A $5 Trillion Bailout

Implications: The US government has finally decided to nationalise the two home loan giants.  Between them, Fannie and Freddie guarantee 47% of all US mortgages, worth around $5 trillion - equivalent to the combined GDP of the UK and France.  High leverage makes earnings and management look wonderful whilst things are going well, but it also (as we now see with Fannie/Freddie), makes bankruptcy much more likely in the down cycle.

Analysis: Deleveraging is an ugly word, and it has ugly implications.  Banks and other lenders are now scrambling to get back to more prudent lending levels.  They therefore have to cut back on loans, and raise more equity capital.   

This process would be difficult enough in normal times.  But now it is being undermined by the losses recorded ($514bn to date, according to Bloomberg), on the loans made during the boom times.  This causes banks to have to raise more capital, to replace that already lost – creating a vicious circle.  

Housing markets have borne the brunt of this deleveraging so far.  The chemical industry has therefore been badly hit, as housing is the largest single market for chemicals.  Each new house uses over $16k of chemicals (window frames, pipes, drapes, floor coverings, kitchen/baths, adhesives, paints/coatings etc).   

But deleveraging has other implications for chemical companies. Banks now need to cut back on corporate lending, to preserve their equity capital. Small companies have already seen overdraft limits cut back. Next, it will be the turn of larger companies.  

This could be very painful. As recently as a year ago, you could still find chemical companies who had convinced themselves that cyclicality was no longer a problem. As a result, debt levels were often much higher than considered prudent when I joined the industry.  

This high leverage boosted chemical company earnings during the boom period. But as we go into the 'down' cycle, leverage will exert its same impact on the downside.  

Chemical company CFOs will be very busy people in the next few months, as they seek to identify and manage their credit risk.