The Many Faces Of Deleveraging...Three and one half years ago in March of 2007, we penned a discussion entitled, "It's Delightful, It's Delovely, It's Deleverage". Of course the upshot of that missive was that we suggested that the whole idea of balance sheet deleveraging was to be a huge investment theme to come. Little did we know, huh? You already know this was well in advance of the ultimate systemic credit cycle debacle that was to come and a year and a half in front of Lehman as a singular event. Deleveraging subsequently became a popular and virtually consensus theme in late 2008 and early 2009. Associated with this headline theme were tangential anecdotes such as "new normal", etc. It's time to quickly revisit the subject of deleveraging now as per the recently released 2Q Fed Flow of Funds statement.

Important now why? Because believe it or not, a good two to three years past what was the initiation of one of the greatest credit debacles in US/global history that is still reconciling as we speak, very little real world deleveraging has actually occurred. Has the need to deleverage private sector and public sector balance sheets suddenly disappeared amidst a miraculous macro economic recovery? Not in the least. Has it been negated by central bankers apparently under the impression that printing unprecedented amounts of what most folks call money will cure all ills? Nope. THE issue has been the ability to deleverage, or inability as may be the more proper characterization. Financial flexibility. It has actually decreased in certain sectors of the economy as opposed to recovered. So the question becomes, if the need to delever private sector balance sheets is just as meaningful and important today as it was three years ago, just what can we expect of the character of the real economy ahead? What does this imply for our investment activities and just how do we position in the current environment given that this proverbial sword of Damacles still hangs over our collective heads? Deleveraging is not a pop culture term whose popularity has come and gone in 2008 and 2009. It remains a construct we will be dealing with for years to come and absolutely must be integrated into thematic decision making ahead.

We'll try to take this in bullet point headline sector format. We want to quickly review deleveraging at the household, public sector and corporate levels. Where are we now? What has happened over the past three years and where do we stand relative to historical context. Let's get right to it.

HOUSEHOLD SECTOR

To the point, the top clip of the chart below is a look at the quarter over quarter change in total household debt outstanding, necessarily inclusive of credit card and mortgage debt. Needless to say, we've never experienced anything like what we have lived with over the last few years anywhere before in the history of the data. As we wrote about long ago, thematic household balance sheet deleveraging in action, no? Actually, not in the manner most would assume.

Over the period highlighted by the red circle, household balance sheet leverage has contracted by $492.6 billion. It just so happens that on September 8th, a little over a month back, the incredible folks at Moody's put out a piece estimating that in the current cycle up to this point, US banks have taken $476 billion in total write offs. They tell us they believe banks have already taken 68% of the residential mortgage and 49% of the CRE losses Moody's believe they will encounter over the entire cycle. We'll reserve judgment for the final tally, but you can see that bank write offs and the contraction in household debt numbers are not too far off parity. Admittedly there is some apples and oranges comparisons going on here as households are not CRE holders per se. But we know intuitively that the bulk of bank booked losses have related to residential real estate as so much commercial property price damage occurred after the FASB threw out mark-to-market accounting in early 2009. Plus, as we have shown you in the past, the bulk of CRE loan maturities lie in the years immediately ahead of us, not behind us. The last data point we will throw into the mix is that as of August 2010 data, the drop in official US bank loans and leases outstanding (very broad categorization) comes in at $454.3 billion. Again, you can see the macro numbers are converging here.

Anyway, although the existing data does not allow us to pinpoint the numbers exactly in terms of comparing household debt declines directly with banking system write offs, we believe it is more than very fair to say that the bulk of household balance sheet deleveraging in the current cycle so far has come from defaults as opposed to loan pay downs.

And to be honest, this is not surprising in the least. Why? Because the means by which to reconcile household balance sheet leverage outside of outright default has been lacking, namely wage growth. As of the latest data per the official 2Q period end numbers to this point, the year over year change in US personal income less US government transfer payments continues to rest in negative territory. You can see the half century plus rhythm of this data. It's not unusual to see personal income less government transfer payments fall into negative territory during prior recessions. We've just never gone as deep in any other cycle but the most recent, and personal income growth excluding transfer payments (think extended unemployment benefits) recovery has been lacking. No big mystery as any semblance of new job growth has been virtually non-existent. Last week we received the personal income and consumption numbers for August of this year. On a year over year basis they finally showed a bit of rate of change growth. But as you know, we are comping against very weak 2009 numbers. You can see as you look at the absolute numbers in the chart below (the area in black) that in nominal terms income exclusive of government transfer payments remains well off the highs.

