Leveraging our most leveraged asset and deleveraging

From the reading I have done, it seems that in almost all bubbles, speculators borrow money (use leverage) to gain exposure to the asset in question. That's right, imagine leveraging up to buy more tulip bulbs. Additionally, access to credit often comes from non-traditional places.

The most recent housing bubble in the US therefore seems like it could represent a special case in that the US home was already the largest asset for most households and accounted for the vast majority of household debt. I think it is safe to guess that Europeans did not use leverage to buy tulip bulbs during normal times. This time around, the asset we collectively levered up to buy more of was already highly levered and very expensive relative to our incomes. There have been real estate booms in the past of course, but the idea that the average household should have the ability to buy a home with 5x leverage is a new one historically speaking. (More recently, we decided that you really shouldn't have to put any equity into your home because we all "knew" housing prices were going to rise forever)

My biggest question is: What are the implications when the leveraged asset is the largest asset most households own to start with (and is already highly leveraged)?

I won't bother rehashing the mortgage mess, but it seems clear to me that household balance sheet have been stretched this time in a way that may not have happened before, at least not on such a broad scale. It seems like there must be implications.

The most likely implication is that households will be rebuilding their balance sheets for several years. Debt to income ratios for the average household went from about 2.5x to over 5x in less than a decade. Some will reduce that ratio by defaulting on their loans. New home equity loans will be very rare. America will simply need to gradually pay down its debts one month at a time.

My second question is: Should we fight the deleveraging trend?

I just argued that household debt is too high and probably needs to come down. But the impact of a massive consumer deleveraging is a bit terrifying, especially if it happens quickly. It seems clear that the government and Fed are doing everything in their power to slow this deleveraging to increase the odds that our economy can absorb it. There is a feedback loop tendency that scares them and rightly so. Maybe the better question is, "To what extent should we fight deleveraging?"

I have a confession: When TARP was being debated, I thought we needed the banking system to start lending again and TARP had a chance of allowing that to happen by removing some of the bad loans banks were carrying. In retrospect, I'm embarrassed to admit, I naively assumed that the problem was the reluctance of banks to lend. Of course that is one problem, but it is much deeper. Did I really want banks to keep lending at the same underwriting standards that facilitated the current state of affairs? By definition, because I think underwriting standards need to be tightened, then I think banks need to reign in lending. That means banks need to be lending out new money slower than they get repayments.

My interpretation of the changes at Fannie and Freddie as well as the modifications to the FHA loan program, is that the government is simply trying to keep underwriting standards at loose bubble-era levels for mortgages. The banks won't do it so the government has to fund mortgage originations. This probably has to happen but I hope the government is planning on gradually tightening underwriting standard over several years until they can turn it back over to the private market.

I think the Fed and Treasury are on the right track; force mortgage underwriting standards back to "stupid" levels in order to slowly adjust them down. If they can pull this off, it will decrease the pressure on businesses and therefore limit the losses on C&I and CRE loans at the banks. They have infused the banks with more capital with which to absorb the inevitable losses from C&I and CRE loans. Keep in mind that the preferred capital will help keep the banks above regulatory capital requirements, but the book value attributable to common shareholders could still go negative. I own one bank in my personal portfolio but I am aware of the risk and you should be too if you own any (I own ZION). Banks are high-risk investments right now.

I'm not really sure how investors will treat a negative equity scenario. Banks are usually priced as a multiple of book value, adjusted for ROE. Investors may start using a multiple on normalized future earnings if that happens, or they may just demand that the bank sell itself. There are public companies with negative common equity, so it is not unheard of, but it would require bank investors to think very differently than they are accustomed to. I also don't know how the regulators will treat negative common equity. I'll leave that question to someone closer to the regulators.

Conclusion:

I expect US consumer spending to be weak for years, not quarters, as the government and Fed slowly deleverage the US household balance sheet. The banking sector broadly speaking will shrink, especially when consumers start allocating back to equities at the expense of deposits.