No LEVERAGE

May / June 2009 By Susan Webber

Why managers need to think differently about this economic crisis.

Susan Webber is founder of Aurora Advisors, a New York-based management-consulting firm. Her last feature article for the magazine was “The Dark Side of Optimism,” the January/February 2008 cover story.

Even in their worst nightmares, business leaders never thought they’d see an economy like this one. Many measures of economic health are flashing red. Unemployment has risen to over 8 percent, on a trajectory for further deterioration. Trade volumes have plummeted, with idled container ships parked in harbors all over Asia. The American consumer has suffered his greatest twelve-month fall in net worth—including during the Depression—and has stopped spending. Some experts think the housing market is only halfway through its price correction. And epitomizing the degree of dislocation, General Electric, a stalwart of American industry, didn’t merely cut its dividend and lose its AAA rating—it had to persuade analysts that it would even survive the crisis.

But the conundrum for executives isn’t simply the depth of the decline—it’s the disorientation. Forecasters and strategic planners are baffled: It’s well nigh impossible to plot a trajectory for business conditions over the next three years with any degree of confidence.

Some economists and analysts, as well as policymakers such as Federal Reserve chairman Ben Bernanke, maintain that the economy will bottom out this year and recovery will be under way by early 2010. Yet at its March meeting, the Federal Open Market Committee announced the radical step of embarking on quantitative easing—basically, printing money and injecting it into the private banking system—implying that the Fed saw the odds of further deterioration as high. While the central bank obviously hopes that this bold move will restart the engines of commerce, the Fed’s alphabet soup of innovative vehicles to revive the credit markets have thus far failed to halt the decay in the real economy.

How can a manager make sense of an environment so far out of normal bounds—and subject to unexpected and unprecedented government intervention? As sentiment and market indicators swing wildly, useful guidance is scarce to nonexistent. Forecasting is fraught with error even in the best of times, and these are not the best of times. We are in uncharted territory.

Or are we? Unfamiliar is not the same as untraveled. In fact, sad as it may seem, financial crises are common events by historical standards; the long, relatively stable period following World War II is an aberration.

Executives risk making costly errors by casting this downturn in traditional recession terms, and by planning ahead as such. Unfortunately, it’s human nature to project one’s experience onto new situations, which is why companies so often botch their entry into overseas markets. They not only assume foreign tastes are the same as back home—they reject advice from locals until disappointing sales lead them to reexamine their preconceptions.

Good and Bad Borrowing
One way to help yourself and your team avoid the pitfall of reacting to this contraction as if it were a more familiar phenomenon than it really is—and find some useful guideposts—is to focus on what makes this downturn different: leverage.

Both simple and more refined comparisons show that borrowings have grown faster than underlying economic growth over the past three decades. And while debt can help fuel economic growth, too much is a millstone.

A basic metric of aggregate borrowings is debt to GDP. In the United States, debt rose from roughly 160 percent of GDP in 1980 to the 220 percent level a decade later. Borrowings continued to grow, albeit at a more temperate rate, during the 1990-91 recession and for a few years afterward, and then picked up steam rapidly after 2000, to reach over 350 percent of GDP by 2008. Similarly, private debt was 123 percent of GDP in 1981 and rose to 290 percent by the third quarter of 2008. During the same period, household debt went from 40 percent of GDP to 100 percent.

And the United States was far from the only country having a debt party. The United Kingdom hit the 100 percent consumer-debt-to-GDP mark five quarters before the United States did. Australia, Spain, Ireland, the Baltics, and Eastern Europe have all seen rapid, destabilizing increases in debt levels.

But how does leverage turn toxic? Borrowing per se isn’t a bad thing when it is temporary—for a business, say, to deal with seasonality or compensate for slow payment from creditworthy customers. Indeed, it can be a plus when used for productive investments—for an individual, in education; for a business, in new equipment, advertising, product development. But borrowing can also serve simply to move future income into the present at the cost of interest payments.

