really don’t know, but the imbalances in the global financial economy are eyepoppingly skewed on a world historical level outside of major war transition points. —So let us all thank our stars that we don’t have the ‘major war’ along with these major skews.

  8. obstruksion


    Challenger wasn’t landing, it was taking off. It would be more like Columbia.

  9. Solar Lad

    Let it be noted that the change in the slope of the curve began under Reagan.

    For over a quarter century I have lived in exile. When when I have my country back?

    If you’re implying that Reagan caused Americans to begin to leverage up, then you couldn’t be more wrong. Try a web-search for “Kondratieff”, if you’d like to know why it occurred, and what’s going to happen next.

    Further, for a third of the time that you’ve been away, Clinton was POTUS. If to you there’s not enough difference between Reagan and Clinton to come back, then the answer to your question is NEVER. You will never get “your” country back. You’re going to die in exile.

  10. Anonymous

    OT (sorry):

    U.S. Treasury Secretary Henry Paulson will join officials from the Federal Deposit Insurance Corp, other financial regulators and some major banks to discuss the guidelines at 2:30 p.m. EDT (1830 GMT) in Washington, the Treasury said.

    Re: Treasury Secretary Henry Paulson, aiming to create a new source of U.S. mortgage financing, wants banks to start issuing covered bonds without waiting for legislation from Congress.

    Regulators can provide the guidance that lenders are asking to be set in law, said a Treasury official working on the issue who declined to be identified. Banks want a standardized definition of a covered bond, which requires the lender to make good on payments if homeowners default, and guidelines on bondholder protections.

    >> The FDIC has issued the attached final interim policy statement on the treatment of "covered bonds" in the event that the issuing insured depository institution is placed into FDIC receivership or conservatorship.

    The collateral for the covered bonds is secured by perfected security interests under applicable state and federal law on performing mortgage loans on one- to four-family residential properties, underwritten at the fully indexed rate and relying on documented income in accordance with existing supervisory guidance governing the underwriting of residential mortgages.
    Up to ten percent of the collateral may consist of AAA-rated mortgage- backed securities backed solely by mortgage loans that are made in compliance with the policy statement.


  11. Anonymous

    On covered bonds and subprime mortgages
    (FT Alphaville) Hank Paulson has been singing their praises for some time now: covered bonds. But it was only in a speech yesterday when he outlined their potential for the US mortgage securitisation market that they’ve got much shrift. The WSJ covers some of the Paulson speech:

    Speaking at a mortgage lending forum in Virginia, Mr. Paulson said he is working with the Federal Deposit Insurance Corp., the Federal Reserve and other federal offices “to explore the potential of covered bonds,” which he described as a “promising vehicle” to speed up the availability of mortgage financing.

    Paulson – notably – also touted the benefits of subprime and the need specifically, for the subprime mortgage market in the US to start rolling once more. From Dealbreaker:

    Hank Paulson lamented the disappearance of the subprime markets in a speech today…

    The interesting part was his plea that the US “not lose the benefits of the subprime market as we eliminate its flaws.” Paulson said that his boys were working on the possibility of covered bonds playing a major part in the mortgage market as a means to increase the availability of mortgage financing. The loss of financing for subprime mortgages has made the correction “more challenging.”

  12. Anonymous

    Paulson makes me ill. Somebody send him Venesoro’s .pdf. He doesn’t get it. “Just borrow more, Mr. and Mrs. Subprime,” ?

  13. Anonymous

    One minor issue first – please leave the Reagan idolatry at the door before entering. Yes, it is correct to say there was a huge difference between Clinton and the last three Republican presidencies. It’s something called a budget deficit. It’s embarrassing that we still must endure comments like these. I doubt in another decade or two, after the coming collapse of the dollar as the world reserve currency and the concomitant collapse of our economy, any but the truly insane will continue to be apologists for the “cut taxes, spend more, bankrupt the government” crowd.

