The 2007 Credit Crunch Liquidity Crisis - Q&A
Stock-Markets / Credit Crunch Aug 24, 2007 - 01:59 PM GMTBy: Andy_Sutton
In lieu of my usual column, I've opted for a co-authored, in-depth analysis of the current liquidity crisis. Despite the fact that the media would prefer to ignore it and focus on the various bailouts being planned or executed, this is a crisis that still poses a very real threat to the economic and banking systems of the world.
Is the current stock market correction a healthy correction, or the start of a bear market?
It's hard to say, because of the mysterious and counterintuitive way that US stock markets tend to recover in the late hours of trading, after stock markets around the world were plunging the rest of the day. There is clearly not the high degree of transparency that small to medium investors need to make sound investing decisions. Perhaps one of the biggest misconceptions with regards to the stock market is that securities are priced fairly. To a large extent, markets run on emotion, and therefore, are inefficient. Today significant portions of the markets are run by computer models and therefore are perceived to be perfect. However, the computer software is only as good as the person writing it. The software often carries the biases and perceptions of the programmer. Instead of trying to predict the future of what the stock market will do, ask yourself if you can think of more rational and more productive ways to make money than trying to buy electronic tokens from each other and later sell them to each other at higher prices.
What caused this recent crisis to happen?
The stock market volatility is being caused by lower-than-usual amounts of ready cash, or in other words, a liquidity crisis. Liquidity means that enough cash is available for assets to trade hands without the sellers taking a significant loss. Liquidity is what the world's financial network is lacking at the moment.
The liquidity crisis happened because of questions regarding the value of several types of securities, which in turn had been used as collateral for outstanding loans. One of the securities in question is the CDO, or Collateralized Debt Obligation . What happens is that investment banks sell interests in a pool of mortgages. The value of the underlying bonds is derived from the expected future cash flow from the mortgages that make up the bond. When these bonds were packaged together, a certain percentage of the underlying mortgages were expected to default and end up in foreclosure. The pool of mortgages was divided up into groups called tranches; each tranche corresponded to different levels of risk and reward. The highest rated tranches had the highest priority for repayment of principal, and the lowest interest rate offered, while the lowest-rated tranches had the lowest priority for repayment of principal but the highest rate of interest offered. However, what we have seen is default and foreclosure rates higher than those assumed. These additional defaults and foreclosures have reduced the future cash flows. Once that happens, it becomes inherently obvious that the bonds are no longer worth the price on the books.
The main problem with this scenario is that some of the mortgages should never have been made in the first place. The reason that they were is because in a fiat money system where credit can be created on demand, investors armed with limitless supplies of borrowed money will tend to bid returns on investment down to absurd levels. Eventually lenders become desperate for new borrowers, and will make irresponsible loans, and then try to sell interests in these to someone else as quickly as possible. The high-risk tranches are popularly known as toxic waste.
They were able to find suckers to buy interests in these loans because major Wall Street credit rating companies were giving investment-grade ratings to high-risk tranches.
Have there been any liquidity crises in the past?
Yes, many. Ironically, one of them, the Banker's Panic of 1907, was the excuse given to create the Federal Reserve. The operations of the Federal Reserve were supposed to prevent such things from happening.
In the case of the panic of 1907, the stock market crashed twice, there was a recession, and there was a run on the banks.
Doesn't FDIC insurance mean that bank deposits are safe now?
FDIC insurance isn't really insurance, it's a pool of money to be used to buy up enough bad loans off the failed bank's books to make it attractive to a potential buyer. It's not used to pay back the depositors .
It only works when bank failures are isolated events, and will not work in a systemic crisis.
The purpose of FDIC insurance is not to really guarantee the safety of the banking system, but to prevent runs on banks by reassuring investors that their accounts are insured. Bank failures, however, are not really an insurable event.
What's different about the liquidity crisis this time?
The biggest difference is that in this case, the crisis is on a global scale due mostly to displaced dollars as a result of our persistent trade deficits. For years we have been importing more than exporting. This has resulted in many foreign countries ending up with a growing excess of US Dollars in their coffers. Instead of holding onto the cash, they invested in government bonds, agency debt, US stocks, and unfortunately, CDO's. CDO's were especially popular due to the high credit ratings coupled with attractive interest rates.
The market for US mortgages is over $9 trillion dollars. To put this in perspective, it is more than the entire indebtedness of the US government. US GDP is around $13 Trillion. The total supply of money in the US system (M3) is around $12 Trillion. So it is easy to see the enormity of the US mortgage market. Granted, many of those loans are prime loans, and the borrowers faithfully make their payments each month.
The biggest threat right now is that we are seeing this crisis coupled with a slowdown in the overall US Economy. As recently as 8/16, the Philadelphia Fed Survey indicated that overall business conditions in the Northeast are at a stall. Retail sales are slowing down, and if you consider that the numbers reported are actual dollars, not units sold, retail sales are flat to negative already.
What has the Federal Reserve done in response to the crisis?
The Federal Reserve conducted several repo operations in which they injected billions of dollars into the banking system. Repos are temporary swaps of collateral for cash. The Fed found that because only quality collateral is used in repost that banks were using the repos to get liquid, then holding the cash. This was done as a defense against further liquidity crunches. The only problem with the repos is that the institutions that really needed the loans couldn't get them because they lacked quality collateral. Once this became evident, the Fed switched to the Discount Window method.
