Friday, November 30, 2007
some observations on liquidity
Is it just me or are we witnessing the complete drying up of liquidity in the entire financial system? I ask you this because even treasuries are all over the place (this can't be good for Fannie (FNM)). Frankly, I am more scared about what is going to happen in the very near future than I have ever been in my life. Forget being bullish or bearish, I am talking about the financial system (the mechanism) being in huge trouble.
to which was responded:
The financial system, here in the U.S., is not functioning. It is burdened with debt and cannot take on any more. The wheels have stopped. Every ounce of new Fed liquidity (FL) is being sapped up by banks' balance sheets to fund declining asset values. There is no solution except for what we are seeing: massive write-offs by banks (which have just begun) to destroy the debt and required new capital.
This will spread, for there is debt everywhere. Certain governments around the world are flush with fiat foreign currency reserves and are now allocating that to investments in dollars for they have nothing else to do with it. But future appetite and trade dollars will evaporate as deflation kicks in, so this source of funds will dwindle over time.
Look for continued massive appreciation of yen over the dollar, massive bank write-downs, and years of deflation to unwind central banks' decades of inflation.
the real extent of the problem is far worse that appears at first glance because with the miracle of fractional reserve lending, money that was "borrowed into existence" was lent out over and over again.
This was not a problem until now. As long as asset prices are rising banks have plenty of capital to lend. But now that bank balance sheets are impaired there is a mad scramble for cash but there isn't much cash anywhere except of course China, Japan, and the oil states, all sitting on huge US dollar reserves and not knowing what to do with them.
In the end, Citigroup had to be bailed out by Abu Dhabi, an obscure country that no one had heard of until several days ago when petrodollars returned home. Expect to see more cash infusions like that, because there is little cash to be found here.
i've been mentioning petrodollars since reading some fine private research early this year.
i recently read a very interesting paper that addressed the mechanics of low interest rates -- why they are low and have stayed low, why volatility is low -- in an effort to give insight on an eventual rise. it maintained convincingly that oil money -- cash paid by the west for oil -- has been returning to western economies directly (from the mideast and russia) and indirectly (from asian central banks) as asset purchasing power, particularly the purchasing of treasury debt and the aforementioned cdo's. as oil prices have risen -- tripling since 2003 -- the windfall has ever more aggressively been reinvested to keep rates down in spite of heated economic growth and the rising threat of inflation that has seen the federal reserve bank raise interest rates 13 consecutive times (inverting the yield curve). this amounts to literal billions flowing into western capital markets annually since 2003 -- enough to also reflate global capital markets post 2001-2, narrowing credit spreads and risk premia (i.e., boosting stock markets) because oil money tends to be riskier capital. the similarity is to the 1970s, except that whereas oil savings influx abetted wage inflation (the 'real' economy) then it abets asset inflation (the financial economy) now -- a product of our structural development from an industiral to a service economy.
on this view, the rise in global oil prices amounts to a massive wealth transfer from oil importers to oil exporters -- the asset value of oil in the ground has risen by a nominal $50bn. that wealth transfer requires a corresponding markdown on western balance sheets -- one that in the 1970s was facilitated by inflation destroying the value of western assets in real terms even as they held steady in nominal terms. in this incarnation, however, not only has the markdown not yet come -- it has been preceded by a period of interest rates suppressed by recycled petrodollar income which has encouraged a massive debt buildup that will because of the level of debt involved quite possibly require a severe debt-deflation depression to correct. even if it does not -- for, say, western monetary policy reasons -- the resultant avenue of correction will be runaway inflation. either way, a large expansion of risk premia is due -- either way, credit spreads and real interest rates will increase dramatically.
this correction is to be expected once the asset-burgeoning effects of oil revenue investment inflows recede. this can result from either a collapse in oil revenue reinvestments (oil price collapse, greater spending than saving in oil exporting economies) or in a forced delevering of petrodollars removing the amplification of purchasing power (as was engineered in 1981 by fed chairman paul volcker -- this latter may now require a broader view of inflation than the fed now takes, one which includes energy and asset prices). but the telltale indication is likely to arrive in expanding credit spreads, which have remained narrow in spite of yield curve inversion thanks to the abundant liquidity of petrodollar recycling.
of course that petrodollar put has accelerated as oil has teased $100/bbl, but the wealth transfer to third-world economies that have been engaging in 'vendor financing' is now, having decided to no longer fuel the incredible bubble in american mortgage debt market, buying american banks and will probably be buying hard assets of all kinds in coming years. (and, lo, credit spreads have indeed widened dramatically!) said minyan peter, the sort of bid that went into citi is sign of the early stage of the game that we are condemned to play by our own profligacy.
and, as noted, we need the money very badly indeed and should welcome it as the necessary recapitalization of the financial system it represents. hope for more, and quickly! as can be seen through big picture and the new york times, bank capital inadequacy is having massive ramifications already.
