Deleveraging is a term that emerges during and after economic turmoil, whether it is a recession, a general recession, or a depression. In most cases, it applies to individuals or consumers who are trying to clean up their balance sheets. But it can also be used to describe the financial status of companies and even governments. But what does this mean? What are its consequences? Okay? Is it not good? Who has it helped and who has it hurt? To unravel the mystery of deleveraging, it helps to start with the antonym: leverage.
- Deleveraging occurs when a company reduces its financial leverage or debt by raising funds, selling assets, and/or cutting back when necessary.
- Deleveraging strengthens the balance sheet.
- With the collapse of these fixed-income investment markets, the balance sheets of debt-laden companies may face a major blow.
- When deleveraging affects the economy, the government will step in, use leverage to purchase assets and set price bottom lines, or encourage spending.
What is leverage?
Leverage has become an indispensable part of our society. The term refers to the possibility of using borrowed funds to increase returns. Companies use this strategy to fund their operations, fund expansion, and pay for research and development (R&D) expenses. By using debt, companies can pay bills without issuing more shares, thereby preventing shareholder equity from being diluted.
For example, if a company is established with an investor’s investment of 5 million U.S. dollars, the company’s equity is 5 million U.S. dollars—this is the company’s funds for operations. If the company borrows 20 million US dollars to further consolidate debt financing, the company now has 25 million US dollars to invest in capital budget projects, and there are more opportunities to add value to a fixed number of shareholders.
Leverage becomes a bit complicated because there are two main types of leverage that can be used: operational leverage and financial leverage. Operating and financial leverage makes income and profits more sensitive to the business cycle, which may be a good thing in periods of economic expansion and may be a bad thing in periods of economic recession. The essence of the problem is that leverage equals debt equals interest payments.
What is deleveraging?
The old adage “all things in moderation” is fully applicable to the concept of leverage. When companies use leverage overdue, they will get into trouble because they pay too much interest. This is when deleveraging-getting rid of debt-comes into play. So what exactly is it?
The term refers to the point in time at which a company attempts to reduce its financial leverage or debt. The best way for companies or individuals to do this is to repay any or all existing debts. This can be achieved by raising funds to clear debts on the balance sheet, or by selling assets to raise funds. Without deleveraging, the entity may default on debt because the burden may become unsustainable.
Handle with care
From a business perspective, deleveraging can strengthen the balance sheet. Getting the company back on track is a reasonable course of action. However, from a practical point of view, deleveraging is not that wonderful. When implementing a deleveraging strategy, layoffs, plant closures, R&D budget cuts, and asset sales are all natural, as the company seeks to retain additional cash to pay off debt.
Deleveraging may require layoffs, plant closures, budget cuts, and asset sales.
Wall Street usually embraces successful deleveraging with an enthusiastic embrace. The announcement of large-scale layoffs led to a decline in corporate costs and a rise in stock prices. However, deleveraging does not always go according to plan. When it is necessary to raise funds to reduce debt levels to force companies to sell assets they do not want to sell at fire-sale prices, the price of company stocks is usually affected in the short term. To make matters worse, when investors feel that a company has bad debts and cannot deleverage, the value of that debt will plummet further. Then the company was forced to sell at a loss if they could.
Toxic debt and deleveraging
Failure to sell or repay debts can lead to business closure. As these fixed-income investment markets collapse, companies that hold toxic debts from bankrupt companies may face a major blow to their balance sheets. This was the case for companies that held Lehman Brothers’ debts before its collapse in 2008.
Banks must reserve certain percentages of their assets to help fulfill their obligations to creditors, including depositors who may request withdrawals. They also need to maintain a certain ratio of capital to debt. In order to maintain these ratios, banks will deleverage when they fear that loans will not be repayable or the value of their holdings will fall. When banks worry about getting repaid, loans slow down. When loans slow down, consumers cannot borrow, so they cannot purchase products and services from businesses. Similarly, companies cannot expand through borrowing, so recruitment slows down, and some companies are further forced to sell assets at discounted prices to repay bank loans.
If many banks deleverage at the same time, stock prices will fall because companies that can no longer borrow from banks will revalue the assets they are trying to sell at discounted prices. As investors are reluctant to hold bonds of troubled companies or buy investments in packaged debt, the debt market may collapse.
Deleveraging comes at a price
When deleveraging caused a downward spiral in the economy, the government was forced to step in. The government borrowed or borrowed to purchase assets and set a price floor, or encourage spending. This can take many forms, including buying mortgage-backed securities (MBS) to support housing prices and encouraging bank lending, issuing government-backed guarantees to support the value of certain securities, holding financial positions in bankrupt companies, and providing direct consumption Those who receive tax refunds, subsidize the purchase of electrical appliances or cars through tax credits or many other similar activities. The Federal Reserve (Fed) can also lower the federal funds rate to reduce the cost of borrowing between banks, lower interest rates, and encourage banks to lend to consumers and businesses.
When the commercial sector deleverages, the government cannot continue to assume leverage forever because government debt must eventually be repaid by taxpayers. The situation quickly becomes complicated, and there is no simple answer. Effective economic policies must be implemented accordingly to compensate for the downward spiral.