Oct 8, 2008
ST-NUS BUSINESS SCHOOL SERIES ON FINANCIAL CRISIS
By Allaudeen Hameed
FINANCIAL markets have suffered multiple crises over the past two decades: the 1991 Gulf war, the 1997 Asian financial crisis, the 1998 collapse of Long Term Capital Management, the 2000 bursting of the dotcom bubble, the Sept11 terrorist attacks, the 2002 Worldcom scandal, and the first 2007 sub-prime crisis. In each instance, stock market prices fell and market liquidity declined simultaneously.
What is liquidity? There are two types of liquidity: asset liquidity and funding liquidity. It is important to understand the differences between the two.
Asset liquidity refers to the ability to buy or sell securities quickly without a significant impact on their prices. Assets such as houses and cars are less liquid as the seller would usually incur significant losses to unload them immediately. Financial assets such as stocks and bonds are more liquid, for buyers and sellers can transact significant quantities of them at ready prices in organised markets.
Funding liquidity refers to the risk of a firm having insufficient capital to meet liabilities when they become due and being unable to attract additional capital at short notice. Both types of liquidity are interdependent and are relevant in the current financial crisis.
In normal circumstances, financial intermediaries and market makers provide ready prices and, hence, asset liquidity. New York Stock Exchange specialists and Nasdaq dealers, for example, play this role. Over the past decade, however, hedge funds and the proprietary trading desks of investment banks have become significant competitors to market makers. In fact, the profits from some of their trading strategies are essentially returns for providing asset liquidity.
As increased competition led to lower returns from these trading strategies, the funds resorted to bigger borrowings or leverage to increase their capital base. And since their capital requirements do not fall within federal regulation, they became excessively leveraged. For example, Lehman Brothers, the investment bank that went bust, borrowed more than 35 times its capital, pledging the assets it held as collateral.
During times of financial stress, both types of liquidity tend to evaporate in financial markets. A large drop in asset values and a concomitant increase in uncertainty about valuations precipitate panic selling. Investors reduce their risky holdings in favour of safer assets, a phenomenon referred to as a flight to safety.
Government securities are believed to be the safest investments. Investors fleeing to safety buy liquid US government bills. As an indication of how nervous investors have been in recent weeks, the yield on Treasury three-month bills has dipped to close to zero per cent. The Treasury paid almost nothing to borrow money and investors were only too happy to lend to the government in return for safety.
An imbalance between the number of sellers and buyers in crisis situations reduces asset liquidity. This calls for greater provision of liquidity, especially for risky, more uncertain assets. But the provision of asset liquidity in crisis periods is constrained by limited capital. Drops in market prices amplify the leveraged positions of investment banks and hedge funds, forcing them to liquidate (deleverage). The forced sale of assets not only leads to a further depression of prices, but also erodes the equity capital of investment banks, making it even more difficult for them to raise new short-term financing.
Nevertheless, when capital does flow into the market, assets that have been pummelled can be purchased easily. This in turn leads to prices reverting to norm. When short-term dislocations in the financial markets arise from liquidity shortages, an infusion of capital, either from the government or private sources, can reverse the fall in asset prices and restore the health of financial institutions.
The current financial turmoil is more complicated because of several factors. To begin with, financial institutions need to deleverage their holdings of 'troubled' assets, mostly linked to housing mortgages. The financial institutions which bought these assets at 'market' prices underestimated their riskiness and overpaid. The worsening economic situation suggests that these assets are not likely to become valuable in the near future.
The extent of exposure in the financial sector to these troubled assets is so huge that the US government has concluded that markets or private capital flows cannot be relied on to sort them out. A large financial firm selling these assets at low prices could have systemic effects leading to the insolvency of many other firms.
For example, if a private fund bought mortgage-backed securities from a failing bank at 20 cents on the dollar, accounting rules would require other institutions holding the same or similar securities to mark down the value of their holdings to 20 cents on the dollar. This 'mark to market' process could quickly become a self-fulfilling death spiral. As part of its response to the crisis, the US government now allows firms to use other information to value illiquid assets on their books rather than marking them down to fire-sale prices.
We are also witnessing a freeze in the market on short-term financing. Companies which used to borrow short-term by issuing commercial papers are no longer able to do so as lenders have become extremely cautious. Even banks have become less willing to lend to other banks in the interbank market, thus raising interest rates on such borrowings.
Hence, to stabilise the financial system and rebuild investor confidence, the US Treasury proposes to bail out financial institutions by buying their troubled assets. There might be lessons here from the Japanese government's bailout of the country's troubled banks in the 1990s.
The Japanese crisis was started by the bursting of its property and stock market bubbles of the 1980s. Tokyo invested in insolvent banks, delayed the resolution of massive bad debts and failed to make fundamental reforms in lending practices or close down insolvent firms. These worsened the banking crisis and led to Japan's 'lost decade'.
What is unclear about the US Treasury's current bailout plan is whether it would solve a funding liquidity problem or an insolvency problem. If it accomplished the former, that would be a good thing. If it did the latter - bailed out insolvent, badly managed financial firms - that would not be a good thing, as Japan's experience suggests.
The writer is Professor of Finance at the National University of Singapore. This is the fourth of 10 articles in the ST-NUS Business School series on the financial crisis.