Big Debt Crisis Flashcards
If a country has a lot of debt, what 3 factors is the magnitude of this risk dependent on?
1) The ability of that country to spread losses over time (low rates, long terms)
2) Whether or not currency is denominated in currency they control (ability to control rates and/or inflate away debt through printing money)
3) If they can influence how creditors/debtors behave with each other - ?
What typically happens in an upcycle?
1) Borrowing (credit) lifts incomes, rising incomes lift spending, rising spending lifts creditworthiness, rising creditworthiness lifts borrowing etc.
2) Rapid growth to fund infrastructure (followed by abrupt decline when infrastructure spending dries) typical of emerging markets
What are the biggest risks during a debt crisis?
1) Failure of policymakers to know the right thing to do
2) Political consequences of hurting some/helping others and delay
What are the 4 levers policymakers have to pull in a downturn?
1) Austerity
2) Debt Defaults/Restructurings
3) CB Printing Money
4) Transfer of money from haves to have nots (via taxes)
What are characteristics of the short term debt cycle?
1) Central Bank can manage with monetary policy
2) Less extreme
3) Self constrained by borrowers and lenders to some degree
4) Debt/Income ratios bottoms and tops are always higher than previous cycle in upcycle
What happens during a deflationary depression?
1) Typical when debts denominated in own currency (otherwise likely inflationary)
2) Central bank can no longer lower rates to stimulate growth
3) Debt restructuring and austerity dominate without stimulus at the expense of credit and growth (error)
4) Debt as % of income actually grows as incomes decrease
What happens during an inflationary recession?
1) Typical when a countrys debts are denominated in foreign currency they don’t control
2) Capital withdrawal of foreign flows from exogenous factors causes lending to dry up
3) Countries print their own money to fund deficits required to stimulate growth as external lending dries up
3) Currency devalued as money supply increases and foreign investors are no longer buying the local currency (net sellers as they leave)
4) (Above 3 combine to produce price inflation)
Deflationary Debt Cycle Phases
1) Early Phase - Debt burden low, goldilocks phase
2) Bubble - avg 3-4 yrs, debts rising faster than income
3) Top - avg 1 year, triggered by CB rates rising or foreign exogenous factors if debt denominated in foreign FX
4) Depression - avg 3-4 years, triggered by policymakers not doing enough quickly enough
5) Beautiful Deleveraging - avg 3-4 yrs
6) Normalization
What is typical of the beginning of a bubble?
1) Overleverage, asset/liability mismatch
2) Borrowing short term to lend long term
3) Liquid liabilities to invest in illiquid assets
4) Investing in riskier debt w/ borrowed $
5) Borrowing in 1 currency, lending in another
What is typical of a general bubble?
1) Debt to income levels: Avg increase 40%, range 14-79%
2) Debt increase: Avg 32%, range 17-45%
3) Income growth: Avg 13%, range 8-20%
4) Equity market growth: Avg 48%, range 22-60%
5) Yield curve flattening (SR-LR): 1.4%, range 0.9-1.7%
What is a fundamental flaw with traditional monetary policy?
1) Reluctant to tighten when some asset prices are booming and inflation (esp core) is OK. Japan 1980’s, world in 1930’s and 2000’s.
2) Some bankers feel it’s not their job to control bubbles, but impact of some bubbles going bust is massive and are always a function of credit and money
What to look for to identify a bubble?
1) Prices higher relative to traditional measures
2) Prices discounting future rapid price appreciation
3) Broad bullish sentiment
4) Purchases financed by leverage
5) Buers have made exceptionally extended forward purchases (inventory, supplier contracts etc.)
6) New buyers enter market
7) Stimulative monetary policy adds to bubble
What is needed to anticipate debt crisis well?
1) Analysis of debt service abilities of specific sectors
2) Forecast of cascading losses from busts in those specific sectors
3) Even if avg debt/income levels are higher, this is less problematic if spread across multiple sectors
What happens during a debt cycle top?
1) % of new borrowing goes to pay debt service, emerges in some sectors 6 mo before peak in vulnerable places
2) Credit spreads tick up (riskiest first)
3) Yield curve flattens or inverts (long down, short up) incentivizing savings and cash
4) Hard to observe, some areas of economy remain fine
5) Fastest rates of tightening typical 5 months before top
6) Unemployment at cyclical lows, inflation rates start to rise
7) Slows demand as items bought on credit more expensive)
8) Short rates peak just before the top
What falls first in a bubble burst?
1) Wealth. Stock declines often misinterpreted as good opportunities when asset values decline, but really an early indicator of income decline.
2) Wealth constricts, credit dries up, investment dries up, spending dries up, asset values decline (wealth constricts)
What was the major difference between the great depression and the 2008 financial crisis?
1) In great depression, slower to ease monetary policy and create fiscal stimulus
2) In financial crisis, quickly dropped rates to 0 and used other measures to stimulate
What issues do depressions cause with institutions, and how are they attenuated by policymakers?
1) Solvency - Accounting rules or equity infusions or MnA
2) Cash Flow - Fiscal or monetary policy infusing cash
What happens to the investor class during a depression?
1) Equity prices decrease an average of 50%
2) Taxes increase
3) Earned income falls
4) Become defensive, move money out of country or into hard stores of value
What is the problem with austerity during a crisis?
1) Cutting spending further decreases incomes
2) Raising taxes further decreases incomes
3) Both above are always mistakes
What must a government do quickly when providing monetary stimulus?
1) Curtail panic and guarantee liabilities
2) Provide liquidity - lending against wide range of collateral or institutions
3) Support solvency of systemically important institutions
4) Recapitalize/Nationalize/Cover losses of systemically important institutions
How many bear market rallies occurred during the great depression? What were the gains during the bear market rallies?
- 6 bear market rallies, gains between 16-48%
- Ultimately market declined 89%
What happens when policy makers are effectively managing debt defaults and restructurings during a crisis?
- Swiftly recognize magnitude of problem
- Don’t save every institution that is expendable
- Create or restore robust credit pipes
- Ensure acceptable growth and inflation conditions while bad debts are worked out
- SPREAD PAIN OVER LONG TERM WHERE NECESSARY
What are the two ways failed lenders assets are managed?
- Transferred to separate entity (Asset Management Company, AMC). Better to isolate problem assets so previous entity can continue.
- Remain on Balance sheet of lender
What were the two periods where the wealth gap grew in the U.S. the most based on what measurement?
- Great depression and now (2020)
- Top 0.1% own as much as the bottom 90%
