Before the credit crunch, firms and households expanded through ‘leverage’ – borrowing to buy assets. It worked provided asset prices rose as lenders knew they could seize and sell them should a client fail to repay interest and/or capital. ‘Deleveraging’ is this process in reverse.
The trigger was the credit crunch, which spawned falling prices for everything from houses and stocks to commodities.
Now over-indebted households, firms and hedge funds, many with falling incomes, can no longer find credit and are being forced to sell assets to repay even existing loans. This reinforces the downward trend in asset prices, leading to more loans being called in. The result is a vicious circle of economic contraction.
• See Tim Bennett’s video tutorial: Three ways leverage can boost your returns.