“Liquidity, Liquidity Everywhere
But Not a Drop to Drink
Liquidity, Liquidity Everywhere
and all the Banks did Shrink”
With sincere apologies Samuel Coleridge and the Rime of the Ancient Mariner
Professor Michael Palmer
Presentation to Schnitzer West, LLC
September 24, 2008
• Michael Palmer, Professor of Finance, Leeds
School of Business, University of Colorado.
• Education: Ph.D. University of Washington,
1967 (Finance and Macro-economics)
• Visiting Professor Status: Kansai Gaidai
University, Osaka, Japan; Jiao Tong
University, Shanghai, China; Semester at Sea
• Academic Director: London Seminar in
• We have experienced an unprecedented
freezing of global financial markets which
is now affecting real economic activity.
– Financial markets are showing some sign of
thawing, but is it too little and too late to
avoid a major global slowdown?
• Current financial crisis is not a liquidity
Liquidity is Not the Issue
There’s plenty of liquidity Borrowing from the Fed, $bn
• Fed’s Discount Window Facility and 28 and
84-day TAF program; 2008 data:
• Discount Window (Primary)
borrowing : $180bn
• Primary Dealer Credit Borrowing:
• Term Auction Facility: $1.7tr
– Fed buying 3 month commercial paper
– Specific companies:
• AIG: $85 billion (US Treasury) +
$38bn (Federal Reserve)
• Fed assets have ballooned to $1.8tr, or 12%
of GDP – double from last year.
Foreign Central Banks and Governments
have also Expanded Liquidity
United Kingdom Euro-Zone
• September 19, 2007: The Bank of • ECB permits approximately 1,900
England announced that it would member country (15) banks to
conduct auctions to provide funds raise 3- and 6-month funds through
to banks at 3 month maturity. weekly auctions.
– Expected injection with this – Funds injected through October
program: $350bn 8: $590bn.
• October 8, 2008: Government • October 6, 2008: German
announced it would buy shares in Government announced a state-
UK banks lead rescue package for commercial
– - Estimated injection: $90bn to property lender Hypo Real Estate.
135bn – Estimated injection: $68bn.
U.S. Financial System has Plenty of
Reserves (Depository Institutions)
Excess Reserves Non-Borrowed Reserves
• = Total Reserves* - Required** • Total – Borrowing from
• Average Monthly Data ($Bn) Fed
– 2005 through 2007: $1.7 • Average Monthly Data
– 2008 (Jan – Sep): $8.5*** ($Bn)
• *Deposits at Fed + Vault Cash – 2005 through 2007: $43.5
• **Legal Reserves against Deposits
– 2008 (Jan – Aug): -$92.0
• ***$6.0Bn in September
But Reserves Are Not (Yet) Showing up
in Money Supply Growth
M2 Growth* Commercial Loans*
• 3 Months, May 2008 to Aug • Aug 4-8, 2008: $42.4Bn
2008: 1.5% • Aug 6-10, 2007: $39.7Bn
• 6 Months, Feb 2008 to Aug • Aug 7-11, 2006: $44.0Bn
2008: 3.3% • Aug 1-5, 2005: $48.0Bn
• 12 Months, Aug 2007 to Aug • *Commercial and industrial
• 2008: 5.3% loans made by large domestic
*Percent change an seasonally commercial banks. Data are
adjusted annual rates. collected during the middle
month of each quarter.
What have Financial Institutions Done
With Their New Liquidity?
Strategy #1 3-month TED Spread
• Investing in Safe-Haven Financial
– Increase in Risk Aversion
• Represented by TED Spread
– Three month U.S. dollar Libor –
Three month U.S. T-Bill rate.
– Early 2007 spread 20 basis
– Oct 14, 2008 spread reached 445
basis points (the largest since
data collection began in 1984)
Impact of Safe Haven on Yields
Yield Curve: Oct 2007 to
Strategy Oct 2008
• Investing in Safe-Haven
– Increase in Risk Aversion
– Moving into Treasury Bills
• Biggest impact on short
segment of U.S. yield curve
• Pushing down the short
end of the curve.