You know the punch line here. At least up to this point, household deleveraging has come "the hard way", via default. Why? Because the means to delever via savings/wages has been virtually non-existent. The important issue is that the deleveraging process at least at the household level hasn't even really begun in any type of organic sense. And that tells us the road to true economic recovery is going to be long. Very long. This process still needs to happen as we'll see in just a moment. Doesn't this say something about the longer term fundamentals of domestic consumption? If you believe, as we do, that true household balance sheet deleveraging must indeed take place before a sustainable new domestic economic growth cycle can take hold, we have not yet even left the starting gate.

A few quick tangential comments and then a quick summary, and we'll move forward. Importantly, the bulk of household deleveraging in the current cycle has been achieved by loan default, not proactive savings or wage based balance sheet actual debt pay down. In spite of the economy being back in recovery mode as per the headline economic stats, the real tale of financial pressure at the household level is being told in the data of US personal income less government transfer payments. We believe it's very fair to say that what little sustainability in consumption we have seen in the recovery cycle so far has in very good part been supported by the government (actually the taxpayers). As you'll see below, we've never seen levels of the current magnitude of government transfer payments as a percentage of personal disposable income. Just what would happen if the government were to stop extending unemployment benefits or cut back on household transfer benefits in any other manner? Don't worry, they will not, especially with the relationship you see below.

In one sense, the government has very much put itself into a box as never have government social payments as a percentage of US personal consumption risen to such a level as you see below. Never. How does the government cut back without very much negatively impacting a consumption based US economy? We do not have an answer. It can't until jobs and wage growth reappear. How does the government cut back and not negatively impact the household deleveraging process that is absolutely a must do prior to true domestic economic healing taking place, to say nothing of the potential for a restart of the household credit cycle? Again, we have no answer.

So just where are households in this whole process of deleveraging considering the fact that excluding the influence of the government their incomes have not risen over the past few years? For that we like to look at household liabilities as a percentage of disposable personal income. Again, remember that a lot of the already seen contraction in household liabilities up to this point has been through default, not repayment.

The ratio of household liabilities today relative to disposable income stands much higher than the longer term average. Will we get back to the average as part of total cycle reconciliation in the years ahead? To be honest, we do not expect that to happen because quite simply the public does not have the financial resources for that type of an outcome. But we do believe this ratio must and will continue to contract ahead. The bottom clip of the chart is data we've not shown you in a while, but repeatedly reviewed regularly a number of years ago. Remember, we define cash in the bottom chart clip as all US household financial assets less equities. Savings, bank deposits and products, bond holdings (taxable and tax free), as well as bond funds. It was only in the prior decade that this relationship fell into negative territory for the first time in the entire history of the data. A "tipping point" as we have described in other discussions. After all, who needed cash when credit inclusive of HELOC's, lines of credit, cards, etc. was so readily available to households? Again, we have a hard time seeing this reconcile back to zero any time soon as we are looking at a $2 trillion mismatch here. BUT, the path of current reconciliation will continue because it must.

Enough of banging on the household data. THE key important point being, although deleveraging remains a very valid construct and investment theme, when it comes to the current reality of the US household balance sheet the deleveraging process has only been achieved up to this point primarily by household debt default. It's not enough as per the history of the numbers you see above. We have a very long way to go in terms of household balance sheet reconciliation still yet to come. Income generation at the household level is the key to the timing and rhythm of this process. Interest income is dead. Small business (proprietors income) literally just recorded its first positive year over year number with the August personal income report, but it's comping against weak prior year numbers. In absolute terms it's not a factor. Jobs and wages are the key to the inevitable household deleveraging process and so far both are MIA. Consumption in the domestic economy remains at risk until this deleveraging process is ultimately completed. And finally, again as is clear per the numbers relationships above, the government is the current wild card in this process as they have acted to hold up nominal headline personal consumption (via income) with transfer payments up to this point. Of course the sarcastic question becomes, can we have a US economic recovery built on government transfer payments? Of course not. QE will do the trick in terms of making that happen, right?

CORPORATE

It's very much consensus thinking these days that corporations are "flush with cash". We will not debate that for a minute. You can see the deals that have been done in tech land as of late for cash, and also cross border deals that are heating up. In fact since 2006, total corporate financial assets (the broadest definition of cash we can think of) are up close to $2.5 trillion. That's a lot. And by the way, this is the number for non-financial US corporate business. But what gets little to no attention, and mostly no attention, is that in aggregate over exactly the same time period non-financial sector corporate liabilities have likewise increased close to $2.7 trillion as we detail in the chart below.

So maybe we're nitpicking, but just where is the corporate deleveraging? In academic terms, it has not happened at all. And yet corporate debt relative to GDP is much nearer record highs as of now than not.

