Leveraging built this economy; deleveraging is now crushing it. Maybe it's time to try something different.

What It is
By Alan Stoga

Cash, not debt, is king again.
In 1931, as the country struggled with the wreckage of Wall Street, Treasury Secretary Andrew Mellon gave tough-love advice to President Herbert Hoover: “Liquidate labor, liquidate stocks, liquidate the farmers, liquidate real estate. Purge the rottenness out of the system. High costs of living and high living will come down…enterprising people will pick up the wreaks from less competent people.”
Fast forward to 2008. While no one wants to play the role of either Mellon or Hoover, the underlying narrative is similar.
For the last decade, people, banks and investors all borrowed wildly to finance consumption or speculation. Now, when everyone seems to have too much debt, deleveraging is rapidly driving markets—as well as the economy—downward.
Yale Professor John Geanakoplos calls it the “leverage cycle,” pointing out that it is “self-reinforcing” both on the way up and the way down. On the way down, however, “negative feedbacks produce ever more financial and economic distress,” says George Magnus, a senior adviser to UBS in London.
How big is the debt problem? Total credit market debt has grown one-third faster than the economy over the past decade. Household debt today exceeds 140 percent of income, the highest in history. According to Daniel Alpert of Westwood Capital, homeowners have already lost $4 to $5 trillion in wealth due to falling
housing prices.
The financial system is overleveraged: at the high point in the cycle, some investment banks were turning every dollar of their capital into $35 or $40 of assets. The $2 trillion hedge fund industry was based entirely on high leverage, with some funds reportedly borrowing as much as $80 for every invested dollar.
When housing prices crashed, financial institutions started to lose money. The International Monetary Fund reported that total losses by banks, insurance companies, hedge funds and other investors reached $760 billion at the end of September. The IMF thinks at least another $700 billion of losses lie ahead. 
The only way to survive is to shrink—get rid of debt, write off bad loans, find new equity, raise cash—as fast as possible.
The problem is the pace at which financial institutions are deleveraging. All that selling and the banks’ continued reluctance to extend new debt adds to the turbulence in the market—and intensifies the hit to the economy.
Magnus worries that the process could go too far. “Deleveraging could overshoot, producing more failures and driving stocks to extraordinarily cheap levels—which then would cause more financial instability.” 
In other words, Mellon’s tough love, without anyone playing Mellon.

With the economy caught in a self-reinforcing deleveraging cycle, down is the new up. FLYP Media presents an interactive infographic that details how the vicious cycle of leveraging and deleveraging affects the economy at large.

So What?
By Julie Satow

“America hasn’t been creating wealth. Rather, we have been borrowing money, consuming and bankrupting ourselves,” says Peter Schiff, the president of Euro Pacific Capital, a global investment strategy company. “Our phony standard of living is now going to collapse, and there is no way around it.”
Whether deleveraging, or even the pace of it, is good or bad may be moot. It seems that everyone, from individual households to the world’s largest commercial banks, is selling off assets and using the proceeds to pay down debt as fast as possible.
The result of this widespread and rapid reduction in debt—economists say it has never occurred on such a grand scale before—will be the liquidation of financial institutions, the bankruptcy of individuals and an extended recession.
“We had an unprecedented degree of leverage over the past few years, and now we are running in reverse,” says Douglas Elmendorf, a senior fellow at the Brookings Institute. “Unfortunately, you can’t run in reverse, especially in the space of a year or two, without it becoming incredibly disruptive.”
Hedge funds are actively deleveraging, which helped to swing the Dow Jones Industrial Average by 1,000 points in a single day last month and contributed to unprecedented volatility. An increasing number of hedge fund clients, who are spooked by the economic downturn, have been asking to redeem their investments. That causes the notoriously over-leveraged funds to sell what investments they can. If enough clients redeem their money, the hedge funds will be forced to liquidate.

Buddy, Can You Spare A Trillion? FLYP sat down with expert Daniel Alpert to discuss the size of the problem. Watch the interview here.

