(B) The present crisis of the US financial system that raised its peak with Bear Stearns’ collapse last week has its roots in the US addiction to put too much cash in order to grow supply faster than demand. Federal Reserve Chairman Alan Greenspan and now Chairman Ben Bernanke have significantly increased the supply of US dollars into the American economy over the last decade. That excess of cash has contributed to large asset inflations with first the 2000 stock market bubble and second the housing bubble that exploded in 2007.
What is paradoxical is that the pendulum has moved from too much liquidity to not enough liquidity where borrowing is currently very challenging. And to fight that one more time, the Federal Reserve has flooded the credit market with new liquidity, lowering the Federal fund rate already three times this year (the most aggressive Federal credit easing since 1982) and helped in a surprising way JP Morgan Chase to rescue Bear Stearns from bankruptcy.
One of the great forces of the US business culture is to be always ready to invest wherever business opportunities seem to lie. There is probably no other country in the world where raising capital is so easy. And where capital is put quickly and efficiently to work in order to create economic wealth. In contrast to old Europe, US management knows that to increase shareholders value, it must invest.
But unfortunately, as always failure lies in success.
A Monetary Environment that Favors Liquidity
The 1973 oil crisis started double-digit inflation that was only defeated a decade later by Federal Reserve Paul Volker but at a very high price: a deep recession from 1980 to 1982 with an 11% unemployment rate. But the US recovered as proved by a bullish stock market from 1982 until Black Monday in October 1987. At that time, Japan and Germany were considered having a better business engine in particular for the industrial sector than the US.
But that changed with Federal Reserve Chairman Alan Greenspan period of economic stability characterized by low inflation and low interest rates. Mr. Greenspan’ s policy attempted to increasing productivity, contributing growth for businesses and guaranteeing lower employment rates for citizens.
But Mr. Greenspan abundant use of liquidity have probably shaped two critical imbalances for the US economy:
- A current account deficit (the gap between what the country earns abroad and what it spends abroad in a year) close to $800 billion or 7% of the GDP;
- And a negative household saving rate.
Derivatives Stimulate Liquidity and Asset Demand
By leveraging excessively their assets (Goldman Sachs, for instance, is using about $40 billion of equity as the foundation for $1.1 trillion of assets), investment banks, private and hedge funds have been generating record revenues and profits from complex derivative instruments in stocks, bonds, interest rates, currencies, commodities, credit…(you name it!).
Many of those derivatives are over-the-counter (OTC) (that is privately negotiated and not traded over an exchange) and so not regulated.
In addition, borderless financial markets have banalized new types of investments such as borrowing of low-interest currencies (in particular with the yen) to invest over longer-term in high-interest currencies, and thus taking advantage of the “carry trade” (or interest rate spread) though obviously very leveraged instruments.
The total present worldwide market for derivatives is $500 trillion while the present US stock market is $22 trillion (only!).
By virtually doing more with less, derivatives free up a lot of cash. And by reducing the cost of owning an asset (without ever having to buy that asset), the demand on the assets increases. Derivatives have increased liquidity into the market and increased asset demand.
Debt Securitization Expanded Liquidity into the Credit Market
Liquidity has been generated as well with new debt created through securitization, that is funds formed from securities, with collateralized debt obligation (CDO) instruments.
CDOs are pools of obligations where the obligations are divided into trenches. The trenches in the CDOs can be viewed as a pyramid of layers of obligations where the obligations with the lower risks are at the top and the obligations with the higher risks are at the bottom. For a pool of mortgages, the subprime mortgages are obviously at the bottom of the pyramid. So when those mortgages grow so does the pyramid.
Through securitization, banks are distributing portfolios of credit assets and risks to other market players. And so, collateralized debt obligations with credit derivatives have expanded liquidity into the credit markets.
Liquidity Fuels Asset Appreciation Beyond Fundamentals
With increased asset appreciation, investors have lowered their fears of risks which have created the conditions that led to this investment exuberance stimulated by liquidity but resulting in unsustainable asset appreciation of stocks and real estates.
In 2000, Internet companies were going IPOs. In 2007, hedge funds and private equity funds were going IPOs.
After the 2001-2002 tech recession, when Silicon Valley was recovering from the dot-com and telecom bubble, mortgage companies, investment banks, and hedge funds were taking too much advantage of friendly monetary policy preparing the foundation for a second bubble and a financial crisis.
With low interest rates, demand for real estate has inflated prices in particular in some areas of the country, creating a second bubble.
In the exuberance, loan underwriting standards fall in particular for subprime loans and accelerated the rapid rise in delinquent loans that caused the housing bubble to burst.
This collapse of the subprime mortgage market and with it the collateralized debt obligations market started in the summer of 2007 with the collapse of two Bear Stearns hedge funds and caused major write-offs in the fall of 2007 from Citigroup, Merrill Lynch, and Morgan Stanley. But this has now obviously spread widely to the overall credit and financial markets.
According to a research note today from Goldman Sachs:
“The global credit losses stemming from the current market turmoil will reach $1.2 trillion…US leveraged institutions will suffer roughly $460 billion in credit losses after loan loss provisions…The cumulative losses expected by these leveraged players, bad residential home loans will represent about half, while poor-performing commercial mortgages will represent 15% to 20%. The rest of the losses will come from credit card loans, car loans, commercial and industrial lending, and non-financial corporate bonds.”
Liquidity Accelerates the Declining Purchasing Power of the Dollar
Treasury Secretary Henry Paulson have shown many times lately his strong will to ensure that the capital markets function properly. During the month of March, the Federal Reserve has already:
- Lowered its fund rate to 2.75%;
- Announced a $200 billion lending program for investment banks;
- Announced a $100 billion credit line for banks and thrifts (and accepting potentially risky mortgage-backed securities as collateral);
- Approved a $30 billion credit line to help JP Morgan Chase acquisition of Bear Stearns.
Now the real challenge for the US economy is if the present actions from the Federal Reserve to heal the financial markets will generate later unwanted side effects.
In particular, easy monetary policy has been a disaster for the purchasing power of the dollar as proved by the record of gold to more than $1,000 per ounce. A weak dollar has increased oil prices, to more than $100 a barrel for crude oil, which has contributed to increasing the US trade deficit up to $712 billion in 2007 and the risk of future inflation.
But more damaging to a weak US economy, a weak dollar might significantly increase at some point in time the outflows of large foreign-owned US assets from the US back to Asia and to the Middle East.
Financial crises are not new; they have recently occurred periodically every ten years: the US stock market crash in 1987, the Asian financial crisis that started in Thailand in 1997 and now the US credit market crisis in 2007.
History repeats itself but never in the same way.
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