Most of us speak rather glibly of “global liquidity”. Reams have been written on how low interest rates have led to a “tsunami of liquidity” and how asset prices have been buoyed on a “wave of liquidity”. More recently, the focus has been on the “ebbing tide of liquidity”: Warren Buffett’s letter to the shareholders of Berkshire Hathaway Inc. says, “You only learn who has been swimming naked when the tide goes out.” The Bank of England’s deputy governor has warned that the ongoing credit crunch was the “largest ever peacetime liquidity crisis”.
A recent paper, Liquidity and Leverage, by Tobias Adrian of the Federal Reserve Bank of New York and Hyun Song Shin of Princeton University, examines the underlying reasons for changes in liquidity. Leverage, they say, is pro-cyclical, which means it rises when the business cycle is trending up and falls when it is on its downward journey. When business conditions are good, companies’ net worth increases and the higher capital allows them to expand business and their balance sheets—they can take on more leverage.
In the authors’ words: “Our empirical findings suggest that funding liquidity can be understood as the rate of growth of aggregate balance sheets. When financial intermediaries’ balance sheets are generally strong, their leverage is too low. The financial intermediaries hold surplus capital, and they will attempt to find ways in which they can employ their surplus capital. In a loose analogy with manufacturing firms, we may see the financial system as having ‘surplus capacity’. For such surplus capacity to be utilized, the intermediaries must expand their balance sheets.”
What the authors are saying is that it is in the nature of firms to expand leverage during the upward phase of the business cycle. For the “surplus capacity” to be utilized, the financial institutions take on more liabilities. They then add on more assets and search for borrowers to whom they can lend. The authors conclude: Aggregate liquidity is intimately tied to how hard the financial intermediaries search for borrowers. In the subprime mortgage market in the US, even borrowers who did not have the means to repay were indiscriminately granted credit—so intense is the urge to employ surplus capital. The seeds of the subsequent downturn in the credit cycle are thus sown.
Conversely, when the credit cycle turns, it leads to a contraction of balance sheets and to a tightening of credit standards. That is precisely what’s happening in the developed markets at the moment. Hedge fund Peleton Partners, while liquidating its asset-backed securities fund, had this to say:?“Because of their own well-publicized issues, credit pro-viders have been severely tightening terms without regard to the creditworthiness or track record of individual firms, which has compounded our difficulties and made it impossible to meet margin calls.” And, as Adrian and Shin point out, contracting balance sheets lead to lower risk appetite.
By how much will the credit crisis contract liquidity? In their paper on Leveraged losses: Lessons from the mortgage market meltdown, by David Greenlaw of Morgan Stanley, Jan Hatzius of Goldman Sachs, Anil K. Kashyap of the University of Chicago and Princeton’s Shin, presented recently at the US Monetary Policy Forum Conference, the researchers write: “Our baseline estimates imply just under a $2 trillion (Rs81 trillion) contraction in intermediary balance sheets, of which roughly $900 billion would represent a decline in lending to households, businesses and other non-leveraged entities.” That’s assuming that losses from US mortgages will be around $400 billion. UBS AG estimates already top that, at $600 billion. And that’s not including possible losses on credit cards and commercial mortgages.
This massive de-leveraging of balance sheets will, of course, lead to a severe downturn in the economy. The authors add that this dramatic decline in liquidity will reduce the US gross domestic product growth by roughly 1-1.5 percentage points.
But won’t the interest rate cuts by the US Federal Reserve help in injecting liquidity? The problem is that risk aversion is now so high that the money is flowing into the money markets and to the US treasurys, which are giving negative real rates of return (returns adjusted for inflation). As the research paper puts it, “liquidity injections by the central bank are an invitation to the financial intermediaries to expand their balance sheets by borrowing from the central bank for on-lending to other parties. However, a leveraged institution suffering a shortage of capital will be unwilling to take up such an invitation.” In other words, as banks de-leverage their balance sheets during bad times, liquidity injections by the central bank don’t work.
So, how long will the pain last? When can we expect the markets to get back a modicum of stability? Greenlaw, Hatzius, Kashyap and Shin have answers for that, too. The credit markets will start turning around, they say, when “either, banks and brokers contract their balance sheets sufficiently that their capital cushion is once again large enough to support their balance sheets; or banks and brokers raise sufficient new equity capital to restore the capital cushion to a size large enough to support their balance sheets; or the perceptions of risk change to a more benign outlook so that the current level of leverage can once again be supported with existing capital”. At present, we’re nowhere near any of these conditions.
Mint’s resident market expert Manas Chakravarty looks at trends and issues related to investing in general and Indian bourses in particular. Your comments are welcome at firstname.lastname@example.org.