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Five Things You Need to Know: Debt Crisis vs. Liquidity Crisis


The disagreement over the Bailout Bill might really be a much deeper and more significant faceoff; a battle for the economic soul of this country.


Kevin Depew's daily Five Things You Need to Know to stay ahead of the pack on Wall Street:

Some "Interesting" Datapoints... Debt Crisis vs. Liquidity Crisis... Why Now?... The Fed Should Have Been Right... What It All Means...

Some "Interesting" Datapoints

Here are some interesting datapoints that all these easy-credit-addled geeks clamoring for a Federal Funds rate cut - such as Pimco's Bill Gross - may not have noticed:

  • Since the Federal Reserve Open Market Committee began lowering interest rates on Sep. 18, 2007 the S&P 500 has declined more than 30%.
  • Over that same period, the PHLX Banking Index (BKX) is down 42%.
  • The PHLX Housing Index (HGX) is down 57%.
  • The PHLX Semiconductor Index (SOX)... Whoa, stop right there. What do semiconductors have to do with subprime mortgages or credit default swaps? ... is down 44%.
  • Since the first special Term Auction Lending Facility was created by the Federal Reserve and offered on December 17, 2007, the SPX is down 27%, the BKX down 28%, the HGX down 19% and the SOX...Whoa, again with the SOX, what does that have to do with the TAF? ... is down 32%.
  • Since the Term Securities Lending Facility was created by the Federal Reserve and offered on March 27, 2008, the SPX is down 20%, the BKX is down 20%, the HGX is down 20% and the SOX... No, it can't be!... is down 20%.
  • Since the Treasury Department's proposal on September 19 of the Troubled Asset Relief Program (TARP), separately, a new $50 billion program to insure investments and the termination of short selling on financial stocks, the SPX is down 16%, the BKX is down 22%, the HGX is down 21%. the SOX... Do NOT Say It!... is down 17%.
  • Since the passage of TARP on October 3, less than two trading days ago, the SPX is down 3.8%, the BKX is down 5.5%, the HGX is down 3.5%, and yes, the SOX is down 3.5%.

For those that have noticed these declines, the most frequently asked question, naturally, is, "Why aren't the Fed's and the Treasury's liquidity attempts working?"

It's a reasonable question, after all, central banks in both the U.S. and Europe have said without equivocation for more than a year now that they will provide "as much liquidity as the market needs" to "fix" the problem. So why has this liquidity not been enough to maintain and support asset prices? Because this is not a liquidity crisis, it's a debt crisis.

Debt Crisis vs. Liquidity Crisis

The difference is important, and grasping it can help us sort through a number of market actions that appear to be counterintuitive.

During a liquidity crisis, the issue is one of supplying money to those who, for whatever reason, have suddenly shortened their time preferences.

Suppose there is a rumor that a large bank has made a bad loan. Because banks lend out more money than they have on deposit - this is called a fractional reserve banking system - if everyone goes to the bank and demands their money at the same time, a liquidity crisis can occur because the simply bank does not have enough cash on hand to satisfy the demand from its depositors. The Federal Reserve will then step in and provide liquidity, allowing the depositor demands to be satisfied. If the rumor of the bad loan proves to be false, then the issue is one of temporary liquidity. Time preferences soon return to a more normalized state, depositors return, everyone feels better. But, if the rumor turns out to be true, it doesn't matter how much liquidity the Fed provides, the bank will go bankrupt.

Similarly, the issue today is not one of temporary liquidity, time preferences being shortened out of a temporary risk aversion. The issue is too much debt supported by too little real income. As a result, global time preferences are retreating, risk aversion is growing, and access to credit is diminishing.

The battle in financial markets over the past year has been between reflation and deflation. The reason reflation has not been winning is because the Federal Reserve is powerless to make bad debt good. The Fed can only provide liquidity, and then hope that liquidity spawns credit creation. The market is fighting this by taking that liquidity and using it to "deflate," or to pay down, debt.

Why Now?

Isn't this like 1991? Or 1997? Or 1998? Or 2001? Why now? In the past, liquidity crises did not turn into full-blown debt crises because banks were able to create new products that allowed debt to be repackaged and sold very quickly.

The acronyms most of us had never heard of at this time last year - SIV's, ABCP, CDO's, RMBS's - were the result of more than a decade of financial engineering that allowed debt creation to expand, and bank profits to increase, thus masking weakness in the overall economy's ability to create enough growth to support this debt.

The process became self-reinforcing. The economy needed more debt to function, the banks needed to package and sell more debt to make money, investors needed to invest in more debt to increase returns, and so the game of musical chairs continued... until one small segment, one tiny fraction of the overall debt picture, subprime mortgage lending, failed.

The Fed Should Have Been Right

In March of 2006, the Federal Reserve and other government officials were repeatedly asserting that subprime mortgages were not a threat. In a sense, they should have been right. Subprime mortgages are/were a very small sliver of the overall mortgage pie. The Fed was correct in asserting that a healthy financial system should be able to support the total collapse of subprime mortgage lending with barely a hiccup. The Fed was incorrect in assuming our financial system was healthy.

The battle between bulls and bears last year at this time was over the following question: did loose underwriting standards and excessive credit creation in the subprime residential mortgage market exist in a vacuum?

Bulls believed that it did and, consequently, that loose underwriting standards and excessive credit creation were isolated to that small segment of the market. Therefore, according to that thesis, overall credit conditions were too tight and higher-quality segments of the market were being unfairly punished.

However, many of us believed that the subprime segment was simply a weaker version of the larger credit market paradigm - that loose underwriting standards and excessive credit creation was the norm across all market segments, not just subprime - and that was/is just the first inning of these credit issues.

What It All Means

One aspect of a debt crisis, as opposed to a liquidity crisis, is that a debt crisis reduces access to credit, and so we begin to see credit availability for even productive areas of the economy dry up; Salle Mae (SLM) cutting back on lending to students due to a combination of credit market turmoil and changes to federal law, for instance, American Express (AXP) cutting back business loans, commercial paper market becoming more fearful and even locking up, and on, and on, and on.

What must be remembered about what I have characterized as "the inevitable failure of the Bailout Bill" is what that failure means. It is not a "failure" in the absolute or idealogical sense; that ANY proposal or government intervention must be viewed as a failure. It is a failure in the sense that it will not return this broken economy to "normal" as so many are hoping.

After two full decades of credit expansion, having finally reached the point where debt is abhorrent, the new reality will be a more NORMALIZED credit market, not a return to the grossly abnormal market many of us have come to view as typical.

Think about it this way; it is not "normal" to be able to walk into virtually any retail store in the country and within 10 minutes be able to access $2,000 in credit by simply showing a drivers' license. It is not "normal" to buy a home with zero money down. This is not "normal" behavior. Adjusting to the new reality of normalcy will be a painful process.

On the one hand, Federal Reserve officials, Federal Government officials, many Wall Street executives and salespeople, believe it is "necessary for our economic security" to return to that place of easy credit. I disagree with that. I believe the American people disagree with that. And so the disagreement over the Bailout Bill, though pegged in the Mainstream Media as a war between battling economic classes, might really be a much deeper and more significant faceoff; a battle for the economic soul of this country.

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