The collapse of Bear Stearns, the depressed housing market and the problems with ING’s Diversified Yield and Regular Income funds have one thing in common, namely the bursting of the global liquidity bubble.
To understand this phenomenon we have to look at recent developments in the financial sector which are best illustrated by the accompanying graph of global liquidity.
International liquidity comprises four basic ingredients: power money (notes and coins), broad money (cheque accounts, credit cards etc), securitised debt (mortgages and other packaged products) and derivatives (futures, options, swaps etc).
Forty years ago power and broad money accounted for almost 100 per cent of global liquidity but they now represent only 12 per cent with securitised debt and derivatives accounting for 13 per cent and 75 per cent respectively.
The financial sector, particularly Wall St, is populated by Masters of the Universe who have invented a huge number of new and complex ways to increase liquidity.
* Securitised products. Banks used to keep mortgage loans on their balance sheets but they now package them into bundles of 50, 100 or more mortgages and sell them to individuals or institutions through investment products.
Securitisation allows financial institutions to create more and more loans without having to raise additional equity capital.
* Derivatives are another form of leverage as they allow investors to obtain an economic interest in an asset for a relatively small outlay.
For example, investors can obtain an effective 1 per cent economic interest in Telecom through derivatives for a fraction of the cost of a 1 per cent shareholding in the company.
* When Tokyo housewives invest 100 million in New Zealand because of our high interest rates they effectively create $1.2 million of new liquidity in this country.
The 100 million doesn’t disappear from Japan as it continues to be a financial asset as far as the Japanese investors are concerned.
The top two trapeziums in the inverted pyramid have grown dramatically in recent years as a myriad of innovative securitised products and derivatives have led to a huge increase in global liquidity.
This surge in liquidity has been the catalyst for a borrowing binge that has resulted in a sustained rise in asset prices, including property, sharemarkets and commodities.
It would probably be more appropriate if the top two sections of the inverted pyramid were bubbles instead of trapeziums.
Major cracks in the top half of the pyramid began to appear in mid-2007 when the sub-prime mortgage crisis surfaced in the United States.
The root cause of this problem was too much global liquidity.
In other words when financial institutions have too much money they lend to individuals who are not creditworthy and who are unlikely to be able to repay the principal or meet their interest payments.
These low-quality mortgages were packaged into securitised debt products and sold to the investing public with a variety of high credit ratings from Standard & Poor’s, Moody’s or other major rating agencies.
When US house prices began to fall, and foreclosures increased, investors realised that these sub-prime mortgage securities were highly dodgy.
This concern has spread throughout most of the securitised debt market, which represents an estimated 13 per cent of global liquidity and is now deeply distressed.
Interest rates are rising – and prices are falling – and there are no buyers for a large percentage of these securitised products. This is why Macquarie Fortress Notes, ING Diversified Yield Fund and ING Regular Income Fund, which have all invested in securitised debt, have experienced a sharp decline in value or have closed for redemptions. Investors in these products, particularly the ING funds, probably didn’t realise that they were exposed to the lightly regulated securitised debt sector.
There are a number of important points to note about the four sections in the pyramid including:
* Retail banks traditionally operate in the power and broad money areas where they are under strict central bank control and there is a high level of disclosure.
* Investment banks operate in the securitised debt and derivatives areas where there is little central bank oversight and disclosure is extremely poor, particularly by hedge funds.
* The deregulation of the finance sector in the 1990s has given retail and investment banks much greater opportunities to enter each others’ traditional areas of operation.
Retail banks have expanded rapidly into the securitised debt and derivatives sections where there is little central bank oversight and disclosure requirements are relatively low.
For example, the four major New Zealand trading banks have total balance sheet assets, mainly power and broad money, of $269.3 billion and off-balance sheet exposures, mainly securitised debt and derivatives, of $1106.4 billion (or $1.1 trillion).
In the past 12 months their total balance sheet assets have grown by 12.8 per cent while their off-balance sheet exposures have increased by a whopping 51.5 per cent.
The effective bailout of US investment bank Bear Stearns, which is a big player in the securitised debt market, is another clear sign that this market is severely distressed.
The bailout also indicates that the Federal Reserve Board is extremely concerned about the state of the US financial system because it usually only rescues commercial banks that operate in the power and broad money areas.
The clear message is that global liquidity, which expanded far too rapidly over the past decade through the widespread use of securitised debt and derivatives, is now contracting. This is having a negative impact on most asset prices as investors are forced to de-leverage.
US Federal Reserve Board chairman Ben Bernanke, who is an expert on the 1930s Depression, is doing everything he can to pump liquidity into the system.
He took a number of important steps this week as there are major concerns that the securitised debt problems will spread to the upper and lower trapeziums of the liquidity pyramid. The next big worry is hedge funds, which are big players in the derivatives sector.
The one big certainty is that the securitised debt and derivatives sectors are going to be more closely regulated in the future, particularly as central banks have had to rescue organisations operating in these areas.
Liquidity problems in the financial sector impact on the real economy because global liquidity is now approximately 10 times world GDP whereas 40 years ago the real economy was bigger than the financial sector.
The clear message for New Zealand is that the highly rewarding borrowing game of the past decade is over.
Blue Chip investors are probably the most unfortunate group as they joined the leverage game just seconds before the final whistle blew.
New Zealand is in a particularly precarious position because we have taken full advantage of the global liquidity explosion to borrow heavily for consumption purposes and to invest in residential housing.
With the contraction in global liquidity expected to continue, the next big issue for the domestic economy is the Tokyo housewives and their New Zealand dollar deposits.
If these investors take their money home there will be a reduction in New Zealand liquidity, we may then have to offer higher interest rates to attract alternative liquidity and the kiwi dollar could come under pressure at the same time.
This is not a particularly attractive proposition for highly leveraged domestic companies and individuals.
Source: Bank of International Settlement & Independent Strategy