    On a more interesting point, and to Yves’ post, I agree that if the dollar were not the world reserve currency, we would be standing at the edge of a deflationary precipice. I just think the dollar issue makes the precipice a mirage. If our debts are denominated in dollars and we control the printing of the dollars, I just don’t see this as akin to Japan’s troubles or the other instances of deflation in the last century. We’re a country of no savers. Why wouldn’t the democracy choose to inflate our way out of the problem?

  14. Anonymous

    Covered bonds allow for extension of credit to a bank SIV or trust that will be serviced by income from hypothecated assets on the bank’s balance sheet. The assets stay on the bank’s balance sheet unless there is a default on the bonds, at which time the assets are forfeit as collateral to the trust vehicle servicing the covered bond.

    Last week the FDIC released a policy statement on covered bonds that provides for “expedited release of collateral” if an issuing bank is taken into FDIC receivership or liquidation. The Treasury is expected to release a protocol on best practices for covered bond issuance in a high profile event next week. Hmmmm. What could be up?

    If I had to guess, I suspect what we will soon see is something near to the following scenario:

    Lists will circulate of troubled banks likely to go into FDIC receivership. Blogs have been full of such lists as of this week, quite suddenly, as it happens. The FDIC has to have a list because there are so many banks approaching insolvency that they are queued for FDIC receivership rather like planes circling Heathrow waiting for runway clearance to land.

    Several of the central players in the recent market dramas – particularly those investment banks and hedge funds on close terms with Mr Paulson (naming no names, but initials GS comes to mind) – will go strong and aggressive for the covered bond market. They will go around to their list of troubled banks, which of course they will have compiled independently using Texas Ratio maybe, rather than having any foreknowledge of FDIC concerns. They will issue covered bonds to these trouble banks against any assets with real, proveable value left on the banks’ balance sheets. They will be praised to the heavens by their friends in Washington as providing timely and necessary liquidity to a troubled banking system, proving the efficiency of the free market, bravely bearing the risk of new credit in exchange for troubled bank assets.
    When the troubled bank nonetheless fails, our golden circle creditors get the good collateral in an expedited release from FDIC under its new policy statement. The FDIC is left with all the toxic waste assets and liability for depositor insurance claims, with no prospect of recovery of any value from the insolvent bank liquidation.

    When the FDIC itself becomes insolvent, which it surely must do as this game gets played to its obvious outcome, then the FDIC gets a GSE-style bailout via Treasury finance and the poor taxpayers get reamed again.

    In the corporate sector, we could see the same kind of issuance. Covered bonds will be used to render profitable assets off soon-to-be-bankrupt corporates, leaving pensioners and other creditors with the stripped carcass in the liquidation.

  15. JHO

    Yves –

    I’d love to have a copy of the .pdf of Veneroso’s report. Thank you for your kind offer. We work with Texas cities and counties at the other end of the housing stick: trying to get the owners/controllers of abandoned and REO residential properties to keep the sites up to local code. You can imagine the frustration so many folks are feeling as their efforts to preserve neighborhoods are pushed to the wall. Increasingly cities are turning to using criminal law against the banks, since the lenders are often so cavalier as to ignore local code (civil) enforcement efforts. Thanks a ton for your great work, which we study every day.

  16. Anonymous

    Will Paulson/FDIC Covered Bonds Destroy The Value Of The Dollar (further)?

    From last Novemeber:

    “People are asking whether Italian government bonds are really as good as German bonds. The rising euro is starting to expose the strains in the system.”

    The euro has reached $1.4850 as Mid-East and Asia central banks and funds switch out of the dollar. The latest balance of payments data shows record portfolio inflows of €46.2bn (£33.3bn) in September.

    Professor Peter Bofinger, one of Germany’s five ‘wise men’ advisers, says the euro may soon reach €1.60 unless the EU authorities takes action to stop it, causing major distress for the aerospace and car industries.

    ING said the euro’s appreciation has gone far beyond the “painful threshold” of most European firms, with big variations by country. The threshold is $1.20 for French companies, between $1.30 and $1.40 for the Italians and Spanish, and $1.50 for the Germans, Dutch, and Finns.