– Fed policy also affecting
Financial Institutions Hesitate to Lend to
One Another or to End-User Market
Strategy #2 U.S., U.K. and Euro-Zone
• Hoarding Reserves
– Represented by spread of LIBOR
over Central Bank policy interest
– Early 2008 U.S. spread was around
– Currently spread is around 200
• Increasing deposits with central banks.
– Banks deposited a record amount
of cash with the ECB (182.6bn
euros) on Oct 13th
Financial Institutions Are Increasing
their Deposits with Central Banks
• In addition to investing in safe haven
assets, commercial banks are also
increasing their deposit holdings at their
respective central banks.
• ECB data:
– Friday, Oct 10, 2008: Bank deposits with ECB
totaled 154.7Bn euros.
– Monday, Oct 14, 2008: Bank deposits with
ECB totaled a record 182.8Bn euros.
• Current financial crisis has little to do
with interest rates!
Central Bank Interest Rates on the
Central Bank Target Rates Through Oct 8, 2008
• Key short term central bank rates are
– U.S. response earlier and deeper.
– From cycle peak:
• U.S. 5.25% (6/06) – 1.5%
– Easing began: Sept 2007
• U.K. 5.75% (7/07) – 4.5%
– Easing began: Dec 2007
• Euro-zone 4.25% (7/08) – 3.75%
– Easing began: Oct 2008
– Other central banks are lowering rates
as well (Australia, India)
Are European Central Banks
Abandoning their Inflation Targets?
Bank of England European Central Bank
– Inflation targeting adopted in – Inflation targeting adopted in
May 1997 and set by 1997 through an amendment to
Government. original treaty of Rome.
– Current CPI Inflation target: – Inflation target: “Below, but
2.0% close to, 2% over the medium
– Current inflation (Oct): 4.7% term.”
– Bank of England “seeks to meet – Current CPI inflation (June –
the inflation target by setting Aug): 3.9%
an interest rate.” – ECB meets their inflation target
through setting an “appropriate
level of the key interest rates.”
Why Might Lowering Interest Rates
Keynesian Liquidity Trap Elastic Demand for Reserves
• Are we approaching, or perhaps already in,
some form of the Keynesian liquidity trap?
– “Liquidity-preference may become
virtually absolute in the sense that
almost everyone prefers cash to holding
a debt which yields so low a rate of
interest. In this event the monetary
authority would have lost effective
• General Theory (1936)
– Monetary policy will not work at this
point because lenders are not willing to
Bank Lending Rates Have Come Down,
but Loans have Not Gone Up
Commercial Loans* Interest Rate on Loans*
• Aug 4-8, 2008: $42.4Bn • Aug 4-8, 2008 4.36%
• Aug 6-10, 2007: $39.7Bn • Aug 6-10, 2007 7.00%
• Aug 7-11, 2006: $44.0Bn
• Aug 7-11, 2006 7.14%
• Aug 1-5, 2005: $48.0Bn
• *Commercial and industrial • Aug 1-5, 2005 5.32%
loans made by large domestic *Weighted average effective
commercial banks. Data are loan rate, calculated from
collected during the middle
month of each quarter.
the stated rate and other
terms of the loans.
•Paul Krugman (1998) has
argued that Japan fell into a
liquidity trap in the 1990s.
•Japan was very slow to
•Monetary policy became
useless because banks
•Fiscal policy in the form of
large public projects finally
moved Japan out of
•But Government debt
now 180% of GDP (US:
• Authorities seem to be treating the current
crisis (in varying degrees) as an liquidity
– Fed of New York (Oct 8), announcing an
additional $37.8bn for AIG stated: This new
action will help AIG “replenish liquidity…”
• But, the current crisis is about(1) insolvency
concerns and a resulting (2) credit freeze!
• It’s really about a loss of confidence.
Interbank Lending is the Problem
• Domestic and interbank lending markets
– Liquidity is there, but banks have been
reluctant to lend to one another.
• Federal funds market.
• LIBOR market.
What is LIBOR and why is it
• LIBOR: The London Interbank Offer Rate is the
interest rate that large banks charge one another for
10 foreign currency denominated loans (deposits)
ranging from overnight out to 12 months.
– Set each day in London around noon through the BBA by
a representative panel of commercial banks.
