The Liquidity Crunch Has Only Just Begun

The current liquidity crunch is not over and financial markets may be on the brink of a crisis that could surpass the emerging markets crisis of 1998.

The asset-backed and other debt markets have seized up, high-yielding currencies are plummeting, bankers won't lend each other money, financial institutions are rumored to be nursing mammoth losses from credit trading and politicians are scouring for someone to blame. The most immediate problem is the liquidity squeeze in the system - the money that is lent to banks and investors to pay for outstanding positions so they don't have to sell them. Bankers privately say they can last another one to two months on their own reserves before they have to start liquidate their own and client positions. Forced selling into a falling market will only make things worse. The only solution is for central banks to drastically cut rates and by something like a full percentage point. As one head of interest rate trading at a European bank said: "We've got contagion on many different fronts. This could potentially be far worse than the 1998 crisis." Back in 1998, a Russian sovereign debt default triggered a sharp repricing of risk which swept through other emerging markets. Soon after, the highly-leveraged hedge fund Long-Term Capital Management imploded. It had to be bailed out by a group of banks and many central banks responded by cutting rates a full percentage point. The European Central Bank and the Federal Reserve, as well as others, provided some quick hits of liquidity last week and much has been made of the fact that overnight rates around the world have dropped sharply as a result. But the fall in those rates hides the fact that, each day, banks are becoming more determined to hoard their reserves and more fearful of lending for any length of time. To see this writ large, look at longer-dated money markets: euro three-month rates have continued to rise over the past week as bankers shun longer-term lending. The liquidity crisis has only peaked in the past week. This means there are lots more three-month borrowing programs which will mature over the next two months and create a renewed squeeze on overnight funds. Banks with brokerage operations may have huge liquidity requirements because they have to finance the leverage they extended to clients during the good times.

Risk Aversion Spreads

The knock-on to investors is already underway with banks demanding only highly-rated securities as collateral against the money they lend them or huge value reductions on riskier assets. This risk aversion started with sub-prime loans, then spread to leveraged loans and asset-backed commercial paper and now it's prime loans. The next step is credit cards with rates set to rise and borrowing terms crimped. That will directly affect consumers. And then there's the next big quarterly expiry of bond futures in September. If a financial institution has gone short bond futures, it will need to buy government bonds to deliver into the exchange to close out its position. Most traders would normally borrow to buy those bonds and pay back with profits from the trade or roll the financing over if it has lost. But if the loans market is as good as closed, some institutions may not be able to buy and deliver the bonds. The demand for those bonds could be huge given that there's an increasing flight-to-quality and this will mean a price squeeze at expiry. So what can central banks do? They could accept the riskiest securities as collateral against ongoing liquidity injections but that would be tantamount to baling out the markets even as the central banks have been making clear their belief that market participants had rashly under-appreciated risk. The only other option is for central bankers to replay 1998 and introduce emergency rate cuts to reduce the cost of borrowing in hopes of raising confidence levels. Central bankers are currently insisting that monetary policy doesn't need to be reassessed due to the liquidity crisis because current economic conditions remain stable. The danger here is that a beleagured financial system will almost certainly hit the fundamental economy.