Phorgy Phynance

How far does this go?

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Over on The Big Picture, Barry Ritholtz asks

Any thoughts as to how far this goes? Will the Central Bankers keep the liquidity infusion flowing? What’s the impact on Markets, the Economy, Risk appetites?

What say ye?

I think there is still pain to be felt in credit. In fact, I think credit hasn’t even begun to feel pain yet. As Roubini so eloquently puts it, this is not only a liquidity problem, but also a credit problem. Years of easy credit resulting from extremely lax (bordering on incompetent) monetary policy has created a “credit bubble” that will make the housing bubble dim in comparison.

Over on NP, there has been some really great discussions lately. For example, on May 22, 2007, “kr” who is PHRIGGIN SCARY SMART started a thread called

Liquidity Liquidity Everywhere

I highly recommend it. He opens up the thread with a FT Report, “Credit creation from seesawing markets”.

Here are some excerpts (my emphasis in bold):

The former chief global strategist at Pimco and current chief investment officer of Alpha Vision Capital Management, a global macro absolute return investment manager owned by Allianz Global Investors, offers cautious words about the Federal Reserve’s ability to control liquidity.

“Financial innovation means that liquidity is now being created outside the Fed’s control,” says Mr Thomas.


Although most market practitioners today were taught Keynesian economics in school, he explains, this offers only one theory of employment, interest and money. Arguably, Austrian economics explains recent history better than Keynesianism does.

Austrians such as Von Mises and Hayek argued that a liquidity glut leads to inflation, but noted all prices do not rise simultaneously. Rather, capital goods are affected first, leading to excess profits and rising stock prices in this sector of the economy. During this first stage, consumer prices may be stable or even falling.

Where non-Austrian economists were optimistic during the 1920s, rejecting the idea that liquidity was too abundant by pointing to stable inflation, many Austrian economists were predicting it would all end in tears.

“Events today are evolving as they would in an Austrian world, when liquidity is too abundant,” says Mr Thomas.

Recent years mark the third period in this historical construct, according to Mr Thomas. Here two considerations arise: first, for the Austrians, goods price inflation is a late cycle event – asset price inflation comes first; and second, liquidity is being created outside the banking system.

Mr Thomas explains that today, instead of holding assets until maturity, banks sell their assets to be securitised, meaning that debt markets have usurped bank credit, and the Fed has been effectively removed from the picture.

“Debt creation depends on the quantity that securitised debt investors [not bankers] deem prudent to hold. Liquidity – the ability to create debt and the associated assets – is effectively unregulated, just as it was before 1913,” says Mr Thomas.


Today, instead of borrowing from a bank, a potential leveraged equity investor can simply buy an equity futures contract or enter into a total return swap, and a bond investor can enter a swap agreement or buy bond and note futures.

As innovation has greased the machine, so to speak, the Fed has given up control in the process,” says Mr Thomas.

Arguably, he says, if the Fed controls only one of the levers that can manipulate credit creation, it will have to push or pull that lever more firmly than it would if the slightest touch had a more substantial effect.

“In such a world, we can expect the Fed funds rate to be manipulated more often and with greater vigour than it has been in the past,” says Mr Thomas.

“It is difficult to ignore the fact that the last time the Fed stimulated the economy, it felt the need to lower the funds rate dramatically.”


“But experience and history convince me that markets are manic depressive, veering from too much optimism to too much pessimism,” says Mr Thomas.

Because commercial banks no longer control credit creation and the Fed no longer even effectively controls commercial banks, expect financial markets to increasingly resemble casinos. This is how Keynes, himself a successful speculator and an early global macro player, described them,” he adds.

Copyright The Financial Times Limited 2007

Ok. Those were a lot of excerpts, almost the entire article, but I think the excessive quoting is justified.

