How does liquidity dry up?

August 2nd, 2007

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Back in January, in Liquidity?Global Markets Face `Severe Correction,? Faber Says, we mentioned that:

What is driving the stock markets is liquidity?the sheer weight of money and money substitutes chasing after a limited supply of assets (bonds, stocks, art, etc), resulting in skyrocketing prices. Therefore, any crunch in liquidity will result in collapsing asset prices.

Marc Faber had observed that liquidity seems to increase as asset prices rises:

The higher the asset markets move, the more the increased asset prices can create liquidity. Let us assume an investor owns a real estate or stock portfolio worth 100 and that his  borrowings are 50. For whatever reason (usually easy monetary conditions), the value of the portfolio now doubles to 200. Obviously, this allows the investor, if he wants to maintain his leverage at 50% of the asset value, to double his borrowings to 100. With the additional 50 in buying power, the investor can then either spend the money for consumption (as the US consumer has done in the last few  years) or acquire more assets.

As we can see, the liquidity that drives global asset prices are mainly made up of debt, which can only happen when abetted by the complicity of central banks who have the power to create money out of thin air via the printing press.

The next question to ask is this: if there is someone doing the borrowing, then who is the one doing the lending?

Traditionally, it is the banks that do the lending. In the good old days, lenders had to conduct due diligence to check out the credit worthiness of the potential borrower before the money enters the wallet of the borrower. The less credit worthy the potential borrowers were, the higher the interest charges were demanded from them.

But today, as we can see from the sub-prime mess (see How did the US sub-prime lenders get into trouble?), lenders are getting reckless in their lending practice. Not only are credit unworthy borrowers granted excessive credit, the interest charges demanded on them were too low to compensate the lenders for the risks involved in lending to such borrowers. In technical language, it means that the credit spreads had narrowed. In layperson’s language, it means the differences between a risk-free rate (e.g. interest rates of Treasury bonds, or the short-term cash rate) and highly risky rates (e.g. sub-prime mortgage payments) are getting smaller and smaller, to the point that it does not make any financial sense. So, who provided the ones who provided the money to lend? As we said before in How to dump risk to consumers: securitisation, modern day financial ?innovations? had allowed debts be turned into ?investment? products for the gullible masses.

Recently, as we mentioned before in yesterday’s article (see Re-pricing of assets- from ?marked? to model to ?marked? to market) with the re-pricing of such ?investment? products, securitised debt became a hot potato that nobody wants to touch. In that case, who will provide the money to do the lending? Would such a lending phobia spread to other sectors of the financial industry, cutting off money to legitimate and sound borrowers? Without access to cheap money to borrow, what can fuel further rises in asset prices?

As we said before in What makes monetary policy ?loose? or ?tight??,

To understand why, we have to remember that the central bank cannot control the demand for money and credit. It can supply whatever amount of them that it wants, but it cannot force business and people to desire them. Put it simply, you can lead a horse to the water, but you cannot force it to drink.

Will this credit crunch lead to the economy’s aversion of money and credit? In that case, there will be asset price deflation (see Spectre of deflation). In that case, we will expect Helicopter Ben (Ben Bernanke) to step up the operation of the money printing press (i.e. cut interest rates aggressively). If you hold plenty of gold on such a day, you will be doing very well (see What should be your fundamental reason for accumulating gold?).