Since 2007, the U.S. financial system has been deleveraging under pressure from regulators and the failure of many borrowers to repay. Many critics of the financial system, including me, greet this trend with approval, but some who applaud reducing debt have not fully recognized all its implications.
Deleveraging means reducing the total amount of debt issued by each lender in the financial system, as compared with the total amount of reserves it holds underlying that debt. This trend is a reaction against too much past borrowing in housing and commercial property markets. But that reduction of debt also means a reduction in the ability of the entire financial system to make new loans or support continuation of existing loans made from 2000 to 2007.
Genesis of a downward spiral
In housing and commercial markets, after the stock market crash of 2000, both lenders and borrowers increased financial leverage. Lenders extended much more debt against their existing reserves than had previously been allowed. That occurred because changes in banking rules permitted banks to issue a set of loans, recast them into bonds, and sell those bonds to other investors.
Hence, banks weren't required to hold reserves against the bonds they sold since they no longer owned the bonds. So they could use their reserves to do it all again, creating more debt against their reserves until they sold off the second set, too. That enabled lenders to originate more loans from the same reserves, and allow borrowers to increase net returns by reducing their equity in each deal.
Motivation for this behavior has best been described by economist Herman Minsky. He claimed that both lenders and borrowers become more optimistic about the economic outlook during periods of prosperity; the longer those periods, the greater their optimism.
Gradually, more and more debt replaced equity, leaving many borrowers in perilous condition if something went wrong. Eventually something always goes wrong with the economy, as pointed out by Hassim Nicholas Taleb, author of “Fooled by Randomness”.
Taleb argued that many people who are financially successful are just lucky. But being human, they attribute success to their personal skill. Hence, they get overextended with too much debt. Then a negative crisis occurs, and many lenders demand immediate payment. This causes a downward spiral of cash shortages and credit demands that cannot be met.
The explosion of borrowing in both housing and commercial markets from 2000 to 2006 illustrates the dramatic rise in debt. Home mortgage originations tripled from $1.05 trillion in 2000 to over $4 trillion in 2003. In commercial property markets, securitization facilitated excessive borrowing. Total CMBS issuance soared from $49 billion in 2000 to $237 billion in 2007, a 383% increase.
Banks shifted from their long-time “originate and hold” strategy concerning mortgages to their new “originate and distribute” strategy. The latter approach was based on securitizing each batch of loans, selling the securitized instruments, and then using the proceeds to do it again — against the same reserve capital.
This permitted banks to expand borrower debt far beyond what banks could previously do. Much of the excessive lending also came from non-bank lenders such as investment banks, money market funds, and commercial paper providers who were not constrained by legal reserve requirements.
The age of deleveraging
But then the credit bubble burst and real estate lending virtually stopped after 2007. Consequently, lenders and borrowers were urged to deleverage. The entire financial system began reducing its outstanding debt — both intentionally and because so much debt proved to be almost worthless when borrowers could not repay.
Another aspect of deleveraging was eliminating many of the previous non-bank lenders. Investment banks converted to commercial banks or went broke, overnight lending vanished when investors refused to put up the necessary short-term funds, and money market funds and commercial paper markets met similar fates. For many such non-banks, deleveraging meant going out of business.
A crucial consequence of deleveraging was a tremendous reduction in the ability of the entire financial system to lend money. Banks sustained huge losses from their securitized instruments and home mortgage loans. They were also pressured by regulators to reduce their total loan volume in relation to their reserves, which suffered major attrition from under-performing loans.
The upshot is that the total amount of loans coming to maturity exceeds the ability of the newly deleveraged system to renew those loans. That explains much of the banking system's unwillingness to provide real estate credit to almost anyone.
This outcome was accentuated by the tremendous fall in asset values during 2008 as the U.S. entered a major recession. After having been on a consumption binge financed by borrowing for over a decade, U.S. consumers slashed their spending, causing disastrous drops in sales of all types of products. The resulting fall in asset values accentuated the inability of the financial system to service all the loans they had originated from 2000 through 2007.
With almost all assets worth less than when original loans were made, most bankers would not extend existing loans. They demanded more equity to offset lower asset values. But where could the borrowers get more equity? They could not borrow it from most banks, especially if they had very little equity left in their loans, and non-bank lenders had almost disappeared.
Vise tightens on owners
This situation creates a horrendous prospect for many owners of commercial properties with debts coming due in 2009 through 2011. Much of their initial equity has been wiped out by falling asset values. So they will have to put up more capital to renew their financing. But where will they get the necessary capital when most of the financial system refuses to keep lending at the volume it did when those loans were originated?
True, the federal government says it will provide some capital through TALF (Term Asset-backed Securities Lending Facility) to commercial property borrowers. But TALF will help only borrowers with AAA-rated properties and enough remaining equity to cope with lower property values and banks' reduced loan-to-value ratios.
That will leave thousands of property owners incapable of refinancing when their loans come due. Thus, deleveraging will inescapably inflict major pain on U.S. commercial real estate property markets in the next few years.
One partial remedy would be for lenders not to fully foreclose, but to pay the current owners to keep managing the delinquent properties and award them with a share of equity. That would keep present owners' interests aligned with the new owners' interests, and prevent the new owners from having to manage the properties involved. While it is not a great solution, it beats total foreclosure.
Tony Downs is a senior fellow at the Brookings Institution. He can be reached at firstname.lastname@example.org