“I would imagine that 50 percent of all hedge funds out there are going to go away,” comments Barry Ritholz, the head of research at Fusion IQ and a well-regarded blogger. “There was an enormous amount of wealth created on paper in the financial community, but the gains from the last five years were illusory.”
With the massive deleveraging and Wall Street spurring many types of debt, industries that depend on issuing bonds to help finance themselves are struggling. A key example is the credit card industry.
“Credit cards are the next shoe to drop,” says Elisa Parisi-Capone, lead analyst for finance and banking at RGE Monitor, a global economic analysis firm. With unemployment already at 6 percent and headed towards a projected 8 percent next year, more and more people will have trouble paying their bills. “Now that the labor market is turning, the financial crisis is becoming a real crisis, affecting all types of asset-backed securities, especially credit cards,” Parisi-Capone suggests.
The spreading of the crisis to new assets, large-scale deleveraging and the slowing of the overall economy are likely to cause the recession to last longer than economists had once hoped.
“There is a worldwide movement to deleverage, and this means that the recession is going to last a long time,” says Michael Cosgrove, a financial strategist at Dallas-based Econoclast.
“Because people and companies are busy trying to improve their balance sheets, they are selling assets, which lowers their value, and they are not taking on any more debt. This means that companies and people are making fewer purchases to help spur growth, indicating this will take time to play out.”

Fix It Now
By Alan Stoga

Solving the housing crisis is the key to stopping the economic meltdown.
In the beginning, there were falling housing prices, which begat the financial meltdown, which begat the recession. Despite the commitment of trillions of dollars of bailout money, housing prices are still falling—and so is the economy.
Increasingly, policymakers, bankers and economists are starting to think that solving the housing crisis is the key to stopping the economic and financial meltdown. Moody’s Economy.com estimates that 7.3 million homeowners are expected to default by 2010, with more than half of that number losing their homes.
Michael Barr, a law professor and former Treasury official, puts it bluntly: “We’re not going to get to the heart of the crisis unless we get to the underlying troubled mortgage loans.”
That realization has produced a wave of proposals to stop foreclosures and keep homeowners in their houses, something that the $700 billion bailout was not designed to do.
At the second presidential debate, John McCain proposed spending $300 billion to buy failing mortgages at their face values, and replace them with 30-year, fixed-rate mortgages. Barack Obama has proposed a 90-day moratorium on foreclosures while bankruptcy conditions are modified to make the restructuring of loans easier.
Both ideas lack detail and have been widely criticized for being unworkable in practice. There are no shortage of detailed alternatives.
Shelia Barr, chairman of the Federal Deposit Insurance Corporation, has proposed that the government provide partial guarantees to modify individual mortgages that are past due.

FLYP sat down with expert Daniel Alpert to get the details on his Freedom Recovery Plan. Watch the interview here.

The Congressional Budget Office is evaluating plans put forward by Martin Feldstein, Princeton Professor Alan Blinder and Columbia Professors Glenn Hubbard and Chris Mayer. All these proposals suggest that the government should get more directly involved in the mortgage business, which they say could cost anywhere from $340 billion to $1 trillion.
New York-based banker Daniel Alpert thinks he has a better idea—and one that would cost taxpayers a lot less. His Freedom Recovery Plan essentially would create tax and legal incentives to convert homeowners who can’t afford their mortgages into renters for five years.
It gives homeowners some ability to recover their freedom now when they’re completely under water with all this debt. And the lenders would receive payments in the form of realistic rents and “have the right to get their collateral back.”
But instead of selling foreclosed homes into a declining market—which reinforces the downward price spiral—or dumping empty houses onto the rental market, Alpert’s plan would keep people in their houses. After five years, “the renter/former homeowner would have the right to buy the home back.”

In FLYP’s interactive feature, read about a few of the most innovative proposals to fix the ailing housing crisis.

The biggest problem with Alpert’s proposal is the same one that hangs over any solution: the security structures that hold most mortgages effectively prevent restructuring. Barr points out that it’s almost impossible to get “at the underlying loan,” without which there is no solution. He and other experts agree that Congressional action is needed to make any of the restructuring proposals work.
Alpert, at least, believes that if we don’t act soon, “you’re going to see real crashes, panic crashes in the housing market.” The tragedy, he adds, is “that’s not necessary.”

Watch a video interview with Michael Barr on the legal challenges to the various proposals.