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Editor's Note: The following is in answer to a reader's question
"What do they mean when they talk about global liquidity drying
up?"
In remembrance of my high school biology teacher, who always reminded
us that the only stupid question is an unasked question, I offer the
following explanation.
Financial analysts and news reporters often refer to the concept of
"liquidity," as though it were a magic wand. One touch and all ills
are cured. Until recently, it was often heard that "the world is awash
in liquidity," which was considered a good thing. More recently, the en
vogue observation is that "global liquidity is drying up," which is
spoken in ominous tones.
Liquidity and You
What is liquidity? Liquidity is simply a measure of how quickly an asset can
be converted into cash. Ultimately, liquidity is cash, because cash can
immediately be exchanged for just about anything else.
Financial assets such as stocks are liquid, but how liquid depends on
the market and the stock. With a phone call to your broker, or even the click
of a mouse, you can convert most of your stocks into cash - immediately. The
market for most stocks is "liquid" because there are so many
participants, and there is always a buyer - at some price.
Real estate - for example your house - is less liquid. Unlike with
stocks, you cannot click a button and convert your house into a pile of cash.
Would that it were so simple. Selling a house is a long, arduous process. You
may have to do some prep work first - painting, repairs, maybe some upgrades,
then you have to find an agent and show it around. Strangers come traipsing
through your living room on Sunday afternoons, peeking in your closets. In a
highly liquid (hot) market, you may only have to suffer such indignity for a
few days, and receive a price much higher than you expected. In an illiquid
(slow) market, you may have to suffer months (or even years) of this
treatment, and still not get an acceptable price.
In Detroit, some houses are
selling for less than the price of a new car. This
is an example of a very illiquid market - lots of people want out of the
city. There are few jobs and less hope. They want to sell, but few people
want to buy.
Then we come to the once haughty (soon to be lowly) hedge fund. Having
money in such a fund can be even less liquid than a house in Detroit. Some hedge funds have suspended
redemptions which is akin
to saying, "Yes, your money is here and it is (ahem) safe -but you can't
have it just now..." When can you have it? Well, that depends. Maybe
never, as investors in two Bear Stearns hedge funds found out a few weeks
ago. Earlier in the year their investments were doing just fine. A few months
later, nothing was left.
What Causes Liquidity to "Dry Up?"
Liquidity - the ability to turn an asset into cash - requires other
people who are willing to pay cash for your asset. Modern bank accounts
rarely suffer from liquidity crises. In the past, such liquidity crises were
known as "bank runs." Mobs of people would rush to the bank to
withdraw their funds, but the bank didn't have the money. This is a classic
liquidity crisis - the bank most likely had the assets (mortgages, loans
outstanding, hedge fund investments, etc.), but the assets couldn't be
converted to cash quickly enough (i.e. immediately) to satisfy the rioting
mob. Bank runs have been rare since the Great Depression because accounts are
now insured by the government.
A mini stock market panic - like the one we saw last week - is a form
of liquidity crisis. As long as stock prices are rising, people want to buy
more and more shares. They will even borrow money to buy shares, and banks
will readily lend them the money. There is no fear that the money will not be
repaid, because the collateral against the loans (stocks) are going up.
But like last week, when stocks suddenly fall, buyers disappear.
Stockholders, like homeowners in Detroit,
and their hedge-fund-holding brethren, want to sell, sell sell!
They want to be "liquid," but buyers are only willing to buy at
lower prices - much lower. "Ridiculous!" the would-be sellers might
say. It is much better to wait, and sell in the inevitable rally that will
follow. (Maybe the rally will even be so good that they won't have to sell at
all!)
But not so fast. The banks that loaned them the money to buy the stock
in the first place have other ideas - namely getting their money back, with
interest thank you very much. They demand repayment in the form of the
dreaded margin call. This forces shareholders
to cough up more money, or "liquidate," i.e. convert assets to
cash even if they don't want to - even if they're going to lose money.
The bank will not lose money.
The factors discussed above are, cumulatively, the factors that determine
global liquidity. The font of global liquidity springs from the world's
central banks, which create liquidity by "printing it" as Fed Chairman Bernanke famously revealed. In
truth, Central Banks do not print money, they loan it, and loans need to be
repaid.
The Fed sets interest rates (the discount rate and the Fed Funds rate)
at which banks can borrow money. The interest rate on money is just another
way of setting the price of money. When the interest rate is low, money is
cheaper. Like cheap anything, there is more demand for cheap money, and there
is also correspondingly more supply. Since it is so cheap, more of it has to
be lent in order for banks to make a profit.
The recent housing boom in the United States was the result of
cheap money. Since interest rates were at historical lows, people borrowed
more. Banks, corporations, individuals and the government borrowed lots of
money because it was so cheap. They all thought they could use the cheap
money to their advantage. The government borrowed a lot of money and had a
war. Corporations borrowed a lot of money and bought their own shares.
Individuals borrowed money and bought houses. Banks had access to so much
money that they let their lending standards go - nearly anyone could borrow
money to buy a house, start a hedge fund, whatever! This is what is meant by
global liquidity. There was so much money sloshing around the globe, just
looking for a home.
As noted however, borrowed money eventually has to be repaid. Because
so much money was lent, and lending standards were so lax, it turned out that
a lot of people couldn't repay their loans. A bank's response when a person
can't make their monthly payments is often to demand full repayment.
Borrowers who couldn't come up with monthly payments certainly couldn't come
up with the full balance, so they defaulted. Hedge funds that invested in
mortgages and derivatives also lost money - lots of it. The banks that loaned
the hedge fund money issued margin calls - the same way they issue margin
calls to individual investors.
Suddenly, with the thought of money actually being lost (or more accurately, as I noted before -
destroyed), banks have become less willing to
lend, because investors are less willing to buy the banks debts. Investors -
having already been burned - are rather looking to sell what they own. Since
everyone is thinking the same thing, there are few buyers. No one wants to
spend his cash, borrowed or not. Ergo, liquidity - the ability to convert
assets to cash - "dries up."
The result of a lack of liquidity is nearly always the same: falling
prices. Just as rising prices can create a virtuous cycle of ever-higher
prices, falling prices can create a destructive cycle of lower prices as
credit is destroyed and asset prices collapse. The housing market in Detroit is one example.
Only when this destructive cycle is complete - after prices have
fallen as far as they are going to - are assets once again viewed as
bargains. At that point, demand again rises and liquidity lubricates the flow
of rising prices.
A word to the young, mobile and wise would-be homeowners - check out Detroit.
By :
Michael A. Nystrom
Bull not Bull
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