    The bank said France, Italy, Spain had all suffered a serious loss of competitiveness against Germany, which has clawed back share since 2000 by driving down relative wages.

    Eurozone industrial orders fell 1.6pc in September, led by drops in chemicals and machinery.

    The concern is that the lagged effects of the surging euro are hitting just as the global economy slows and the housing booms in southern Europe deflate. “We have all the ingredients coming together for a very sharp slowdown in euro zone growth next year,” said David Brown, an economist at Bear Stearns.

    Marc Ostwald, an economist at Insinger de Beaufort, said the flight to German bonds was linked to the global credit crisis. “There’s a lack of liquidity so people are switching to Bunds, which are heavily traded,” he said.

  17. S

    you may be correct on the debt markdown (which itself has serious implications and explains the permanence of the auction facilities), but the GDP nominally may also be one of the biggest bubbles going. The stimulus is as much about aesthetics as anything else. Le’s call it operating GDP, and that is contracting ex government largess.

    If everyone is going to export their way to prosperity (devalue), exactly how do you avoid the paradox of thrift. Impossible. Rest of world is slowing and incremental data points confirm: Japan exports, china reversing course on Yuan, German confidence, UK home prices, Latam inflation etc… note the Aussy situation. AUD fx trade is showing signs of strain. one of the last great bastions of safety. the only thing left holding the US from being crushed under peak debt is as you rightly point out sovereign generosity.

    Treasuries have been in a bubble for a long time. it is highly ironic that people continue to view this as a safe haven. Then again, real estate was something of a sacred cow until it wasn’t. The rest of the world is moving on or has moved on from US hegemony and the dollar is a lagging indicator in this regard. The continued flows into the US perhaps reflect the best of the worst at the moment, but that shouldn;t be mistaken for the structural shift that is set to gather pace ver the next decade. Cyclical and structural shifts virtually ensure the US long term outlook is grim. Implications abound.

  18. Anonymous

    Very interesting graph.

    So when the deleveraging process starts to occur, assuming it does, such that it shows up in the numbers, leading to some type of significant downturn in the graph, what happens then?

    Or will it happen?

    Magical numbers are really neat.

  19. mal


    Would you please email me the Venroso pdf?

    The critical question as others have pointed out is the total credit market debt marked to reality or fantasy? That should provide a very good idea if deleveraging is taking place.

    Of course if they are marked to reality then we have a case of insolvency that is now being transferred to the Treasury/Fed balance sheet.

    I believe we will see the largesse from the Chinese, japanese and arabs decline as the current account deficit declines due to demand destruction. So bond market takeoff is not a given.

  20. Marco


    is there an email-address to which send a nicely demand of a pdf copy of Venroso work?

    Thank you

  21. Anonymous

    Hank is re-writing accounting rules for QSPEs with FASB, so that FDIC and Fannie can play spin the money with accounting fraud, i.e, bring part of the debt on to the balance sheet for Level 3 shit, then allow the QSPEs and SIVs and CDOs to act as conduit to taxpayers — meanwhile these covered bonds will devalue the dollar…

    Treasury backed notes will be diluted!!!

  22. C & C

    if treasuries with their meager yields are supposed to be the ‘safe haven’ of debt, I would sooner stick with the higher dividend paying MLP’s who generate a consistent income stream with payouts far better than treasuries.
    frankly, in a dollar depreciating world, where the dollar is on a downtrend, the ‘safety’ factor may be stonger in asset classes with consistent earnings than the dollar itself.

    PS. May I get a copy of the .pdf email me as well.

    PSS. This blog has now become one of my top reads every day. I rarely comment, but I always ready. Thanks for the good work Yves!

  23. Paul

    Timely and pertinent post as usual.

    I’d love a .pdf of the Veneroso report if you get a chance.

    I know you have been covering Michael Pettis’s work, so you are probably familiar with the thesis of his book “The Volatility Machine”, which examines sovereign capital structures for their vulnerability. Any thoughts on the sovereign capital structure of the US once contingent liabilities are taken into account? John Hussman wrote a piece a while back which made a stab at describing the US sovereign capital structure, and there is plenty of other research out there which illuminates US dependency on short term financing. I imagine this vulnerability could precipitate a more rapid and radical deleveraging.