Needless to say, this sparked a long and fascinating discussion (at least until I chimed in 🙂 ). Then on, May 25 kr (Did I say he was PHRIGGIN SCARY SMART?) posted another article, which seems prescient now:

Questions raised over how long buy-out funding can last
By Paul J Davies

Published: May 24 2007 20:11 | Last updated: May 24 2007 20:11

Here are some excerpts:

“People talk about the ‘private equity put’ on the stock markets like they used to talk about the ‘Greenspan put’. Who knows how long it will last, but the notion that it’s permanent is not true.”

He says today’s market is a lot like 1988-90’s.

“There is a huge LBO boom, a huge real estate boom and people then ascribed permanence to the liquidity that was financing it and they forget now how quickly that dried up when it did.”


Furthermore, many bankers in the leveraged finance industry are aware that in the heat of the competition to get a slice of the private equity action, they are underwriting increasingly aggressive structures.

It is often said that banks do not have to worry about underwriting standards in this market because they can quickly sell it on to other investors.

But this is far from the case, according to bankers. They say that a lot can change in the long lead times between committing to underwrite a deal and reaching the point when the debt can be sold [Comment: Man, he nailed that one.] – the warehouse period.


Other leveraged finance bankers on both sides of the Atlantic identify this as their biggest single concern about the current loan markets. It is the “warehousing” risk that caused significant pain for a number of banks in the US subprime mortgage market recently.

That crisis illustrates just how quickly a market for selling loans on to investors can shut down. Furthermore, the close inter-relations between different securitised debt markets – the vehicles that provide liquidity to leverage loans, mortgages and other types of debt – mean that subprime mortgage has had an impact on the funding for leveraged loans and other kinds of debt.

Spreads – or risk premiums – on the more junior notes issued by collateralised loan obligations, the vehicles that buy a significant portion of leveraged loans, have widened significantly. Part of this is due to concerns among investors that there could be similar problems with lax underwriting standards as in subprime mortgages.


This is all happening while many CLO managers – particularly newer ones – are already concerned about their ability to generate good enough returns to pay their investors.

It is far from certain how CLOs and their investors will react to these dynamics even before a rise in default rates. Mr Bernstein’s warning about the current surfeit of liquidity seems well worth heeding.

Copyright The Financial Times Limited 2007

Then the peanut gallery entered the discussion. On May 29, I added:

Remember those old “Jack in the Box” toys? Those things always phreaked me out. You wind the crank and that song plays menacingly, the more it winds the more intense the anticipation becomes.

Does anyone else feel that way about the state of the (global) markets today?

There went the neighborhood 🙂

I completely agree with a statement by AndyM early in the discussion:

Austrians are being revisited because of their focus on the central role of investment and the forces that promote / amplify malinvestment. Add in a dollop of Minsky and you have a useful framework for analysing aspects of the current environment. It will arguably be a much more useful framework than the random shocks to productivity school.

Austrian school plus a dollop of Minsky. That is where we are and that is where we’re going. The bursting credit bubble will be painful. Inflation, as the Austrians might claim, is around the corner. The Fed has lost its ability to influence the situation. Bank overnight rates shooting to 6% might indicate that is where the Fed rate SHOULD be. The Fed will be required to infuse cash into the system until inflation is apparent enough that he can actually raise the rate. That will cause even more pain, but the pain it will cause is completely justified. Innocent people will definitely get hurt in the process, but that is an unfortunate side effect of economic Darwinism.

Most of the doom and gloom will be US-centric in my opinion. The US can’t get toasted without impacting the rest of the world somewhat, but the global economy has been steadily decoupling from the US. Not everyone will be hurt equally. I think there are opportunities in Europe (East and West), Asia, Middle East, emerging markets. I am very bleak on the long term outlook for the US. Long periods of neglect of our infrastructure combined with demographics as the baby boomers begin to retire will place tremendous pressure on the US financial system.

One more note regarding risk appetites…

Risk appetite is a lot like the concept of “hysteresis” in physics. Even if conditions return to “normal”, risk premium will not come back to where it was. Risk premium is here until the beginning of the next credit cycle, which is obviously far away as this cycle is only beginning to turn.


Written by Eric

August 10, 2007 at 4:52 pm

Posted in Credit, Markets

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