– US dollar LIBOR the most important.
• It is estimated that $360tr of financial products
worldwide, from mortgages to company loans and
derivates, is tied to a LIBOR rate.
– Other regional markets have similar interbank rates
(HIBOR, in Hong Kong).
Retail Lending is the Problem
Commercial Paper Markets Shift to Short Term
• Key source of short term funding is
– Especially for longer term (3-
• Last year outstanding commercial
• Recently: $1.6tr (3 year low)
– Most of it 1 to 4 days maturity.
• Markets do NOT want to lend
– Prime money market funds pulled
$200bn from this market from Sept
16 to October 8th
Bond Spreads are Increasing
Pre-Financial Crisis Now
• September 20, 2007 • October 14, 2008
• Corporate: • Corporate:
– Aaa: 5.88% – Aaa: 6.55%
– Baa: 6.73% – Baa: 8.86%
• Spread: Baa- Aaa • Spread: Baa – Aaa
– + 85 basis points* – +231 basis points
• Government • Government
– 10 year 4.69% – 10 year 4.08%
• Spreads (over 10 year Government rate) • Spreads (over 10 year Government rate)
– Aaa: +119 basis points – Aaa: +247 basis points
– Baa: +204 basis points – Baa: +478 basis points
* 1934 – 2003 spread = 103 basis points
U.S. Bond Markets
• U.S. corporate bond sales were at their lowest September
level since 2000.
– September 2008: $11.7bn
– September 2007: $32.7bn
• “Corporate borrowing options have dwindles as the
investment grade bond market (Baa and above) remained
all but closed for a fifth week.” (Bloomberg, Oct 8)
– Companies like Gannett (the largest newspaper company in the
U.S.) and Southern have had to forego issuing debt.
– The new issue market is especially troubling for financial firms,
which have about $145 billion in fixed- and floating rate debt
maturing in the rest of 2008, according to JPMorgan data.
– Overall corporate bond spreads have hit record highs , closing
on October 2 at 339 basis points, up from 317 at the start of the
• Until we understand the current
situation, we cannot offer appropriate
and lasting solutions.
• Financial markets work best when participants have
confidence in dealing with one another and with the
“value” of the assets they are involved in.
• Today, confidence has broken down.
– Confidence regarding the solvency of borrowers.
– Confidence regarding the solvency of lenders.
– Confidence regarding the “market-values” of financial
– Confidence regarding the “tradability” of financial assets.
– Confidence regarding the regulation of markets.
– Confidence regarding policy makers.
Lack of Confidence
• When confidence breaks down, financial
markets cease to function (efficiently).
– Interbank market – which has been regarded
as close to risk free- suddenly freezes up.
– High investment grade companies are forced
out of the long term bond markets.
– High investment grade companies struggle
to raise short term funds.
Will $700Bn Bailout Restore
• On Oct 3, Congress passed a $700Bn bailout
• In and of itself will this restore confidence? I
don’t think so.
– Issue: What if “toxic” loans are removed from
the balance sheets of financial institutions?
• Will the credit markets “unfreeze?”
• Will the interbank market “unlock?”
• Will financial institutions continue to seek “safe
Will The Injection of Government Money
into the Equity Position of Banks Restore
• U.S. announced that they will inject $250Bn into
banks through the purchase of preferred stock.
– What will banks do with these funds?
– With this action, combined with the $700bn bailout,
there is the issue of “moral hazard.”
• Essentially rewarding bad behavior and setting a precedent
for future bailouts.
• French model: (Oct 20) Announced that they
would invest $13.99 billion (in subordinated
debt) in the country's six biggest banks by year-
end on condition that they increase lending to
companies, households and local governments.
Will a More Globally Coordinated Policy
Response Restore Confidence?
• Over the last two weeks, central banks have
engaged in coordinated policy actions:
– Central banks are taking equity positions in their big
– FED, BOE, and ECB all lowered their key short term
target interest rate by 50 basis points.
– Central banks have agreed to provide unlimited
dollar funds to financial institutions in Europe and
• Trying to bring down the overseas dollar rate.
– Central banks are lending to corporate borrowers in
their money markets.
