Types of Deleveraging
Any entity, a consumer, a business, an investor or even a government can undergo the process of deleveraging. Here are how different types of deleveraging works.
Deleveraging for Consumers
Consumers take on debt for many different reasons. That could include mortgages, auto loans, or credit card debt. Sometimes economic conditions or a household’s own financial situation can make the size of the debt difficult to manage. That’s when consumers can consider deleveraging. While a shift from spending to servicing debt may be the most common form of deleveraging, other ways consumers can deleverage is by taking on less new debt or even writing off old bad debts. One way for consumers to measure their leverage is by looking at their household debt service ratio. That is calculated by dividing the total quarterly household debt payments by the total household disposable income. Consumer deleveraging can also be used in a macro-economic context. When households in an economy start paying off debt en masse, it is called deleveraging. Typically, when this happens, consumer spending falls, because funds that could be spent are used to pay down credit cards or auto loans instead. An example of consumer deleveraging is the Great Deleveraging that followed the Great Recession of 2008. Total household debt doubled from 2000 to 2008, then consistently fell through 2014. Less new debt was issued and existing debt was paid off; consequently, consumer spending fell and the savings rate went up. In fact, the savings rate in the U.S. more than doubled from a low in 2005 to 2011. Some economists believe that consumer deleveraging is harmful to the economy—it reduces GDP after all. When consumers don’t spend, business revenue goes down and employees are laid off. On the other hand, some economists believe that consumer deleveraging and an increased savings rate is a benefit to the economy over the long term. Economies grow by building up capital, and capital can only be built up with savings.
Deleveraging for Governments
Governments borrow money to spend on public programs (among other needs), and government debt usually is considered safe. However, governments also need to deleverage if they find themselves in positions where the amount of money they borrow becomes untenable. A default on debt by a government could have far-reaching economic consequences.
Deleveraging for Businesses
Leverage in businesses can be measured using a leverage ratio such as debt/equity. The ratio is calculated by dividing total liabilities by total stockholders’ equity. Anything over 2 is generally considered overleveraged.
Portfolio Deleveraging
Institutional investors such as hedge funds often have highly leveraged positions. In times of market volatility, leveraged positions can lead to losses. Portfolio deleveraging then is used by such investors to pare down risky positions.
What It Means for Individual Investors
Leverage in itself is not necessarily a bad thing; it’s the opportunity cost that matters. It’s possible to have a highly leveraged personal balance sheet if, for example, you just bought a house. But that house payment replaces a rent payment and will eventually be a big unencumbered asset. On the other hand, individuals who don’t own a house but have a lot of student loans, credit card debt, or auto debt would probably be better off deleveraging. It’s easy to find out. Over the long run, the S&P 500—the representative index of the stock market—has delivered almost 10% per year over a 10-year period as of October 2022. If you have a car loan with a 2.5% rate or a student loan with a 4% rate, it’s an easy choice whether you should pay down the debt or invest in the stock market. Depending on your financial situation, you might be able to chip away a little toward both investment and paying down debt. It may also make sense not to deleverage if you are saving for an emergency fund or putting funds into an account to be used for a future down payment. The key is to be mindful with your money and deleverage when it’s the best option for you.