Credit flowing to American companies is drying up at a pace not seen in decades, threatening the creation of jobs and the expansion of businesses, while intensifying worries that the economy may be headed for recession.
Not once in the years since the Fed began tracking such numbers in 1973 has this artery of finance constricted so rapidly. Smaller declines preceded three recessions going back to 1975; at other times such declines tended to occur in conjunction with an economic downturn.
the situation is looking bleaker for many businesses. Already, companies in everything from furniture manufacturing to Web site design are tightening their belts, delaying expansion and scrambling for other sources of cash.
“This is a very big deal,” said Andrew Tilton, a senior economist in the United States Economic Research Group at Goldman Sachs. “You’re basically crimping the growth of the more vulnerable companies. If they can’t borrow the money, their options are much more limited. They’d have to have less ambitious hiring plans, buy less machinery and cancel projects.”
In recent years, a lot of commercial lending was inspired by an upward spiral of enrichment: banks made new loans, then swiftly sold them off for profit, using the proceeds to extend still more. But with much of the financial world unnerved by the mortgage meltdown, buyers for commercial loans are scarce.
“Since the resale market went away, major banks have had much less availability to make loans,” said Mark A. Sunshine, president of First Capital, a private commercial lender. “Absolutely, credit is much less available.”
the question is: will foreign entities (such as sovereign wealth funds) offer enough cash, soon enough, to prevent the disorderly collapse of the american economy into a debt-deflation spiral of rampant credit contraction -- one that will likely drive off further bids and recapitalizations? or could they?
i frankly doubt it. from brad setser -- appropriately called "scary graph" -- it's clear from recent TIC data that despite anecdotal instances like abu dhabi's investment, global capital is generally beginning to flee the united states for the first time in more than a decade.
mish again, noting the horrifying pressure building up in the international banking system as exemplified by libor spreads, and passing on this wise quote from fil zucchi of minyanville in december of 2006 with his own comment appended.
As central banks rain liquidity (credit) down on markets, its long range effects eventually cause the very thing central banks are trying to avoid: deflation. The reason people don’t understand this is that it is cumulative; the accumulation of debt is in itself inflationary, but at a certain point it becomes unmanageable. Why is this?
Easy or free money (when central banks drive real interest rates below inflation rates) is irresistible. It wouldn’t be if people managed risk properly but they do not. Easy money causes competition for “projects” to increase; companies with free money take risk with it for less and less return. I am seeing deals getting done in LBO-land and commercial real estate being built using very aggressive assumptions and low cap rates. With all that “money” out there, rates of return drops dramatically. Everyone is starved for income.
At the very time income and returns are dropping, debt is increasing. Less income with more debt means that eventually it gets impossible to service that debt.
Well here we are. It has become impossible to service that debt. Massively rising foreclosures in the residential sector should be proof enough. And the downturn in commercial real estate has just started. Bank capital is severely impacted already and supposedly we are not even in a recession yet. We soon will be and watch what happens to unemployment rates and additional credit impairments when we do.
The problems are now so huge that it does not matter what the Fed does with interest rates. Asset prices are dropping like a rock even though the stock market has not yet gone down for the count. With the enormous leverage in the system, credit and capital is being destroyed at a very fast clip and it will be destroyed at an even faster clip once the stock market and corporate bond market head south in a major way. Both will.
A key point in this mess is that the Fed cannot provide capital (drop money out of helicopters), all it can do is provide liquidity. However, liquidity is not the problem here, solvency is.
again, i have the distinct impression that what is transpiring here is more than a slowdown, and probably more than a run-of-the-mill, 1990-style recession. it's a good time to get out of debt and hoard your cash, being very particular about the assets you choose to own.