“A bank may be said to be solvent when its assets are so constituted that a liquidation would necessarily result at least in complete satisfaction of all of its creditors. Liquidity is that condition of the bank’s assets which will enable it to meet all its liabilities, not merely in full, but also in time, that is, without being obliged to ask for anything in the nature of a moratorium from its creditors…If the bank is in immediate need of large sums of money it can procure them only by disposing of its assets; when the panic-stricken public is clamoring at its counters for the redemption of notes or the repayment of deposits, a bill that has still thirty days to run is of no more use to it than a mortgage which is irredeemable for just as many years. At such moments the most that can matter is the greater or lesser negotiability of the assets.”–Ludwig von Mises, Theory of Money and Credit, 1934
For Professor von Mises, the concept of a liquidity crunch was more than academic: he had the immediate experience of bank runs in the Great Depression. Though we have no such experience today (although as of mid-September, there is a financial institution in Britain that is facing a bank run), recognizing the symptoms of a liquidity crunch remains simple…once it has begun.
Take the symptoms we saw develop in August 2007: The Dow Jones Industrial Average and the S&P 500 were solidly in “correction” territory, down 10% from their highs. The Nikkei average was down over 5% in one day’s trading. The two-year U.S. Treasury traded from 5% down to 4% as investors fled to the safety of high quality assets.
In the middle of these developments, The New York Times ran a “hindsight-is-20-20″ story about one smart (or lucky) individual who prior to heading off to the Continent on vacation heeded the evidently obvious signs of market meltdown while the rest of us (evidently stupid) market participants failed to see the writing on the wall and are now nervously awaiting pink slips.
This most recent meltdown was sparked by, though not completely attributable to, the now dreaded subprime mortgage sector. Subprime mortgage lending was merely the most obviously underperforming asset class in a series of highly leveraged and increasingly complex transactions which seem to all have gone wrong at once, causing a global panic in debt markets.
In reality, the assets underlying these transactions have not all gone wrong. Though subprime mortgage delinquencies have indeed skyrocketed, other kinds of lending, such as that to corporate borrowers, remains on fairly good fundamental footing (see “Not So Bad” charts on page below). However, if no one is willing to buy loans or bonds under any circumstances, the credit markets stop working. The “negotiability” of which von Mises wrote become “liquidity” in our parlance, and in that sense refers to a degree of depth within the now dominant capital markets model where a run on the bank morphs into a run on the market’s depth. That market depth has been tested severely lately, to the point that central banks across the world have injected short-term funding into the banking system in order to maintain orderly lending. It is in these times that it becomes clear that global financial markets require an enormous degree of funding just to run mundane operations on a day-to-day basis.
Of Risk and Leverage
A sea change has occurred in the attitude towards leverage and so-called “structured products.” Much of the growth in financial markets over the past several years, particularly within fixed income, can be attributed to a shifting of and repartitioning of risk. In the past, banks were the major repositories of risk. In particular, they would originate and hold credit risk in the form of loans (both residential and corporate) and fund these loans through short-term deposits. The “run on the bank” that von Mises describes occurred when those short-term deposits were suddenly in demand and the bank was unable to monetize its longer-term loans. With the advent of new financial technology and burgeoning global capital markets, banks and others (including mortgage lenders) were able to originate risk but then remove it from their balance sheet. The risk was further partitioned to appeal to a large variety of potential investors by dividing it (with the help of rating agencies) into a series of ratable pools. The AAA investor got AAA risk, the BBB investor got BBB risk, and the equity investor got equity risk, all at supposedly higher returns than comparably rated securities with less complexity.
So banks removed risk from their balance sheets and distributed it to a wide array of investors, effectively diversifying the risk into a large liquid capital market. Market participants trumpeted this shifting of risk to investors as healthy, but it is becoming evident that there are two inherent problems with the model. The first problem comes in the form of the age-old “run on the bank.” This time, however, the lending institution could be a leveraged hedge fund versus an old-time bank. The hedge fund in effect has short-term deposits (its investors, which may be able to remove their money) but holds longer-term illiquid securities. So part of the investor base in risky securities has the same funding issues today that banks in the 1930s did, even though the humming supercomputers in their trading rooms and fast cars in their parking lots may indicate otherwise.
The second problem comes from the fact that this process of shifting risk separates the origination function from the risk-taking function. When banks lent to a corporation or individual and held that risk, that bank’s credit committee had the burden of significant analysis. If however, that same bank merely lends the money to the corporation, but then sells the loan to a group of investors, it has much less inherent interest in making a good loan. Add an additional layer of structure and complexity through the division of risk described above, and the end investors have much less ability or inclination to analyze the risk they may hold. Even if the end investor is a supposedly responsible buyer, the layers of risk and complexity as well as the inherent distance from the loan origination make understanding the risk of any given security very difficult. Investors as diverse as highly rated insurance companies, European and Asian banks, and highly regarded mutual fund families all seem to have taken the plunge.
