LeoGlossary: Deleverage

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This is the opposite of leveraging.

Individuals, companies, and economies all can deleverage. This means it operates both at the micro and macroeconomic level.

This is the process of reducing debt on a balance sheet. More specifically, it is the percentage of the balance sheet that is financed through debt.

The Business Cycle

The process of leveraging and deleveraging often follow the business cycle.

A risk-on sentiment starts to take place after the trough is reached in the cycle. Markets can precede the economy meaning the leveraging occurs in the financial segment first.

After the peak in the business cycle is reached, risk-off takes hold. Deleveraging is the result as participants take a more conservative approach.

This can often be aided by a reduction in credit offered by the banks. They raise lending standards making it harder to qualify for a loan. Lines of credit such as HELOC are often tightened. Credit card limits are also reduced.

Defaults are also part of the deleveraging process. This is forced by changes in market conditions.

When payments are not made on debt, the lender will eventually have to write it off. This is a default. It also can apply to bonds.

Microeconomic Deleveraging

This is where individuals and businesses reduce the amount of debt.

When markets are expanding, returns can be increased by using leverage. The opposite happens in reverse, compounding losses.

During downturns, assets decline in value, lowering the ratio between asset and the debt associated with it. If the value drops enough, the borrower is at risk of default.

Investors and funds will often follow the banks. Market conditions could mean shifting to securities with less risk. The use of margin is avoided as stocks and other assets decline in value.

Another move is to increase the cash position. This can be done through the selling of securities (or assets for a business) and not reinvesting the money.

During these times, capital is hard to acquire. All markets can start to seize up and market makers remove liquidity.

Macroeconomic Deleveraging

Economies go through the deleveraging process, often as a result of trouble in the financial markets. Both the private and public sector has historically started the process a couple years after financial crisis.

This is often accompanied by recession in the economy. This forces a reduction in spending, causing further pain.

On a macro level, the debt-to-GDP is what many focus upon. Gross domestic product will fall as the economy falters. This is outpaced by a reduction in the debt levels as it needs to fall faster.

Banks tightening the lending means the money supply is reduced. Since credit is not issued, the money is not deposited into accounts. This is compounded by economic participants paying down debt along with rising defaults.

Deflation is a part of the deleveraging process. The money supply tightens which flows through the economy. Prices end up falling, first in assets followed by the same in goods and services. Employment eventually drops as corporations see revenues decline along with decreasing profits.

Central Bank

Central banks, in the era of quantitative easing, engage in a similar process although the term is not typically applied.

During QE, central banks such as the Federal Reserve, expand their balance sheets by purchasing mortgage backed securities (MBS) and sovereign debt. This is done mostly through the issuance of central bank reserves.

Quantitative tightening (QT) is when the central bank either allows the bonds to run off their balance sheet by letting them reach maturity and not replacing them.

The central bank will often work in opposite of the business cycle. During expansion, it will tighten, reducing the balance sheet. When things turn sour in the economy, it want to stimulate, providing liquidity by expanding reserves.

Monetary policy from the central bank is indirect. Liabilities on the balance sheet are not legal tender except for the banknotes. The economy today sees most transactions occurring using the digital version of the currency, which is created by the commercial banks.

Interest rate manipulation and the expansion of reserves are all done in an effort to get the banks to increase their lending. That is the only way the legal tender can be expanded, something that is needed during economic contraction. The problem is the commercial banks operate in their own interest which means lending when conditions are beneficial.

Market Collapse

Deleveraging into falling markets can be fatal. It can often lead to a company becoming insolvent and having to file bankruptcy.

This process often involved the selling of assets. Problems arise when everyone else has the same idea. As markets are flooded with sellers, the ratio of buyers drops. This causes prices to accelerate creating market collapses.

The lack of liquidity means that companies become insolvent even though they have assets.

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