We're not trying to create the impression that corporations are somehow in trouble due to leverage. They face a completely different set of dynamics than do US households. The source of "income", per se, for US households is derived in the domestic economy. For so many US corporations, that's not true at all, especially in the current environment of continued strong emerging economic activity. Moreover, although a certain segment of US households has been able to participate in the benefits of lower interest rates (the solvent ones, that is), US corporations have been given the debt cost of capital gift of a lifetime. So it's not so much the level of liabilities that is the issue, but rather the cost of carrying the liabilities. Big plus for the corporate sector for now. We just wanted to point out the facts here. Yes, corporations are flush with cash/financial assets. But their liabilities have actually risen more in the last four years than have their cash assets. Although we do not expect dramatic and life changing balance sheet reconciliation ahead, we do expect some debt pay down to come in the current cycle. Although we'll be the first to admit that when IBM can issue three year paper at 1% and have it be oversubscribed (the exact terms of a recent deal), who the heck wants to pay down debt? In fact, any CFO not issuing paper at these mind boggling interest rate levels should be shown the front door.

As a final comment, we do need to keep in mind that a lot of corporate cash is being kept very safe and warm...off shore. We hear the number is close to $1 trillion, so that puts the total financial asset number in perspective. So as we think about the bigger picture macro of the need for domestic jobs and wage growth that would indeed facilitate household deleveraging, could corporations use that cash for capital spending and expansion that would potentially create jobs and income? Sure, but probably not in the US . Taxation is going to keep this cash hoard offshore unless something dramatic changes. That means the cap and equipment spending, and resulting job expansion, will happen in higher growth rate areas of the world. Again, where is the spark for household deleveraging we know has to happen ahead? Probably not in the corporate sector, at least not for now.

PUBLIC SECTOR VERSUS PRIVATE SECTOR DEBT

It's simply a toss away comment to say that the government has borrowed a lot of money over the last two to three years. Everyone and their brother already knows that. And there is plenty more borrowing to come where that came from. But a bit analogous to the comments about household debt contraction and bank write offs above, what about the relationship of private sector debt contraction and public sector leverage acceleration? Is there a similarity or mismatch here? As of the Fed Flow of Funds statement for 2Q, the following table delineates the change in public and private sector debt outstanding since the end of 2007. Have a peek.

Again, we're not going to dwell on this or drag you through a series of charts. We've done all of that before. The numbers tell their own story in rather dramatic fashion. In nominal dollars total public sector debt has expanded over twice as much as private sector debt contraction over the last two and one half years. Not only have we academically offloaded private sector debt onto the public sector, the public sector as doubled the number in terms of additional leverage assumption. So as we look at the public and private sector from a birds eye viewpoint, again the question becomes what deleveraging systemically? Just how does the public sector delever when the private sector is contracting? It can't. Academically the public sector has the means (taxes and spending cut backs) but never the will. The perception is out there that public sector debt accumulation has simply offset private sector debt contraction. Not true. It has more than offset private sector debt contraction. And still households have not been able to achieve organic balance sheet deleveraging? Again, the process of total cycle deleverage remains in its infancy.

Enough charts and numbers and all that other stuff. We think the summation messages are very clear and certainly have implications for at least a domestic economy that is suffering primarily from a lack of aggregate demand, let alone a global economy in part suffering from the same. As hard as this may be to hear, deleveraging is still barely out of the total cycle starting gates. At the household level we have not yet even seen organic deleveraging, but rather deleverageing through defaults. Jobs and income growth are the keys to the deleveraging process at the household level, but they are for all intents and purposes missing in action in the current cycle. And that speaks to time. Time for true balance sheet healing and ultimately a recovery in aggregate demand. The very means for households to delever independent of default are not visible. Not yet. And so we need to expect 1) a stop-start real world domestic economic recovery, 2) Fed QE that does nothing to reinvigorate the real economy, but has the real potential to create yet more unproductive asset bubbles, 3) continued volatility in financial asset and commodity prices based on investor perceptions of Fed and global central banker sponsored liquidity and the effectiveness or not of liquidity injections at any point in time. In reality, this is nothing we have not already been dealing with up to this point. But for our investment activities specifically, we believe it all comes down to just how far the Fed and their global central banking brethren are willing to push the envelope in terms of money printing, currency intervention, etc. For now, investors still view these activities as virtuous. But at some point unless we do indeed see true real world economic reinvigoration, we believe the markets will come to view further Fed and global central banker monetary "experiments" quite negatively. All part of the psychology of a financial market and economic cycle.