What a “Liquidity Crisis” Really Means
From a “Dot Com” Bubble to a “Housing” Bubble to an “Everything” Bubble
Here we go again.
We’re about to be propagandized by the rent-seeking class with their latest opaque term to describe their own recklessness. They’ll coin a new term designed to make you think the economy is too complicated for mere mortals.
God forbid Dorothy and her friends see behind the curtain.
This really isn’t hard or complicated. We do not need people who essentially credential themselves with letters after their names which testify mainly to their ability to restate the same group-think with an ever-more opaque vocabulary.
For example, we are about to be told there is a “liquidity crisis.” For an asset to be “liquid” means it is easily convertible to cash. This, in turn requires people/organizations (also known by the incredibly erudite term “buyers”) who have cash and are willing to buy the asset. So a “liquidity crisis” is a fancy Wall Street way of saying: “No one’s buying what we’re selling.”
Hmmm… Wonder why that might be. After a quadrupling of the Federal Reserve’s balance sheet, a lack of cash manifestly cannot be the reason.
Every Man’s Debt is Someone Else’s Asset
The reason is painfully simple. No one buys something unless they know what it is worth. And knowing that means you have to have some reasonably objective sense of value.
We have to start with a basic observation: If you take out a loan, that obligation is a liability to you (the obligated payments are debited from your account). That same loan, however, is an asset to the lender — the obligated payments are credited to the lender’s account. Or in other terms: Every man’s debt is someone else’s asset. And knowing what that asset is worth means you have to have some idea of what makes the asset valuable.
So what makes the asset counterpart of my mortgage (a liability to me) valuable? This goes to the heart of what happened ten years ago. We were told the Fed had to bail out the banks by buying up mortgage loans (which were bundled together and called “asset backed securities”). This happened because nobody else wanted to buy them. Again, why might that be? I mean, its backed by a house on land, right? That has to be worth something…
Because the value of an asset — when the asset is a mortgage — is not just the value of the home and the land on which it sits. The value of a mortgage (or any loan) is first the ability of the borrower to make the payments; the underlying value of the home and land is a function of the price it can demand in the market. If someone can buy it outright with cash, discovering that value is straightforward. But that is clearly the exception, not the rule. So the value of the house and land becomes a function of the ability of a buyer to obtain a mortgage… And the value of that loan as an asset is a function of the borrower’s ability to pay it back.
How “Injecting Liquidity” Guaranteed the Last Financial Crisis, and Guarantees the Next
In the late 1990’s the Internet was the shiny object of all shiny objects — to the point where its newness deluded people into thinking the Internet was where 2+2 could actually equal something more than 4. People were piling into IPOs of companies who had what we in the software world like to call “vaporware” — an idea without a market.
As has happened in every crash/crisis, the laws of mathematics caught up with Wall Street. Many tech startups in the late 90’s financed themselves partly with what Wall Street likes to call “high yield growth” (HYG) bonds. They like this particular term because its synonym — “junk bonds”— might actually lead you to understand what is really going on here. When you realize a “bond” and an “interest only mortgage” are actually identical, it becomes clear that a “junk bond” is just the corporate version of the “subprime mortgage.”
Tech companies had floated bonds to raise operating capital. Bond rating agencies — knowing nothing about the technology — had no possible way to accurately rate these bonds. Some were rated highly (“investment grade” or IG) and others lowly (HYG — Why in the world would you use the word “high” when describing a “lowly” rated bond unless it was to obfuscate reality from the public?) In the end, these companies with ideas without a market missed their bond payments, defaulted, and disappeared and all but took the market capitalization of the NASDAQ with them.
Why in the world would you use the word “high” — as in High Yield Growth — to describe something rated “lowly” by the rating agencies, unless it was to obfuscate market realities to the general public?
Normally defaults and bankruptcies like this would have been an economic blip. But because the Federal Reserve had “injected liquidity” into the market with low interest rates, all that extra money piled into the same “dot com” trade. A correction became a crash.
And then our finely credentialed faculty lounge — with their shiny Nobel Prizes — chimed in.
The fix, as Paul Krugman so famously said in 2002, was to create a housing bubble. How? By “injecting liquidity.”
We all know how that ended.
And it was the exact same dynamic: It started with Fannie Mae and Freddie Mac using cheap money to buy up mortgage loans — remember, your liability is someone else’s asset.
When liquidity is injected by making money artificially cheap, lending standards must be lowered. Money in the economy is like a vacuum in nature; shareholders will not tolerate an excess of cash on the balance sheet when interest rates are low. The cash must be deployed, so it ends up going to increasingly unqualified borrowers — in the hopes that their 2+2 will somehow, at some point, magically equal something more than 4.
So as Fannie Mae and Freddie Mac used easy money to end up financing 90% (no, that is not a typo) of all new mortgages by 2007, a housing collapse across all markets at once (which, again, the credentialed class told us could not happen) was all but guaranteed.
And so these “mortgage backed securities” spread the risks associated with easy money throughout the entire banking system — and the economy which depended on it. And then it dawned on everyone that the 2+2 of those who had been lent the money was not going to equal anything other than 4 after all. At that point — when it became clear that the “securities,” which were “backed” by “assets” which were these sub-prime mortgages, could not possibly be worth what they were marked as worth — everyone rushed to the exits at the same time.
Remember, these were the assets on the books of the larger banks which decided to play in this sub-prime sandbox. Banks stopped lending to each other because no one knew what their counterparty bank’s “assets” were actually worth. At the end of the day no one was buying what anyone was selling because we spent a decade “injecting liquidity” into the market so it could continue with the pretense that 2+2 can somehow magically equal something more than 4.