Key: Restoring Confidence
• How might financial market confidence be
– Greater transparency by all participants, but
• Originators of new financial products.
• Risk evaluation services.
• Major financial institutions, include government
• Policy makers.
– Acting as lenders of last resort to end users.
– Through globally coordinated action
Theme # 5: Looking at the Big
• What About the Economy?
– How Did we Get Where we Are Today?
– Where Are we Today?
– Where Are we Going?
How Did We Get Here?
Recent History Lead to
• Easy monetary policy • Increasing domestic debt
fueled economic growth – Explosion of household
• Generally a period of low debt.
and falling inflation – Deteriorating current
– China Effect account balance
– Resulted in low interest rates – Increasing foreign
(falling cost of debt) ownership of U.S. debt
• Long Equity Bull Market • Easing spreading to the
Bull housing market
– Increasing wealth effect
Fed Policy and Economic Growth
Monetary Policy Economic Growth
Inflation and Interest Rates
Inflation Long term Interest Rates
Relationship of Inflation to Long
Term Interest Rates
Consumer Credit and Household
Household Debt Service
Consumer Credit Ratio
Equity Markets: Wealth Effect
1990’s 2000 – Oct 2007
Impact on Housing Sector
Mortgage and Housing Markets
Mortgage Markets Housing Prices
Where are we Today?
• Financial crisis spilling over to real economy
– Recent announced job cuts (downsizing)
– Surveys of consumer holiday buying intentions
• Housing lead slowdown (recession?)
– Bloomberg GDP survey: 3Q: -0.2%; 4Q: -0.8%
• Falling asset prices
– Equities and real estate
– Stock market generally a leading indicator of a recession
• Frozen credit markets
• Weakened financial institutions
• Weak household balance sheets
• Global contagion (economic slowdowns coupled with rising cost of
developing nation debt)
• Loss of confidence (in markets, in financial institutions, in regulators and
Leading Indicators of Economic
Useful Leading Indicators Stock Prices
• Conference Board’s • Shaded area is a NBER dated
Leading Indicator Series
– Indicates direction of
economy over next 3 to 6
• Sept +0.3%
• Aug – 0.9%
• Stock prices
So Where is the Economy
• Consumer spending is the key.
– Represents about 68% of GDP (2006)*
• Services: 38%; Durables: 10%; Non-durables: 20%
– Private Investment about 17%**
• Housing: 3.5%; Producers durables: 11%
– Government Expenditures about 17%
• Federal Government: 5%; State/Local: 12%
*Consumer sector represented 66.5% of GDP from 1996-2006
**Private Investment represented 25.2% and housing 1.6% of GDP from
1996 to 2006
So What About the Consumer?
• Consume spending will be affected by:
– Confidence (contagion effect of financial
– Income levels (income and unemployment
– Wealth effects (stock market and housing
Signals from Today: How is the Consumer
Likely to React in the Future?
Unemployment Rate (Sept
Consumer Confidence 6.1%)
Signals from Today: How is the Consumer
Likely to React in the Future?
Wealth Effect: DJA Down
Earnings Growth 38% from high
Wealth Effect: Housing Prices
Housing Price Data 1975 – 2Q2008
• During the 25-year period from 1975
through 1999, real house prices stayed
within the range of $132,000 to $171,000.
• Only since the year 2000 have real house
prices risen above this range.
• The United States median price was at
approximately $206,500 as of the second
quarter of 2008.
– This is 21% higher than the previous
housing boom peak of an inflation-
adjusted $170,900 in 1989.
• Nominal prices peaked in 2Q2006 at
$252,514. Currently at $206,500 (-18%)
Regional Impacts of Housing
Los Angeles: Sept 06: -26% Seattle: July 07: -7%
Where are Financial Markets
Headed? Are we at the Bottom?
• Indications of some financial market thawing out
– LIBOR (dollar) rates easing (Oct 22, overnight USD at 1.12% has fallen to lowest
level since 2004).
– TED spread easing (from 434 a week ago to 250 now).
– Interbank rates easing (globally, in Asia and Europe).
– Commercial paper rates easing (Oct 22, 30-day paper at 1.93% at lowest level in 4
– Money market fund rates easing.
– Recent money supply growth.
