1
Liquidity, Liquidity EverywhereBut Not a Drop
to DrinkLiquidity, Liquidity Everywhereand all
the Banks did ShrinkWith sincere apologies
Samuel Coleridge and the Rime of the Ancient
Mariner

• Professor Michael Palmer
• Presentation to Schnitzer West, LLC
• Seattle, Washington
• September 24, 2008

2
Quick Bio

• 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
  International Finance

3
Punch Line

• 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?

4
Theme 1

• Current financial crisis is not a liquidity
  crisis!

5
Liquidity is Not the Issue

• Theres plenty of liquidity

• Borrowing from the Fed, bn

• Feds Discount Window Facility and 28 and 84-day
  TAF program 2008 data
• Discount Window (Primary) borrowing 180bn
• Primary Dealer Credit Borrowing 117bn
• Term Auction Facility 1.7tr
• Fed buying 3 month commercial paper from
  issuers.
• 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.

6
Foreign Central Banks and Governments have also
Expanded Liquidity

• United Kingdom

• Euro-Zone

• September 19, 2007 The Bank of England announced
  that it would conduct auctions to provide funds
  to banks at 3 month maturity.
• Expected injection with this program 350bn
• October 8, 2008 Government announced it would
  buy shares in UK banks
• - Estimated injection 90bn to 135bn

• ECB permits approximately 1,900 member country
  (15) banks to raise 3- and 6-month funds through
  weekly auctions.
• Funds injected through October 8 590bn.
• October 6, 2008 German Government announced a
  state-lead rescue package for commercial property
  lender Hypo Real Estate.
• Estimated injection 68bn.

7
U.S. Financial System has Plenty of Reserves
(Depository Institutions)

• Excess Reserves

• Non-Borrowed Reserves

• Total Reserves - Required
• Average Monthly Data (Bn)
• 2005 through 2007 1.7
• 2008 (Jan Sep) 8.5
• Deposits at Fed Vault Cash
• Legal Reserves against Deposits
• 6.0Bn in September

• Total Borrowing from Fed
• Average Monthly Data (Bn)
• 2005 through 2007 43.5
• 2008 (Jan Aug) -92.0

8
But Reserves Are Not (Yet) Showing up in Money
Supply Growth

• M2 Growth

• Commercial Loans

• 3 Months, May 2008 to Aug 2008 1.5
• 6 Months, Feb 2008 to Aug 2008 3.3
• 12 Months, Aug 2007 to Aug
• 2008 5.3
• Percent change an seasonally adjusted annual
  rates.

• Aug 4-8, 2008 42.4Bn
• Aug 6-10, 2007 39.7Bn
• Aug 7-11, 2006 44.0Bn
• Aug 1-5, 2005 48.0Bn
• Commercial and industrial loans made by large
  domestic commercial banks. Data are collected
  during the middle month of each quarter.

9
What have Financial Institutions Done With Their
New Liquidity?

• Strategy 1

• 3-month TED Spread

• Investing in Safe-Haven Financial Assets
• 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 points.
• Oct 14, 2008 spread reached 445 basis points (the
  largest since data collection began in 1984)

10
Impact of Safe Haven on Yields

• Strategy

• Yield Curve Oct 2007 to Oct 2008

• Investing in Safe-Haven Financial Assets
• 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 this segment.

11
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 rates
• Early 2008 U.S. spread was around zero.
• Currently spread is around 200 basis points.
• Increasing deposits with central banks.
• Banks deposited a record amount of cash with the
  ECB (182.6bn euros) on Oct 13th

12
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.

13
Theme 2

• Current financial crisis has little to do with
  interest rates!

14
Central Bank Interest Rates on the Way Down

• Central Bank Target Rates

• Through Oct 8, 2008

• Key short term central bank rates are coming
  down.
• 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)

15
Are European Central Banks Abandoning their
Inflation Targets?

• Bank of England

• European Central Bank

• Inflation targeting adopted in May 1997 and set
  by Government.
• Current CPI Inflation target 2.0
• Current inflation (Oct) 4.7
• Bank of England seeks to meet the inflation
  target by setting an interest rate.

• Inflation targeting adopted in 1997 through an
  amendment to original treaty of Rome.
• Inflation target Below, but close to, 2 over
  the medium term.
• Current CPI inflation (June Aug) 3.9
• ECB meets their inflation target through setting
  an appropriate level of the key interest rates.

