Five Things You Need to Know: Debt Crisis Vs. Liquidity Crisis
What you need to know (and what it means)!
Kevin Depew's daily Five Things You Need to Know to stay ahead of the pack on Wall Street:
1. Debt Crisis Vs. Liquidity Crisis
Here is an interesting datapoint that many may not have noticed. Since the Federal Reserve Open Market Committee began lowering interest rates on Sep. 18, the S&P 500 has declined more than 7%. For those that have noticed the decline, particularly the decline in shares of Financial stocks as the PHLX Bank Index (BKX) has plummeted by 24% since Sep. 18 - a bear market by any measure - the most frequently asked question is "Why isn't the Fed's liquidity working?"
It's a reasonable question, after all, central banks in both the U.S. and Europe have said without equivocation 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. 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. Mr. Practical, writing on Minyanville's Buzz & Banter, characterized it this way:
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 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 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 value and income generation. As a result, time preferences are retreating, risk aversion is growing, and access to credit is diminishing.
The battle in financial markets is currently between reflation and deflation. The reason reflation is not 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, pay down debt.
2. 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 become 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.
In March last year the Federal Reserve was repeatedly asserting that subprime mortgages were not a threat. In a sense, they should have been right. Subprime mortgages are 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.
3. The First Inning
The battle between bulls and bears is over the following question: did loose underwriting standards and excessive credit creation in the subprime residential mortgage market exist in a vacuum?
If one believes that it did, and consequently that the paradigm within which loose underwriting standards and excessive credit creation came into being were isolated to that small segment of the market, then overall credit conditions here are too tight and higher-quality segments of the market are being unfairly punished.
However, if one believes that the subprime segment is 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 - then we are still in the first inning of these credit issues. In fact, if that is the case, we may not even have seen the first out of the first inning yet.
4. A Debt Crisis Reduces Access to Credit...
... And so we begin to see credit availability in other areas dry up. Salle Mae (SLM) said recently it would cut back on lending to students due to a combination of credit market turmoil and changes to federal law.
On Friday the company said in an SEC filing that it would be "more selective" in originating both government-backed student loans and private loans, the Wall Street Journal reported.
The company has said that its higher financing costs, as well as the subsidy cuts, will reduce and possibly eliminate the profitability of making new government-backed loans.
What Sallie Mae is saying here is important. The bottom line is that it no longer makes sense to pursue this credit expansion because it's are no longer profitable.
5. The "Real" Fed Model
The LA Times back in December took a look at auto loans. What is astonishing is how clearly the Fed's credit paradigm has been adopted by the auto loan segment.
The length of the average automobile loan hit five years, four months in October, up more than six months from 2002, according to data from the Federal Reserve. And nearly 45% of loans written today are for longer than six years, the Times noted.
Meanwhile, the amount of money drivers owe on their cars increased more than 10% in the past year. The Times article reports that today's average car owner owes $4,221 more than the vehicle is worth at the time it's sold.
Yet, how has the auto loan industry responded? By extending loans further and allowing consumers to roll old loans into new loans with longer terms to avoid the shock of an increase in the monthly debt service obligation. The net result is that drivers are in many cases paying a loan on two or more cars simultaneously.
"From the point of view of those who sell cars and car loans, long-term loans are good for business and good for buyers," the Times says.
No, actually, it's not. Like the car buyers, the car loan lenders in this case are also borrowing from their future. Eventually, these loans have to be repaid; these people will eventually reach the end of their borrowing capabilities. By delaying the day of reckoning, the auto loan sellers are simply adopting the same model of liquidity expansion as the Fed. They too, like the Fed, will ultimately meet a wall of resistance.
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