  24. Anonymous

    Foreign government bonds look more appealing than U.S. treasuries. The U.S. now has default risk and dollar depreciation risk. I would buy German govt bunds instead.

  25. S

    there is plenty of other research out there which illuminates US dependency on short term financing. I imagine this vulnerability could precipitate a more rapid and radical deleveraging.

    The governement has crammed down short term rates and has been issuing heavy in the front end of the curve. yet another case of self dealing.

  26. S

    MER back to the well…that makes it $15B or so in the last few weeks

    Bloomberg $4B
    FDS $3.5B
    New Offering $8.5B

    Per Thain
    "As you can see on the top of Attachment VI, on a super senior ABS CDO front, at quarter end our net exposure was approximately
    $4.2 billion, which was comprised of a $20 billion long position and a $16 billion short position."

    M. Whitney on the Q2 call

    "Okay. Thanks. My second question is a broader question, and I appreciate it's sort of easier asked than done, but given the fact that this is sort of the fourth quarter of material writedown for the company, and just knowing what your reputation is, I can
    imagine you are incredibly frustrated. And why not at this point be the first to purge assets and just get it over with? And if that means raising capital, that means raising capital. But you bring people to want to be long-term shareholders. Stock go down,
    just start fresh. What is the pushback on that? It seems like the most basic question out there. If you could just elaborate on
    that? Thanks."

    Thain on Q2 Call per Temesak (they can;t have like this comment on waiting them out – looks like they prevailed)

    "John Thain – Merrill Lynch – Chairman & CEO Well, the — two things about that. One is it's obviously very dependent on the share price, and second, you shouldn't assume we would necessarily have to pay them whatever the contractual terms were, since that expires in less than six months."

  27. doc holiday

    yves, here:

    Financial Stability OvERviEW
    National Bank of Belgium
    http://www.nbb.be/doc/ts/Publica…R/ FSR2008EN.pdf

    The global covered bond market which was estimated to amount to 1600 billion euro at the end of 2007 is concentrated in Germany (Pfandbriefe) with 47.1 p.c. of covered assets, France (obligations foncières) accounting
    for 12.8 p.c., UK (contractual covered bonds) for 12.3 p.c. and Spain (cédulas hipotecarias) for 10.8 p.c. The resilience of this market to the current market shocks has been uneven and dependent on jurisdictions, with a
    temporary suspension of market-making by the European Covered Bond Council in November 2007. While the German market has resisted well, the UK market suffered, with some banks being temporarily unable to raise funds.
    Part of the explanation could be that covered bonds in Germany, France or Spain are issued under special legislation, while in other countries such legislation is lacking and the double investor protection is only provided
    by contractual arrangement. But even when such legislation is in place, markets may discriminate between jurisdictions. So, in Spain, the spreads between mortgage notes and Spanish government bonds widened during 2007, while in Germany the corresponding spread between Pfandbriefe and German government bonds remained stable.
    Of course, covered bonds can only partially fill the role of ABS. For a start, assets remain on banks’ balance sheets.
    Moreover, covered bonds generally pay fixed rates and have bullet maturities which may reduce their attractiveness in countries with substantial mortgage prepayments (like in the UK, Ireland and the Netherlands).

    An important caveat is that the largest part of interbank transactions is contracted for a much shorter duration than 3 months, so that these rates are not necessarily representative of rates that banks actually have to pay to get liquidity. Indeed, according to the ECB Euro Money
    Market Survey, about two thirds of the transactions in the unsecured interbank market are overnight while almost the whole remaining portion has a maturity of maximum
    1 month.

  28. Anonymous


    What does your research suggest the USD will do?

    This is an important question as where the USD goes will impact all the factors above, particularly those dependent on funds inflow and ofcourse imports/exports?

