Adhvith Dhuddu, CT Regular Columnist
Wednesday, January 16; 12:00 AM
Historically, the root of all financial innovations and the origin of most global financial meltdowns has been (ironically) the United States. Although this is changing with a leveled playing field and the democratization of finance, the source of the most recent credit turmoil has been the United States, and unsurprisingly, this is where subprime securities first found their market.The recent financial credit crisis is creating jitters around the world among central banks, private banks, and other financial institutions. Even now, six months after the damage was discovered, no one knows the true extent of the ramifications. The "R" word is being tossed around freely and economists fear a global slowdown in business and investments. The crisis is far from over, but a root cause analysis will help understand what is going on and, more importantly, how and to what extent it affects us.
Understanding the ABCs of liquidity and how its game has changed since the emergence of securitization helps us assess the situation better. Central bankers primarily use two instruments to control the flow of money (or level of liquidity) in the economy. They are calibration of reserve requirements for banks and modification of interest rates at which banks can borrow from central bank (the banker's bank) and inter-bank loan rates.
By these mechanisms, central bankers not only control the capacity to which a bank can lend out money, but also the level of inflation. Excess, or easy credit, can lead to surplus liquidity, which might later translate to high inflation for a country.
Normally, a bank's balance sheet is supposed to include the money loaned out, helping keep tabs on how fully loaned out they are. But the ability to "securitize" a loan helped them move it off their books. Institutional and individual investors who invest in debt primarily use two methods to securitize debt in order to make it more accessible. One way is to group all the loans and divide that cluster into smaller units to sell as bonds. And the other, more complex, way is to eliminate default risk and lock in interest rates using credit default and interest rate swaps, respectively.
So once the bank's loan is sold off via securitizing, disappearance of the loan from the bank's balance sheet essentially frees up the capacity of the bank to lend out more money. This obviously renders the reserve requirements frivolous because as long as the bank can keep selling off its loans to individuals investing in debt, they can keep lending out more and more money. Central banks have no control over this phenomenon because there are no controls over how much debt can be securitized or how many loans can be sold off, thereby losing control over liquidity and money flow in the country.
This vicious cycle created an environment conducive to extremely cheap credit and outrageous asset prices (which is why real estate prices rose from 2001 to 2006). Like all good things, this came to an end when a higher-than-expected number of home owners defaulted and triggered a chain reaction leading to lower home prices and a decrease in demand for home building materials. Eventually cheap credit became a thing of the past even with the Federal Reserve continually lowering interest rates.
We are a credit nation and a chief ingredient for our growth is access to cheap credit. But as the cost of borrowing increases, everything from savings to expenditures and investing will experience a slowdown.
The Dow Jones has gotten off to its worst start in 16 years and is down over 5 percent in the first two weeks of the year. This is just the beginning, and we can expect more woes to follow. Credit will continue to be expensive, and individuals with adjustable rates on their mortgages, car loans and student loans will have to shell out more for their monthly payments.
Unemployment rates may rise and uncertainty about the economy will continue. Economic recession is now more of a possibility than a probability. The best investment strategy during these troubling times is to stay in cash to wait for opportunities (preferably in non-dollar denominated currencies) or invest in safe havens such as gold and silver.
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