There is an eerie moment before a tsunami hits when the water retreats from the beach. The water is sucked out to sea, leaving the fish flapping and the seaweed exposed as the tsunami gathers itself before rushing in to destroy all in its path.
In years to come, investors and economists alike will see this year as
the year debt was sucked back out of the world's thriving financial and
This year will be seen as that moment before the tsunami of the worst
recession in 80 years wreaked havoc on the global economy for at least
the next decade.
It's worth explaining how de-leveraging works and why it is such a powerful force.
Over the past six years interest rates were kept low globally in the wake of the 9/11 attacks and investment banks in the Northern
Hemisphere were let off the leash to indulge in massively leveraged
lending to all and sundry for all sorts of assets.
The most popular type of lending was home mortgage lending to consumers by banks and pension funds either directly or through a number of intermediaries using securitisation and "insured" lending backed by
investment banks and insurers using strong credit ratings.
The power of that leverage was enormous. It doubled house prices in
most Western property markets over that six-year period.
Estimates vary about how much borrowed money was pumped into property
markets over that period. Some estimate it was at least US$3 trillion ($5.8 trillion).
Others point to the value of Credit Default Swap instruments outstanding at the end of last year of US$600 trillion as a fair estimate.
I think a number closer to US$15 trillion is more accurate.
That is about 534 times New Zealand's annual GDP. It's a number too big to comprehend.
But what we're seeing now is a good portion of that money being sucked back out of the property market either through force or through debt not being rolled over.
Sucking the money back by force through mortgagee sales, foreclosures and liquidations is the most dangerous type of de-leveraging.
This is what has caused so much havoc on global financial markets in the past six months.
The de-leveraging debt spiral goes like this.
Borrowers can't pay their interest. The lender is forced to book a provision for the lower value of the loan. This reduces their equity capital to back their other loans.
The bank is forced by investors, depositors or regulators to raise fresh
capital to ensure its capital backing is strong enough to keep its credit rating or retain its special status as a bank or just retain confidence.
If they can't raise fresh capital they must raise cash by liquidating the loan. They force a mortgagee sale or foreclosure.
That drives down asset prices, which in turn forces the bank to acknowledge lower asset values across its entire loan book.
This forces more capital raisings or asset sales.
You get the picture.
It is a debt death spiral that can only stop when asset values stop falling or capital has been replenished with enough cash. Essentially, this is the de-leveraging tsunami that sucks debt out of the property market and then destroys the value of that property.
New Zealand's banks borrowed $72 billion from foreign banks and investors in the five years to 2008.
It virtually doubled house prices. Some of that will be sucked back home
over the coming decade.
This is the reason I believe house prices will fall 30 per cent from their peaks of last year and not recover to that level for another
Bernard Hickey is the managing editor of www.interest.co.nz, a website for investors and borrowers wanting free and independent news and information about interest rates, banks, finance companies and the economy.