  29. doc holiday

    The following is an excerpt from a 10-K SEC Filing, filed by WASHINGTON MUTUAL, INC on 2/29/2008
    http://sec.edgar-online.com/2008…3/ Section24.asp

    At December 31, 2007, loans totaling $84.83 billion, $10.49 billion,
    $9.09 billion and $8.59 billion were pledged to secure advances from FHLBs,
    preferred securities issued by an indirect subsidiary of the Company, borrowings
    issued under its covered bond program and other borrowings.

    At December 31, 2006, loans totaling $58.95 billion, $7.28 billion,
    $6.25 billion and $2.62 billion were pledged to secure advances from FHLBs,
    preferred securities issued by an indirect subsidiary of the Company, borrowings
    issued under its covered bond program and other borrowings.

    In September 2006, WMB launched a $20 billion covered bond program intended
    to diversify its investor base, lengthen the maturity profile of its liabilities
    and provide an additional source of stable funding. Under the program, the
    Company may, from time to time, issue floating rate US dollar-denominated
    mortgage bonds secured principally by its portfolio of residential mortgage
    loans to a statutory trust not affiliated with the Company, which in turn will
    issue Euro-denominated covered bonds secured by the mortgage bonds. At
    December 31, 2007, $7.74 billion of covered bonds were outstanding. Under
    current program covenants, due to recent downgrades by Moody's and Standard &
    Poor's, the WM Covered Bond Program may not issue additional covered bond

    Includes $7.74 billion and $5.05 billion of covered bonds that were
    outstanding at December 31, 2007 and 2006.

  30. doc holiday

    As of June 2006 FHLB loans to WaMu were $55 billion, 16% of its assets. Lessening its dependence on FHLB is a continuing aim at the bank. Because finance provided via FHLB is typically less than three years, banks that use the system are building in an asset and liability mismatch because mortgages are long-dated.

    Government-sponsored enterprises are an important source of liquidity to mortgage markets by making loans against mortgage portfolios. But in recent years there have been a lot of negative headlines about Fannie and Freddie; against that backdrop it makes a lot of sense for banks to diversify their sources of funding. The problem banks had was that it was virtually impossible to match FHLB rates.


  31. Anonymous

    Indeed. Last August/September it was impossible to find matching or even close rates to those provided by FHLB Pittsburgh. I’m familiar with PNC Bank, and they started borrowing from the FHLB heavily around that time because all other markets practically shut down.

    The funny thing was that in normal conditions, the FHLB was always the most expensive option.

  32. Richard Kline

    So S. at 1:55: “The rest of the world is moving on or has moved on from US hegemony and the dollar is a lagging indicator in this regard.” That is a very cogent comment regarding which I have had similar thoughts, but ones less coherently formulated that that statement. I agree completely, and will bear this in mind going forward.

    The rest of the world is already adapting _to a changed environment_. In the US, though, we are still viewing events through a fading perspective rooted in past conditions. In doing historical modeling, the question of differing temporal frames of reference which this situation describes is one to which I’ve given no little thought; funny that I didn’t see it here. But this is surely the case. We are looking forward from the past, while they look back from the future _simultaneously_. Their actions will prove more substantive than ours accordingly. Hmmm.

  33. Doug

    To add to this classic thread, here is a similar Debt-to-GDP chart for Australia, except this one goes back even further, to 1880:


    It looks like the chart may only include private debt, but it’s interesting to note that the chart is generally similar to the U.S. chart with a sizable peak in the 1930’s and a much larger ascent now. But going back to 1880 we see yet another major peak in 1890, larger than the 1930’s peak, but still smaller than today’s. True debt deflations seem to only come around once every 50-80 years.

    See this article for context:


  34. Helix

    One man's debt is another man's investment.

    I believe this chart illustrates what we call "debt peonage".

  35. Helix

    Richard Kline asked " When will we have our country back?: When we take it back."

    It ain't coming back.

    It died the day Kennedy was shot. And the parties responsible for that crime then proceeded to suck the lifeblood of the country. What we would get back, even if we could take it back, is an empty husk. More likely what we would get is Predator Drones over our neighborhoods.


    What we need now is not to get our country back but to create a new one. The path to the future may be rooted in the past, but never goes back to it.

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