– Perhaps some confidence is coming back, BUT spreads are still historically high
suggesting the thaw still has a way to go.
• Future short term and longer term problems?
– Mounting credit card delinquencies
• BofA lost $373 million in the 3rd quarter on card services unit.
– Falling U.S. savings rate might discourage household consumption (if rebuilding
savings takes place).
– Rising Federal government deficit.
Is the Federal Reserve Running out
of Traditional Options?
Traditional Policy Tools Contemporary Approach
• Lender of last resort to important
• Fed funds rate now at 1.5% financial markets.
– Running out of downside – Oct 21: Providing $540bn to
room? money market mutual funds so
they can meet redemptions.
• Discount window borrowing
– Unfreeze frozen markets
facility has been expanded to
– Expand direct lending beyond
non-commercial bank the commercial paper market
borrowers. where needed.
• Reserve ratio remains • But, Fed assets are ballooning,
unchanged. $1.8tr, or 12% of GDP – double from
What else Needs to be Done?
Restore Confidence Ongoing Issues
• “Temporary” increase in FDIC • Cleaning up the securitizations and
insurance and guarantee of money derivatives markets.
market mutual funds. – Including educating end users to the
• Global coordination must continue. risks involved.
– Europe has increased deposit • Revising regulation decisions.
insurance as well. – Glass-Steagall
• But, continuation of strong dollar – Mark- to-market accounting rules
suggests ongoing global flight to • Europe easing rules allowing
safety is still an issue (next slide). banks to reclassify some assets
as long term.
• Balance all actions against moral
• Examining the response of credit
U.S. Dollar Remains Strong
Turnaround in July Consequences of strong $
• Keep U.S. inflation in check.
– Provide greater flexibility to
• Discourage foreign central
bank withdrawals from U.S.
– Foreign ownership of U.S.
marketable debt now around
Do We Need Another Stimulus Package?
• Bernanke (Oct 20): indicated that
he would endorse additional
fiscal stimulus to help
– “The pace of economic activity is
likely to be below that of its longer-
run potential for several quarters.
The slowing in spending and
activity spans most major sectors.''
• Bush Administration indicated
they were open to the idea.
• House democrats suggested
“infrastructure spending and
– New infrastructure projects
generally slow to come on line.
– Perhaps we need to consider tax
cuts for businesses.
Two Macro-Economic Scenarios
Scenario 1: V shape Scenario 2: U, W or L shape
• Quick recovery • Now some are thinking:
– Within 2 to 3 quarters – U: More gradual recovery
• Historically this has been the (e.g., 1990/91), or
case – W: Recovery followed
• Early 2008 optimism for closely by another recession
second half turnaround (aka “double dip”) as 2008
resulting from: stimulus dries up (e.g., 1981,
– Assumed positive lagged 2001), or
response of Fed interest rate
cuts. – L: Prolonged recession (e.g.,
1929 or Japan in the 1990s).
– Spring tax rebates.
U-Shaped Recovery Likely
• Caveat: The factors underlying a U-shaped scenario
are notoriously difficult to predict.
– Specifically, exactly when and to what degree factors
impacting household and business behavior will kick in
and when they will translate into GDP.
• U-Shaped recovery scenario likely based on:
– Severity of financial asset bubble collapse
– Large debt burdens (household)
– Financial market freeze (and its contagion effect on real
– Global reach of current situation (through
trade/business coupling of economies)
Post Scrip: The U.S. Economy and
the Rime of the Ancient Mariner
• The mariner’s tale is about a ship (U.S. Economy) which
leaves its native harbor. Initially, all goes well and the ship
smoothly sails across the seas. However, misfortune strikes
as the voyage darkens and the ship is caught in a labyrinth of
ice (Credit Crisis; Frozen Capital Markets).
• The ship is lead from ice to uncharted waters (Sub-Prime
Mortgage Meltdown and Non-traditional policy responses).
• The mariner eventually hears the voices of two angelic
spirits (Ben Bernanke and Henry Paulson) whose
conversation reveals that his ship was maneuvered by
heavenly forces. When the mariner awakes he finds himself
home among familiar landmarks (Hoped for Outcome?)
Questions and Answers and