16
Why Might Lowering Interest Rates Not Work?

• 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
  control...
• General Theory (1936)
• Monetary policy will not work at this point
  because lenders are not willing to make loans.

17
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 6-10, 2007 39.7Bn
• Aug 7-11, 2006 44.0Bn
• Aug 1-5, 2005 48.0Bn
• Commercial and industrial loans made by large
  domestic commercial banks. Data are collected
  during the middle month of each quarter.

• Aug 4-8, 2008 4.36
• Aug 6-10, 2007 7.00
• Aug 7-11, 2006 7.14
• Aug 1-5, 2005 5.32
• Weighted average effective loan rate, calculated
  from the stated rate and other terms of the
  loans.

18
Lessons from Japan?

• Paul Krugman (1998) has argued that Japan fell
  into a liquidity trap in the 1990s.
• Japan was very slow to react.
• Monetary policy became useless because banks
  stopped lending.
• Credit freeze!
• Fiscal policy in the form of large public
  projects finally moved Japan out of recession.
• But Government debt now 180 of GDP (US 80)

19
Theme 3

• Authorities seem to be treating the current
  crisis (in varying degrees) as an liquidity
  problem.
• 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!
• Its really about a loss of confidence.

20
Interbank Lending is the Problem

• Domestic and interbank lending markets are
  frozen.
• Liquidity is there, but banks have been reluctant
  to lend to one another.
• Federal funds market.
• LIBOR market.

21
What is LIBOR and why is it Important?

• 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).

22
Retail Lending is the Problem

• Commercial Paper Markets

• Shift to Short Term

• Key source of short term funding is drying up.
• Especially for longer term (3-month) paper.
• Last year outstanding commercial paper 2.2tr
• 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

23
Bond Spreads are Increasing

• Pre-Financial Crisis

• Now

• September 20, 2007
• Corporate
• Aaa 5.88
• Baa 6.73
• Spread Baa- Aaa
• 85 basis points
• Government
• 10 year 4.69
• Spreads (over 10 year Government rate)
• Aaa 119 basis points
• Baa 204 basis points
• 1934 2003 spread 103 basis points

• October 14, 2008
• Corporate
• Aaa 6.55
• Baa 8.86
• Spread Baa Aaa
• 231 basis points
• Government
• 10 year 4.08
• Spreads (over 10 year Government rate)
• Aaa 247 basis points
• Baa 478 basis points

24
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 month.

25
Theme 4

• Until we understand the current situation, we
  cannot offer appropriate and lasting solutions.

26
Financial Markets

• 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 assets.
• Confidence regarding the tradability of
  financial assets.
• Confidence regarding the regulation of markets.
• Confidence regarding policy makers.
• Etc.

27
Lack of Confidence

• When confidence breaks down, financial markets
  cease to function (efficiently).
• Examples
• 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.

28
Will 700Bn Bailout Restore Confidence?

• On Oct 3, Congress passed a 700Bn bailout
  package.
• In and of itself will this restore confidence? I
  dont 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 haven investments?

29
Will The Injection of Government Money into the
Equity Position of Banks Restore Confidence?

• 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.

30
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 banks.
• 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 Asia.
• Trying to bring down the overseas dollar rate.
• Central banks are lending to corporate borrowers
  in their money markets.

31
Key Restoring Confidence

• How might financial market confidence be
  restored?
• Greater transparency by all participants, but
  especially
• Originators of new financial products.
• Risk evaluation services.
• Major financial institutions, include government
  organizations.
• Policy makers.
• Acting as lenders of last resort to end users.
• Through globally coordinated action

32
Theme 5 Looking at the Big Picture

• What About the Economy?
• How Did we Get Where we Are Today?
• Where Are we Today?
• Where Are we Going?