WorldCom and Enron Revisited?
While driven by fundamental weakness in U.S. real estate, in particular subprime loans, the current liquidity crisis has become a general lack of confidence in banking and financial institutions globally. If the large international investment bank BNP Paribas proclaims one week that its subprime exposure is “negligible,” but then the next week discloses that it is blocking redemptions from several funds that invest in mortgages because they cannot appropriately value the securities within the fund, what are we to believe? We’ve seen this story before, when WorldCom and Enron showed us one set of books, then swapped that set for another, uglier set. The financial markets extrapolated that all companies were corrupt and punished them by discounting their equity 50% or more in that case. Sarbanes-Oxley legislation was enacted. In this case, financials are being discounted due to potential exposure to subprime or risky mortgage product. Similarly, the market is discounting every financial institution for its potential exposure to toxic mortgage debt. Congress is debating legislative measures that will no doubt be too little, too late, even if they strike at the heart of the problem, which is unlikely.
The real danger is not the holdings of these securities within large, theoretically sophisticated banks and other financial institutions, however. The true danger from this situation comes when these institutions do not or cannot continue with their businesses. If the market no longer believes that these financial institutions hold assets which have significant value, then money flows will slow or stop. The severe funding issues in money markets in Europe and Canada as well as the dramatic appreciation in U.S. Treasury bills are a symptom of this. When panic takes hold of credit markets generally, financial institutions no longer lend (for example, by providing mortgages). This slows economic activity and actually creates a recession where none may have existed before. It is this transmission mechanism which could make everyone poorer.
This lack of confidence becoming a credit crunch becoming a recession is the real risk and the problem which the Federal Reserve is attempting to ameliorate. There is plenty of money, but suddenly no one has the confidence to lend it. As a result, ugly news stories cascade across our computer screens. What do Countrywide Financial, Bear Stearns, BNP Paribas, and IKB have in common? They have all been making headlines, but more specifically, they are all finance companies which to a greater or lesser degree participate in the creation of–and require–”liquidity.”
Though the Federal Reserve Board of Governors voted to decrease the discount rate to 5.75% from the 6.25% rate on August 17th, the Federal Open Market Committee (FOMC) has thus far kept the Fed Funds rate at 5.25%. Though this stance may have changed at the FOMC’s September 18th meeting, the committee has thus far shown extreme reluctance to give up on their fight against inflation.
To see why, examine conditions across the globe even taking into account financial market volatility. In the last month Australia and Korea have raised rates, and recent inflationary pressures make it possible that Mexico and Europe will follow suit. China, the source of much of the disinflationary pressures in the U.S. in the past decade, has raised reserve requirements to combat rising inflation.
Global growth thus far has continued, and the Federal Reserve is stuck. If the Fed cuts rates, the already weak dollar will fall further, leading potentially to a devaluation of the world’s reserve currency. Though the current crisis may make it necessary for the FOMC to lower rates as it did in 1998 to alleviate the ongoing liquidity problems caused by the collapse of Long-Term Capital Management, the Committee is no doubt reluctant to do so. If rates are lowered, it will be not to save financial markets, but to keep the crisis from spreading to the economy at large. The hope is that an injection of liquidity (and thereby, confidence) will restore financial markets to more solid footing.
So, What to Do?
Taking all of this into consideration, it is important to invest by looking forward to what is likely to happen versus backward towards what has already occurred (and been priced). In times of crisis, front-end U.S. Treasuries and other high-quality, short-term securities become a safe haven, and the current environment has been no exception. At the same time, securities that have credit risk (either corporate or otherwise) have suffered significantly. Given the significant flight from risk, however, we are inclined to slowly add to our holdings of riskier securities (staying well within the investment guidelines of our funds, of course). The current flight to quality has thrown the proverbial baby out with the bathwater and some securities which were, in our opinion, priced to perfection have now become much more attractive. Profit growth and real GDP growth are still solidly positive. We will continue to invest money with great caution, but though we take this liquidity crunch very seriously, we remain primarily guided by fundamental considerations. For the first time in a long while, prices for credit assets are beginning to reflect those fundamentals. Which means? During difficult markets a disciplined and long-term approach can create value.
Jason Brady, CFA, is a managing director at Thornburg Investment Management and portfolio manager of the Thornburg Limited Term Income and Thornburg Limited Term U.S. Government Funds, and co-portfolio manager of the Thornburg Investment Income Builder Fund. Prior to joining Thornburg, Brady was a portfolio manager with Fortis Investments in Boston and has held various positions at Fidelity Investments and Lehman Brothers. He can be reached at [email protected].