When loan values drop and net worth declines, firms reduce lending in a process called:

Question

BlackTom AI · Accepted Answer

Deleveraging is the process by which firms reduce their leverage—cutting back lending, selling assets, or paying down debt—to restore balance-sheet strength after asset values fall.

Relevant concepts:
- Leverage measures the degree to which a firm uses borrowed funds (debt) relative to its equity. Common measures include debt/equity or assets/equity.
- When asset (loan) values decline, equity (net worth) falls because equity = assets − liabilities. A lower equity base raises leverage even if debt is unchanged.
- Deleveraging is the deliberate reduction of leverage (reducing debt or lending) to lower risk.

Step-by-step reasoning with a numerical example:
1. Start: assets = 100, debt = 70 → equity = 30. Debt/equity = 70/30 ≈ 2.33.
2. Asset value drop of 20%: assets = 80, debt still 70 → equity = 10. Debt/equity = 70/10 = 7. Leverage has sharply increased because net worth fell.
3. To reduce leverage, the firm deleverages: it sells assets and uses proceeds to pay down debt or simply cuts new lending. Suppose it sells 20 of assets and repays 20 of debt: assets = 60, debt = 50 → equity remains 10. Debt/equity = 50/10 = 5. Leverage has fallen from 7 to 5, demonstrating reduced lending/borrowing exposure.

Why the correct choice is d. deleveraging:
- The scenario describes lower loan values and declining net worth prompting firms to reduce lending/exposure—this is precisely deleveraging.

Why other options are incorrect:
- a. Releveraging means increasing leverage, the opposite of the described action.
- b. Capitulation refers to surrendering in markets (panic selling) but does not specifically mean reducing lending due to falling net worth.
- c. Deflation is a general decline in price levels across the economy, not the firm-level reduction of lending.

Conclusion: The correct answer is d. deleveraging, which matches the provided answer.

When loan values drop and net worth declines, firms reduce lending in a process called:Single choice

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