33
How Did We Get Here?

• Recent History

• Lead to

• Easy monetary policy fueled economic growth
• Generally a period of low and falling inflation
• China Effect
• Resulted in low interest rates (falling cost of
  debt)
• Long Equity Bull Market Bull
• Increasing wealth effect

• Increasing domestic debt
• Explosion of household debt.
• Deteriorating current account balance
• Increasing foreign ownership of U.S. debt
• Easing spreading to the housing market

34
Fed Policy and Economic Growth

• Monetary Policy

• Economic Growth

35
Inflation and Interest Rates

• Inflation

• Long term Interest Rates

36
Relationship of Inflation to Long Term Interest
Rates
37
Consumer Credit and Household Debt

• Consumer Credit

• Household Debt Service Ratio

38
Equity Markets Wealth Effect

• 1990s

• 2000 Oct 2007

39
Impact on Housing Sector
40
Mortgage and Housing Markets

• Mortgage Markets

• Housing Prices

41
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 policy makers)

42
Leading Indicators of Economic Activity

• Useful Leading Indicators

• Stock Prices

• Conference Boards Leading Indicator Series
• Indicates direction of economy over next 3 to 6
  months.
• Oct
• Sept 0.3
• Aug 0.9
• Stock prices

• Shaded area is a NBER dated recession.

43
So Where is the Economy Headed?

• 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

44
So What About the Consumer?

• Consume spending will be affected by
• Confidence (contagion effect of financial crisis)
• Income levels (income and unemployment effects)
• Wealth effects (stock market and housing prices
  effect)

45
Signals from Today How is the Consumer Likely to
React in the Future?

• Consumer Confidence

• Unemployment Rate (Sept 6.1)

46
Signals from Today How is the Consumer Likely to
React in the Future?

• Earnings Growth

• Wealth Effect DJA Down 38 from high

47
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)

48
Regional Impacts of Housing

• Los Angeles Sept 06 -26

• Seattle July 07 -7

49
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 years).
• 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.

50
Is the Federal Reserve Running out of Traditional
Options?

• Traditional Policy Tools

• Contemporary Approach

• Lender of last resort to important financial
  markets.
• Oct 21 Providing 540bn to money market mutual
  funds so they can meet redemptions.
• Unfreeze frozen markets
• Expand direct lending beyond the commercial paper
  market where needed.
• But, Fed assets are ballooning, 1.8tr, or 12 of
  GDP double from last year.

• Fed funds rate now at 1.5
• Running out of downside room?
• Discount window borrowing facility has been
  expanded to non-commercial bank borrowers.
• Reserve ratio remains unchanged.

51
What else Needs to be Done?

• Restore Confidence

• Ongoing Issues

• Temporary increase in FDIC insurance and
  guarantee of money market mutual funds.
• Global coordination must continue.
• Europe has increased deposit insurance as well.
• But, continuation of strong dollar suggests
  ongoing global flight to safety is still an issue
  (next slide).
• Balance all actions against moral hazard issue.

• Cleaning up the securitizations and derivatives
  markets.
• Including educating end users to the risks
  involved.
• Revising regulation decisions.
• Glass-Steagall
• Mark- to-market accounting rules
• Europe easing rules allowing banks to reclassify
  some assets as long term.
• Examining the response of credit rating agencies.

52
U.S. Dollar Remains Strong

• Turnaround in July

• Consequences of strong

• Keep U.S. inflation in check.
• Provide greater flexibility to Federal Reserve.
• Discourage foreign central bank withdrawals from
  U.S. financial markets.
• Foreign ownership of U.S. marketable debt now
  around 60

53
Do We Need Another Stimulus Package?

• Bernanke (Oct 20) indicated that he would
  endorse additional fiscal stimulus to help
  consumers.
• 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 extended unemployment benefits.
• New infrastructure projects generally slow to
  come on line.
• Perhaps we need to consider tax cuts for
  businesses.

54
Two Macro-Economic Scenarios

• Scenario 1 V shape

• Scenario 2 U, W or L shape

• Quick recovery
• Within 2 to 3 quarters
• Historically this has been the case
• Early 2008 optimism for second half turnaround
  resulting from
• Assumed positive lagged response of Fed interest
  rate cuts.
• Spring tax rebates.

• Now some are thinking
• U More gradual recovery (e.g., 1990/91), or
• W Recovery followed closely by another recession
  (aka double dip) as 2008 stimulus dries up
  (e.g., 1981, 2001), or
• L Prolonged recession (e.g., 1929 or Japan in
  the 1990s).
• .

55
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 economy)
• Global reach of current situation (through
  trade/business coupling of economies)

56
Post Scrip The U.S. Economy and the Rime of the
Ancient Mariner

• The mariners 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?)

57
Questions and Answers and Discussion