Corporate leaders rationalized the practice as “expenditure smoothing”; lawmakers saw it as a boon to the economy. But it clearly went far beyond the point of occasional, responsible use. Yet remarkably, economists rationalized rising levels of consumer debt that went into consumption or housing, which does not qualify as a productive asset. This section from a 2005 Bernanke speech illustrates the mindset: “Some observers have expressed concern about rising levels of household debt. . . . However, concerns about debt growth should be allayed by the fact that household assets (particularly housing wealth) have risen even more quickly than household liabilities. Indeed, the ratio of household net worth to household income has been rising smartly and currently stands at 5.4, well above its long-run average of about 4.8. With real disposable income having risen over the past few quarters, most consumers are in good financial shape—a positive indication for household spending.”

The flaw in the logic is that rising debt levels are serviced by earnings, not by asset appreciation. If you discover a Picasso in your garage, you can borrow against it, but the only way to pay the interest is either from your income or the sale of the Picasso or other property.

It’s Not the Bubbles, It’s the Leverage
A contraction driven by a debt splurge is a different beast than a normal recession. And although there is no clear-cut definition of a depression, a credit unwind is a deeper, more persistent phenomenon than a garden-variety downturn.

A typical recession is the result of inventory cycles. Eighty percent of the reduction in GDP is the result of manufacturers’ inventory reduction. While the press often discusses tight lending conditions during a recession, those conditions serve to intensify it but are not a primary driver.

Similarly, asset bubbles that are not fueled by leverage are not terribly pernicious. Recall that the deflation of the spectacular dotcom bubble produced a comparatively mild hangover. Why? The excesses took place in equities, and (unlike the 1920s bull market) borrowing against stocks did not play a major role in the runup.

Economist Irving Fisher, whose reputation crashed with the stock market in 1929, was the first in his discipline to implicate excessive borrowing in deep slumps. It was he who had the vast misfortune to make history’s worst market call by declaring that stock prices had reacted “a permanently high plateau” two weeks before the Great Crash. Both blindsided and wiped out by the bust, Fisher set out to understand how such an unforeseen and inconceivable event as the Great Depression had come to pass. Even though his role as Roaring Twenties enthusiast tainted him with contemporaries (save John Maynard Keynes), his debt-deflation theory now has considerable respect within the profession. Irving wrote in 1933: “[I]n great booms and depressions, each of the above-named factors has played a subordinate rôle as compared with two dominant factors, namely over-indebtedness to start with and deflation following soon after; also that where any of the other factors do become conspicuous, they are often merely effects or symptoms of these two.”

Debt accumulation builds on itself, as the institutional and social inhibitions fall, but the process, like taking an amphetamine, in the early stages appears to improve performance. Consumers and businesses have more to spend, boosting overall activity.

But borrowings keep growing relative to incomes, and most important, debt-service costs keep rising too. The process breaks down when an increasing number of speculators buy assets with borrowed money, for they are unable to fully service the debt out of their own cash flow; they expect to either roll over the debt, borrow more, or sell their holdings to repay the lender. Asset prices eventually rise so high that near-term appreciation starts to look dubious. The owners of the leveraged properties move to the exits, starting a cycle of liquidation.

Levels of Intervention
Thus credit booms and contractions feed on themselves. Debt deleveraging gets a nasty accelerant from deflation. In the Depression, a debt overhang and deflation interacted in a particularly pernicious way. Businesses and consumers tried or were forced to reduce the size of their obligations, which meant they spent less on goods and services. The drop in demand in turn led to a generalized fall in prices, which made borrowers worse off.

Let’s say your company takes out a $1 million loan for ten years at a 7 percent rate of interest when inflation is 3 percent. Your real rate of interest is 4 percent, and you will pay back the loan in depreciated dollars ($1 million compounded forward by 3 percent inflation is $1.124 million, but you have to pay back only $1 million).

