The Liquidity Bubble.

The recent problems the world is experiencing in credit markets are directly attributable to the massive injection of liquidity caused by the lowering of interest rates around the world. Why are central banks using the same tactics now if they already know what problems widespread availability of easy money can cause?

Since the start of the credit crunch last year the world’s central banks have been printing money like it has gone out of fashion and lending it to the very bankers who can be blamed for the crunch. This month the Federal Reserve announced that it would lend primary dealers in the bond market $200billion in Treasury securities and accept triple A-rated mortgage-backed securities in return, something the ECB has been quietly doing for Spanish banks for some time now. The Fed also provided a $30billion credit line to JP Morgan to enable it to purchase Bear Stearns. In August last year the ECB injected 94.8€ billion in overnight money. The Bank of England has effectively provided $48billion of state aid to support the British bank Northern Rock. In addition to all these injections of money into the financial system, and plenty of others, the Federal Reserve has now lowered interest rates to 2.25% and the yield on the 10 Year US Treasury has come down to 3.33%.

The aim is to ensure that financial institutions who require funds for refinancing, such as lending institutions, hedge funds, private equity houses, banks etc, have access to the kind of funds their business models depend on, and which, when left to market forces, have disappeared. The US is supposed to be the greatest champion of the freedom of market forces and ‘laissez faire’ macro-economic management but when it’s own house is in trouble then the state has to intervene. This is understandable, even if state intervention is usually more negative than positive, but the fact that the immediate problem is being solved with the medicine that poisoned it in the first place makes it seem a little hypocritical.

The credit crunch was initially a problem that only affected niche areas of the financial system but its effects have spread much further. Banks are reluctant to lend money to each other because 1) they might need it themselves and 2) they are worried about getting it back. This general fear about lending has meant that all asset-backed securities are now looking far less attractive and the assumed liquidity of such assets is now much less than it was a year ago. This means that all mortgages are now looking more risky, as housing markets topple over around the world, and even loans backed by assets such as cars are being re-rated.

For the average person this means that it is now harder to meet lending criteria when trying to obtain a mortgage, or even to refinance a mortgage that is coming off its initial low fixed rate. Even though base rates have gone down in some countries, actual mortgage rates have gone up and many mortgage products have been removed from the market. In addition, the loan-to-value ratio has shrunk, which means that buyers (and those refinancing) have to provide a larger deposit or piece of equity in order to qualify. With house prices still very high by historical standards, many people will struggle to find the extra funds, especially after the spending binge of the last few years and when faced with rising food and energy bills. Volume in the mortgage market has shrunk dramatically and is likely to shrink further.

The tightening in loan-to-value ratios has also started to affect lending to investors and is putting downward pressure on certain types of stocks. At least one broker in the City has raised the margins it requires for investors in CFDs of small companies and this has meant a number of margin calls are now being made, causing investors to sell down their holdings. Hedge funds, who rely on leverage to achieve above-average returns are also feeling the squeeze as their lending costs are raised and their lending facilities are reigned in. Private equity deals have almost ground to a halt as banks question the ability of venture capitalists to finance interest payments out of falling earnings.

The financial system obviously faces huge problems that need addressing but is the injection of billions of Dollars the best answer? Low interest rates and a large increase in the money supply after the dotcom bubble burst led to a massive increase in lending by financial firms, governments and individuals until it got to a point where it seemed everyone had plenty of money to spend, none of it theirs. Is this what the central banks are trying to achieve once more?

However, I would say that the problem this time around is not one of lack of money, it is more to do with fear of being over-extended against over-priced assets. Even though they are prepared to take your house as collateral, the banks don’t really want it because they can’t sell it any easier than you can. We know this because this scenario has played out before in the UK and Japan in the last property crashes but lending institutions seem to have forgotten. However, also like Japan, an injection of liquidity can be useless if people simply don’t want to spend money and prefer to save it. Japan dropped interest rates to zero (which in itself added to the liquidity bubble in the rest of the world) but it didn’t encourage the Japanese to borrow and spend. When the Bank of Japan finished lowering rates to zero it effectively exhausted its greatest weapon and we could see the same thing happen in the US today. The effect of negative real interest rates is unlikely to have the same positive affect on borrowing and spending that it had after the dotcom bubble popped. And if it did, and people started borrowing and spending furiously once more, what would happen when that bubble popped?

This is not a sustainable strategy. It undermines the currency, having destroyed the Dollar’s credibility as a solid currency, and it just exacerbates the real underlying problems and pushes them forward until it is no longer possible to postpone the inevitable. We could well be at that stage already because there would appear to be little chance of consumers increasing their borrowing significantly in the face of rising unemployment (in the US only, so far) and higher prices (everywhere). Flooding the financial system with money might only weaken the currency further, making the US in particular a less attractive place to invest, and if it simply serves to bail out the bankers and hedge fund managers who have made poor investments then the longer term consequences for the US could be much wider.

We don’t try to help drug addicts with the problems of their addiction by giving them more drugs. We make them go cold turkey. Central banks need to face up to reality and stop giving people cheaper borrowing. What the world’s consumers and investors need now is a bit of cold turkey.