Fed, Investors Disagree on Liquidity Worries

NEW YORK -- The Federal Reserve and financial markets don't see eye to eye on liquidity. The Fed says it isn't scarce, but investors don't entirely agree.

Thanks to everything from surging corporate profits to high savings rates in emerging market nations like China, markets have been awash in cash in recent years, helping keep interest rates and borrowing rates remarkably low. That means there has been big money to put to work in stocks, bonds, commodities, real estate and more.

But there are signs that the liquidity spigot is starting to slow. While that hasn't yet prompted Fed policymakers to suggest a cut or two may needed in the overnight borrowing rate to keep the U.S. economy from stalling (their public focus still is on the threat of higher inflation), it certainly has spooked investors enough to spur recent market turbulence.

There are many facets to liquidity, making it difficult to define. On the most basic level, it refers to the growth rate of money supply or the availability of credit. It also means being able to trade one asset for another to help minimize a loss in value.

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A major source of liquidity has been financial innovation, in areas like the mortgage and derivatives markets. That has greatly increased the ability to conduct financial transactions, according to Wachovia Securities senior economist Mark Vitner.

But when there is too much liquidity for too long, "people tend to do some very foolish things," he said, like loaning money to individuals with spotty credit histories to buy homes more costly than their limited income would deem to be prudent.

Renewed calls from central banks and financial regulators for tightened lending standards are finally starting to take hold, which many market-watchers point to as one of the drivers of the recent pullback in stocks after months of record-setting gains.

Fed Governor Kevin Warsh tried to ease such concerns in a speech earlier this month. "Markets are functioning well amid higher volatility, market discipline appears effective as investors are reviewing their positions, and overall liquidity does not appear to be in short supply," he told the Institute of International Bankers in Washington.

But clearly big changes are under way in the mortgage market. After soaring to 20 percent of total new mortgage issuance in 2006 from 5 percent just five years ago, the volume of subprime loans to individuals with shaky credit are likely to decline at least 30 percent this year, analysts forecast. That means a big slowdown in the economic effects of the $600 billion in new obligations created last year, according to Merrill Lynch.

The effect of that has broad implications since subprime loans are diced up and repackaged into collateralized debt obligations, which represent a big chuck of the mortgage-backed securities market. Managers of CDOs are already becoming more risk averse, so if they don't buy those mortgages, institutions won't produce them, and lenders won't offer them.

Already, Freddie Mac, the nation's second-largest financier of home loans, said recently that it will stop buying subprime mortgages it deems most vulnerable to default or foreclosure.

Also affecting liquidity is the trend of rising interest rates in many global markets. Not only has the Fed raised the overnight federal funds rate 17 times since 2004 to 5.25 percent, but the Bank of Japan has also become less accommodative by ending its zero interest rate policy last spring. After two increases, its benchmark rate now stands at 0.5 percent and some economists see that going higher later this year.

On Thursday, the European Central Bank raised its key interest rate a quarter point to 3.75 percent, its seventh rate hike since December 2005. ECB President Jean-Claude Trichet signaled to markets that this move won't likely be its last should inflationary pressures continue to rise.

U.S. corporate profit growth also is slowing. After 14 consecutive quarters of double-digit gains for companies in Standard & Poor's 500 index, the outlook is deteriorating at the fastest pace in six years, according to Merrill Lynch. Consensus estimates of the first-quarter increase went from 9 percent on Oct. 1 to 4 percent this week.

That's a big pullback from the 11.9 percent actual rise in the fourth quarter and the 14.9 percent increase in last year's first quarter, according to Thomson Financial. Not a single sector has been spared by the decline.

The trickle-down effect of this eroding liquidity will take time to see. Wachovia's Vitner says the pullback may be most pronounced in gold and oil prices, which were fed by the liquidity boom, and in the premiums that private-equity firms are willing to pay for businesses, since those buyout firms have benefited from the easy access to credit.

For now, liquidity isn't totally dried up, but it certainly isn't as plentiful as it was not too long ago.

Editor's note:
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