In deflation, the process works in reverse. Let’s say prices fall by 1 percent. Suddenly, your 4 percent real interest rate is now 8 percent. And the cost of your principal repayment rises rather than falls. Your lender would come out whole in economic terms if you paid him back only $904,000, but you are on the hook for the entire million.

And it doesn’t take a descent into Depression-style falling prices to produce this outcome. Japan in its post-bubble years suffered only mild deflation, but recent studies indicate that the economic costs have been considerable and lasting.

The only way out of a credit down cycle is via debt restructuring. This can be overt, via writeoffs and renegotiation, so that debt servicing is realistic relative to borrower incomes (think of the efforts to lower principal on underwater home mortgages). The other route is covert, in which government raises nominal incomes and reduces the real amount of debt by creating meaningful inflation. That is why the Federal Reserve has embarked on its program of quantitative easing. If done on a big enough scale, it is highly inflationary: Quantitative easing occurs when a central bank uses open market operation—in the Fed’s case, buying Treasury and Agency bonds—to increase the money supply.

What makes matters more complicated for executives struggling to make budgetary plans is that the economic outlook is far more dependent on government action than in normal times. Even the experts are uncertain as to how much intervention is needed. While modern economists have been trained to break glass and create inflation at the merest hint of oncoming deflation, there is little agreement on the nature and level of response. Different economists use different multipliers for various forms of fiscal stimulus. Opinion also varies greatly as to whether quantitative easing is necessary; most economists agree that a determined central bank can create inflation, but some worry about side effects. And a successful program of quantitative easing will create serious enough inflation that the Fed will be required to rein it in quickly, an even trickier operation than providing stimulus.

In addition, even if the authorities were confident of their road map, political considerations may block the best course. For instance, the evidence strongly suggests that recovery will require banks to take losses, rationalizing and recapitalizing the industry, and instituting regulatory reforms. Yet the way the United States has approached the problem—via bailouts—is costly, wildly unpopular, and likely to impede other fix-the-economy measures. The United States often criticized Japan for failing to take sufficiently bold steps to combat its deflation, but now that we are in a similar fix, we are repeating many of Japan’s moves; as that country learned, it takes a great deal of political will to implement reforms.

The likely outcome, nevertheless, is that the United States and other advanced economies will keep trying enough stimulus measures that growth will finally start to take hold. Such measures, of course, come at the cost of creating considerable government debt, explaining why both the United States (in 1937) and Japan (in 1996) applied the brakes too early. And while contemporary economists are thus for the most part urging the government to do more rather than less, others argue that the United States should scale back plans, since too much government debt doesn’t simply create a risk of inflation (and the need for a Volcker-style deep recession to wring it out) but also threatens rapid dollar depreciation, which would be destabilizing.

Too Much? Too Little?
Another way to assess how the crisis might play out is to look at historical precedent. In two recent papers, Carmen Reinhart of the University of Maryland and Harvard’s Kenneth Rogoff compared the United States to other countries that suffered severe financial crises in the postwar period. They found that the U.S. situation was comparable or worse than others in its pre-crisis conditions, and was tracking the typical path through the early stages of the credit crunch.

And how did those other countries fare? Not well: The fall in real GDP averaged over 5 percent, in advanced economies, and it took over three years from the trough to return to normal growth. Unemployment rose for nearly 5 years, and peaked at 7 percent over pre-crisis levels, which in the United States would be 11 percent to 12 percent. Housing prices took over five years to reach bottom.

None of which is encouraging. And keep in mind that past crises affected particular countries and regions. This crisis is global, and lacking a backdrop of global growth, recovery is likely to be slower to come.

Now, one can hope that the policy measures under way—fiscal stimulus and aggressive monetary easing—will keep the United States from having as bad an outcome as this. But there are reasons to be cautious and watchful. Most economists say that if the United States succeeds in jolting its economy back into growth, it is almost certain to produce an unwanted degree of inflation, which means the Fed will have to tighten monetary policy quickly. This is a tricky act, and the odds are high that the authorities will put on the brakes too soon, leading to a slide back into weakness, or too late, meaning it will take a severe, Volcker-style recession to wring out inflation.