Yes, We Have Done Exactly the Same Thing — Again!
Remember that a loan is an asset, and the value of the loan as an asset is a function of the ability of the borrower to pay it back. Investors used cheap money to pile into bonds issued by tech companies in the 90’s. Then they used cheap money to pile into securities backed by mortgage loans in the 2000’s. Now we are sitting on the pinnacle of an “everything bubble” where companies across all sectors of the economy have loaded up on corporate debt at low interest rates— mainly for the purpose of buying back their own company stock. Note: We are not talking about a single sector like tech or housing… It’s now across all sectors.
The stock buyback part of this is especially pernicious. The market values the stock of a company by dividing the company’s earning by the number of outstanding shares of stock. We can simplify it with this:
V = E/S: Value equals Earnings divided by the number of outstanding Shares of stock.
Now if you want to increase V you must do one of two things: Make the numerator (E) higher, or make the denominator (S) lower. If a company has a strong business value proposition — meaning it is selling something people want or need — that company is increasing the numerator by being competitive in their market and efficient at what they do. In order to accomplish this, the company might sell bonds (remember, a bond and an interest-only mortgage are basically the same) and use the proceeds to upgrade their equipment, do R&D on a new product line, or otherwise improve their ability to deliver value to their customer. But that approach can be fraught with risk. What if the R&D initiative produces a product no one wants?
Or, if you can get an unusually high price for your bonds (meaning the interest rate is unusually low), you can take the easy way out and decide not to worry about growing the “E” part of the equation. Instead you buy back your own stock, reducing the number of outstanding shares. By lowering the “S” denominator, you increase V (earnings per share). This, along with the artificial demand you are placing on your company’s stock, causes the stock’s price to rise.
There’s a reason this was considered an illegal stock price manipulation scheme until the 1980's… Because it is — a stock price manipulation scheme.
And So Here We Are: On the Cusp of What Will be Sold to Us as a “Liquidity Crisis”
Stock buybacks are so pernicious because they pollute the information available to pension plans and ordinary folks trying to make good choices with their retirement accounts. They are pernicious because the executives who sign their companies up for this receive bonuses tied to their stock price. Stock buybacks are a perfectly legal, but morally outrageous, form of C-suite self-dealing. And lastly, when money is no longer free and companies who long ago forgot how to add to “E” discover they can no longer subtract from “S” — well, Warren Buffet described this when he observed that “when the tide goes out, we see who is swimming naked.”
When you realize management of that company you loaded up on are all swimming naked, it’s time to sell.
And Fed Chair Jerome Powell Just Might “Get It”
At least we know who not to listen to.
This is such an outrageous display of the flaming stupidity of Ben Bernanke, Hank Paulson, and Paul Geithner that it merits being fully quoted (with emphases and commentary in brackets added):
“ The seeds of the panic were sown over decades, as the American financial system outgrew the protections [you mean leveraged campaign contributions to have them removed] against panics that were put in place after the Great Depression. Depression-era safeguards, like deposit insurance, were aimed at ensuring that the banking system remained stable [as were amazingly simple laws like Glass-Steagall, which the Republican Congress and Bill Clinton repealed — what a wonderful thing “bipartisanship” was!], but by 2007 more than half of all credit flowed outside banks. Financial “innovations” [the quotes are added to stand in for: “are you effing kidding me?”], like subprime mortgages and automated credit scoring [you mean “liar loans” made on the basis of unconfirmed income to people with no possible way of repaying], helped millions to buy homes, but they also facilitated unwise [No!!! You think?] risk-taking by lenders and investors.”
One has to wonder why these three would write such drivel, unless they know full well what is coming.
This week’s interest rate hike wasn’t really the news-maker. The Fed has signaled it will be reducing its balance sheet on “autopilot” for the time being. (Again, this is all designed to be opaque so Dorothy and her friends don’t get behind the curtain.)
When the Fed “injects liquidity” it essentially creates new money to buy bonds issued to finance government spending and mortgage lending. As it buys these “assets,” its balance sheet grows, essentially representing an increase in the money supply — injecting liquidity.
When the Fed decides to “reduce its balance sheet” that means they are actively selling these assets on the open market. When someone who is a very large buyer in a market shifts to being a net seller, that thing they are now selling will decrease in price. This is basically the opposite of a stock buyback — only with bonds. The money the Fed is paid for these assets then digitally “disappears” exactly as it digitally “appeared” in the first place. In the past this was described as “soaking up excess liquidity.” Today they can’t call it that; it’s too clear and easy to understand and gets in the way of the “liquidity crisis” narrative. Now it is “Quantitative Tightening” (QT).
When the price of a bond goes down, it means the interest rate on the bond goes up. Now, just as no one refinances a mortgage at a higher rate, if a company has to refinance a bond at a higher rate, it means they get less money from that bond issue — not enough even to redeem the first issuance at full value. If their earnings per share have depended mainly on taking shares off the market rather than organically growing their business, they are now looking at using the proceeds from today’s investor to pay off yesterday’s — the textbook definition of a Ponzi scheme. Buybacks come to an end and their stock price reverts to something a bit more realistic.
Unfortunately all of the past “liquidity injections” have propped up asset prices across the board — including stocks to a point where that “more realistic” place will be quite shockingly lower than the inflated prices we see today.
There’s a bunch of memes out there of Jerome Powell as Superman. Maybe one as a lifeguard clearing the beach of buck naked swimmers is more apt.
Then real businesses can create real wealth again and my kids might have half a shot at something other than a neo-feudal economy of Wall Street lords and their debt serfs.