Quoting from their own press release: To promote the restoration of orderly conditions in financial markets, the Federal Reserve Board approved temporary changes to its primary credit discount window facility. The Board approved a 50 basis point reduction in the primary credit rate to 5-3/4 percent, to narrow the spread between the primary credit rate and the Federal Open Market Committee's target federal funds rate to 50 basis points. The Board is also announcing a change to the Reserve Banks' usual practices to allow the provision of term financing for as long as 30 days, renewable by the borrower. These changes will remain in place until the Federal Reserve determines that market liquidity has improved materially. These changes are designed to provide depositories with greater assurance about the cost and availability of funding. The Federal Reserve will continue to accept a broad range of collateral for discount window loans, including home mortgages and related assets…
In other words, the Federal Reserve lowered the interest rate at its discount window, will accept the toxic waste as collateral (they have no reason not to, since the credit they use to buy the collateral isn't real money that they had to work for), and are encouraging banks to get loans from them.
Will lowering the interest rate at the Fed's discount window solve the problem?
No. The discount window is still a higher rate than the federal funds rate, so the only banks that have an incentive to apply to the federal reserve for loans are those banks that are being turned away from other banks. This smacks of desperation, but it doesn't solve the problem of collateral that is worth significantly less value than it's on the books for. If the central banks just keep rolling the loans over and over again, first of all that creates moral hazard (an incentive to do the wrong thing), and second, it amounts to monetizing worthless debt, or in other words, it causes inflation and lack of confidence in the currency.
On top of this hazard, the Fed is going to be faced with the reality of a recession in the near future. Monetizing junk mortgages and cutting rates at the same time to spur the economy is likely to trigger a sell-off of the dollar. The dollar seems to have 9 lives, but it is difficult to imagine a scenario in which the above conditions occur and the dollar doesn't fall.
If lowering the interest rate on the discount window won't solve the problem, then why is the Federal Reserve doing it?
Average people who read the mainstream media's reassurances that this will solve the problem are likely to believe them. So above all, this is a confidence game. The purpose is probably to keep average American and foreign investors in the stock, bond, and money markets so that favored corporations have more time to get out.
Letting banks that are in trouble apply for loans at the Fed's discount window allows the Fed to figure out who is in trouble, and it buys time. The real danger to this situation is that the bigger banks either try to smooth over or understate their exposure and risk and one (or more) end up going bust. If this were to happen, the financial system itself could collapse.
Is this something that I should be worried about?
It's impossible to predict the future with any accuracy. It's better to make preparations according to likelihoods and how much is at stake , and then worry less.
What are some possible risks associated with this crisis?
Many types of assets will become difficult to sell without a loss. Slow-moving assets such as real estate and small businesses will move slower than usual unless deeply discounted. Fast-moving assets such as stocks may plunge in value. Long-term bonds have inflation risk. Even inflation-indexed bonds have significant inflation risk because they are indexed to ridiculously low measures of price increases.
Money-market funds, that tend to contain uncollateralized debt, are not necessarily covered by the FDIC. Many of the higher-returning money market fund have also bought heavily into the subprime mortgage bonds. They did this to capture the higher yields. What they also captured was higher risk, risk that is not perceived to be present in money market funds.
The FDIC can't handle a systemic banking crisis or for that matter one really big bank failure.
What can I do to protect myself from possible consequences of this situation?
While we cannot make specific recommendations because of suitability requirements, some strategies used in situations like this are:
- Keeping on hand, in cash, expense money calculated to last for a predetermined period of time
- Buying quantities of precious metal bullion coins to use as currency substitutes
- Buying precious metal collectible coins. During the crisis, these might fall in price, which is actually a good opportunity to buy them at a discount as a hedge against currency depreciation. If the crisis is too bad, however, then they will skyrocket in price against a collapsing currency. Decide what you can afford and how much you're willing to pay. History has shown our government's predilection to confiscate bullion. So far, such has not been the case with numismatic (collectible) coins
- Selling US Dollar-based assets and converting the funds to cash or near-cash positions denominated in multiple foreign currencies, while avoiding money-market funds.
- Keeping printed statements from brokerage and other stock accounts on hand
The mainstream media isn't discussing the crisis much anymore. How will I know when it's over?
The crisis is probably actually in its early phases! Public sentiment is usually wrong. Right now there is still too much optimism, as is typical of the early phases of a crisis. Think of the passengers on the Titanic who were casually chipping pieces of the iceberg off to cool their drinks. When the crisis actually bottoms out, there is likely to be a lot of leftover hand-wringing and despair. To stay better informed, read financial news sites such as this one.
The mainstream media is incredibly biased in this regard. Remember, the media outlets are owned by large companies with profit motives and an interest in keeping the status quo healthy. Many of these ‘economic experts' seen on TV are nothing more than journalists.
**This article was written for informational purposes only and does not constitute advice to buy or sell securities or any other assets. You are responsible for any financial decisions that you make.**
By Andy Sutton and Atash Hagmahani
http://www.my2centsonline.com
Andy Sutton holds a MBA with Honors in Economics from Moravian College and is a member of Omicron Delta Epsilon International Honor Society in Economics. He currently provides financial planning services to a growing book of clients using a conservative approach aimed at accumulating high quality, income producing assets while providing protection against a falling dollar.
Atash Hagmahani is the editor of Mutually Assured Survival ( www.mutuallyassuredsurvival.com ), a place where friends exchange advice and information about surviving the hazards of world government, permanent war, fiat credit schemes, & economic starvation.
Andy Sutton Archive |
© 2005-2022 http://www.MarketOracle.co.uk - The Market Oracle is a FREE Daily Financial Markets Analysis & Forecasting online publication.