A further complicating factor is the outlook for the dollar. Large fiscal deficits and quantitative easing are negative for the dollar, to the point where aggressively printing money could produce a disorderly fall. Indeed, Europe’s most respected macroeconomist, Willem Buiter, has advised the United States against pursuing the stimulus that would normally be deemed necessary for a slump as deep as the one we are in. His reasoning is that the United States is not a credible borrower, the stimulus will generate insufficient income to service the incremental borrowing, and too much additional indebtedness risks a collapse in dollar assets, which would be destabilizing globally. Better to undershoot and suffer suboptimal growth for a while longer than risk upending the world currency regime.

Where We’re Headed
As George Bernard Shaw famously quipped: “If all economists were laid end to end, they would not reach a conclusion.” But in all seriousness, how can a company navigate an environment in which the defusing of a massive credit bubble is taking center stage?

Despite the seeming complexity of possible outcomes, some things seem probable:
Recovery is likely to be slow in coming. Even if fiscal stimulus and quantitative easing succeed, monetary measures take time to have effect. The normal lag for monetary expansion to produce inflation is eighteen to twenty-four months. And fiscal measures in the United States and China are also back-loaded, again pointing to delayed benefits.

The days of the strong dollar are numbered. It is part of the typical response to a financial crisis to depreciate the currency. In fact, many students of the Depression believe that Great Britain’s decision to suspend the gold standard in 1931, which led to a sharp fall in the value of the pound, helped the country to recover faster than most major economies.

But aside from these two probable outcomes, much else is in flux. How should business leaders respond? Some ideas:

Work from a broader range of scenarios than normal. Most companies, whether formally or not, have a default strategic plan, and perhaps a downside contingency plan. But the fundamental nature of the environment three to five years out may be radically different depending on how events play out. And most people tend to gravitate to one view of the future, not multiple possibilities. It would be a worthwhile investment of time for heads of major operating units and corporate staff to work through the implications of different developments to preserve flexibility and reduce risk.

Focus on advice from experts who have done a good job in forecasting the downturn. As strange as it may seem, the press keeps turning to established pundits, even though most of them failed to anticipate the financial train wreck and then badly underestimated its seriousness.

Try to avoid being unduly influenced by noise in the news, and seek out the views of those who have been more right than wrong about this crisis. And be even more diligent than usual in getting behind the intelligence you get in your industry. Listen less for conclusions and more for the underlying conditions they are witnessing.

Keep an eye on cash, liquidity, and credit exposures. Cash is king in deflationary times. If you are one of the fortunate with ample access to credit, congratulations—but consider how quickly sentiment turned on General Electric.

In addition, it is important to watch credit exposures to customers, and avoid the pitfall of knee-jerk decisions. It is tempting to clamp down on terms across the board to reduce risk, but it you impair or kill customers who have good odds of pulling through, have you really come out ahead? While it is awkward to deal with customers that are slow to pay, in this environment, you ought to be able to get more disclosure about their financial condition than in normal times. Invest in understanding the health of important customers under stress.

For those in a strong financial position, consider acquisitions, particularly foreign opportunities. If your company has ample liquidity buffers and a conservative debt-maturity schedule, keep an eye out for attractive purchase candidates. Many private-equity firms entered into highly leveraged deals that will need to be restructured. Some will wind up in Chapter 11 and perhaps even Chapter 7 liquidation. Given the cautious business environment and limited access to deal funding, prices should be very favorable. And the negative outlook for the dollar suggests keeping an eye out for good foreign candidates.

After such a jarring deceleration, with many businesses forced to make sudden, drastic changes in operations and staffing, it is easy to either become overreactive or simply hunker down. Focusing on the deleveraging dynamic should give some guidance in making strategic and tactical choices. At a time when good options are hard to come by, it’s important to have a sense of where things might head—even if the experts disagree on which direction that is.