Deleveraging - Deleveraging of Micro-Economic Entities

Deleveraging of Micro-Economic Entities

While leverage allows a borrower to acquire assets and multiply gains in good times, it also leads to multiple losses in bad times. During a market downturn when the value of assets and income plummets, a highly leveraged borrower faces heavy losses due to her obligation to the service of high level of debt. If the value of assets falls below the value of debt, the borrower then has a high risk to default. Deleveraging reduces the total amplification of market volatility on the borrower's balance sheet. It means giving up potential gains in good times, in exchange for lower risk of heavy loss and nasty default in bad times.

However, precaution is not the most common reason for deleveraging. Deleveraging usually happens after a market downturn and hence is driven by the need to cover loss, which can deplete capital, build a less risky profile, or is required by nervous lenders to prevent default. In the last case, lenders lower the leverage offered by asking for a higher level of collateral and down payment. It is estimated that from 2006 to 2008, the average down payment required for a home buyer in the US increased from 5% to 25%, a decrease of leverage from 20 to 4.

To deleverage, one needs to raise cash to pay debt, either from raising capital or selling assets or both. A bank, for example, can cut expenditure, sell liquid assets, absorb off-balance-sheet structured investment vehicles and conduits, or allow its illiquid assets to run off at maturity, which, however, can take a long time.

Deleveraging is frustrating and painful for private sector entities in distress: selling assets at a discount can itself lead to heavy losses. In addition, dysfunctional security and credit markets make it difficult to raise capital from public market. Private capital market is often no easier: equity holders usually have already incurred heavy losses themselves, bank/firm share prices have fallen substantially and are expected to fall further, and the market expects the crisis to last long. These factors can all contribute to hindering the sources of private capital and the effort of deleveraging.