Strategic Investment

Leverage Cycle Tourism: My Trip to the Other Side

The IMF is famous for holding back emerging economies by enforcing anti-growth policies. But not everything the IMF does or says is wrong.

Consider this logic from a recent IMF statement, which provides a good introduction to the leverage cycle:

Recessions associated with financial crises have typically been severe and protracted. Financial crises typically follow periods of rapid expansion in lending and strong increases in asset prices. Recoveries from these recessions are often held back by weak private demand and credit reflecting, in part, households’ attempts to increase saving rates to restore balance sheets. They are typically led by improvements in net trade, following exchange rate depreciations and falls in unit costs.

Globally synchronized recessions are longer and deeper than others. Excluding the present, there have been three episodes since 1960 during which 10 or more of the 21 advanced economies in the sample were in recession at the same time: 1975, 1980 and 1992. Recoveries are usually sluggish, owing to weak external demand…

When most people think of cycles the first things that come to mind are bicycles and tricycles and maybe even their big, fat Harleys. But Yale economist John Geanakoplos has discovered another cycle – one that has always been at work in the economy, but until recently went mostly unnoticed. I refer to the leverage cycle.

Understanding the Leverage Cycle

The general idea of the leverage cycle is that there is another important variable in loan markets apart from interest rates. That is the degree of leverage or collateral involved with the loan.

In good times, when the leverage cycle is expanding, leaders don’t require a lot of collateral. Indeed, they may not require any at all. Think of Alt-A mortgages, so-called “liars loans.” Although they entailed collateral, as they were lent on the basis of real property, homes, condos, etc., they entailed no verification of assets and income, the foundation upon which most loans are made.

The environment in the U.S. today, like that of most advanced economies, is one of shrinking leverage: borrowers are obliged to pony up more collateral, and loan-to-value ratios shrink even as the banking system is required to increase capital and thus employ less leverage in the lending process.

Lower leverage, other things being equal, means less spending and less purchasing power – and therefore, as the IMF suggests, slower recoveries from downturns.

Credit Unwinding Means a Painful Period in the U.S.

In a bankrupt world, where every economy is struggling compared to recent levels of prosperity, the questions are: Where is recovery possible? And how long it will take?

This is a bigger question than it normally would be, because of the drastic deterioration of balance sheets and prospects in North America. We are living on the dark side of the leverage cycle – with higher margin requirements, lower loan-to-value ratios and little credit available as banks and financial institutions shrink their gearing. We’re in the process of going from 30 to 1 to 10 to 1. This means a long period ahead of falling real estate prices and asset liquidation.

I don’t know about you, but I have mostly been stuck in the United States since last autumn, witnessing the bleak spectacle of back-to-back quarters of GDP shrinkage of more than 6%.

I have not enjoyed the opportunity to see how the rest of the world is responding to depression. I read about it. Allegedly, there are “green shoots” of growth here and there. But I haven’t seen too many of them.

Becoming a Leverage Cycle Tourist

Hoping for something better, I recently decided to become a “leverage cycle tourist” and book a seat aboard United Airlines flight 0861 to Sao Paulo, Brazil.

Why Brazil?

I indicated a prejudice in an early issue of Crisis Strategy Alert.
I got to know Brazil better than I ever dared hope as a consequence of some supernaturally good luck: I met and married a stunning young woman who is a recent Miss Brazil.

Thanks to the excellent introduction she has provided, I have come to learn more about Brazil’s economy at a higher level than the typical tourist would ever see. One of the things that I found most striking is the very low level of consumer debt in Brazil and the high savings rate – 25.4% according to the latest statistics. This is in marked contrast to the U.S., where the savings rate shot up above 4% after falling below 1% in 1Q 2008.

Another measure of the different positions in the leverage cycle between Brazil and the U.S.: auto sales in Brazil hit an all time high in the month of March. In the U.S. the headlines announce the bankruptcy of Chrysler, one of America’s iconic auto brands.

Brazil is still on the sunny side of the leverage cycle. There is no subprime mortgage problem in Brazil. My wife has quite a few real estate holdings in Brazil. I have not pried too much into her finances. But I did ask her what type of mortgage she got when she bought a house in a gated community her father was developing. She said, “30, 60, 90.” In other words, you pay the whole thing in three installments, of 30, 60 and 90 days.

Nobody buys a house in Brazil unless they can pay cash. That really puts the leverage cycle in perspective.

I’m going to Brazil with my eyes open, looking for opportunities for you to profit from the sunny side of the leverage cycle. From what I have seen in the past and what I already know, I am confident that Brazil will recover from depression before North America does.

I’ll send you a post card from Rio.

Best Regards,

James Dale Davidson

Editor, Crisis Strategy Alert

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