Tuesday, October 28, 2008

What is debt deflation?

Suppose asset value today is 100. Debt is 80. Equity is 20. So leverage = debt/equity = 80/20 = 4x

Suddenly, asset value falls by 10%. So new asset value = 90. Debt = 80. Equity = 10. So new leverage = 80/10 = 8x.

And suppose at the same, the system wants you to delever to 2x leverage.

When asset prices weren't falling, one would have needed another 20 of equity to bring leverage to 2x.

When asset prices fall by 10%, we need 30 of equity. Now because we cant get that much equity, a better idea would be to sell assets. We need to sell 60 of assets to go to 2x leverage.

But if everybody tries to do that at the same time. i.e. sell assets to reduce leverage, there is only one thing that will happen, which is that asset prices will fall. Which, can actually end up increasing the leverage, as we see from the small example above. Which increases the compulsion to sell even more assets, which pushes down asset prices even more. And we go into a huge negative feedback loop, which is where we are now.

Having falling asset prices and the compulsion of delever at the same time is thus very harmful for equity owners. Equity is the first loss tranche in the capital structure. Negative momentum can wipe equity to 0. Momentum is more important than valuation today.

1 comment:


Thats another way of looking at money.