How Far Will Deleveraging Go?

From Wall Street Journal (November the 8th); via Yves Smith

Wall Street Journal Opinion November 8, 2008

How Far Will Deleveraging Go?

Credit will still have to shrink to keep leverage at precrisis levels.

The global economy is in recession. Will this lead to depression? And if not, how long and deep will the recession be? The answers to both questions depend on the extent of deleveraging by financial institutions.

The amount of risk-free or “tier-one” capital a bank is holding is a good reverse indicator of how leveraged it is. Globally, financial institutions had about $5 trillion of tier-one capital on the eve of the credit crisis. Those in the United States and European Union had about $3.3 trillion of tier-one capital supporting a loan book of some $43 trillion.

Then came the crisis.

How much did they lose? There are three answers. If mark-to-market rules are applied, global financial sector losses are estimated to amount to 85% of tier-one capital. But mark-to-market rules are extreme and assume the banks are insolvent and that all their assets will have to be fire-sold for whatever they can fetch in today’s dysfunctional markets.

If economic value, a concept based on the present value of future cash flows of the assets, is used instead, current losses are about half the amount calculated using mark-to-market rules.

Finally, if we use only the losses that have been recognized by the institutions themselves so far, we are a touch short of $700 billion.

Despite these losses, the loan books of banks have grown, not shrunk during the credit crisis. Only the balance sheets and leverage of the nondeposit-taking institutions, such as hedge funds, investment banks and prime brokers have shrunk, probably by 40%-60%.

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