August 20, 2007 - "A banker is the person who lends you his umbrella when the sun is shining and wants it back the minute it rains."
We can smile at the humor in these words penned by Mark Twain over a hundred years ago, but the ugly truth they convey is not so funny. Many companies today are having their umbrella taken away.
That reality is of course bad enough, but unfortunately, some companies had been using the umbrella they borrowed as a crutch. Without that crutch, those companies are now in serious trouble, as are those individuals who relied upon bank credit in the same way. They got into trouble by not understanding the true nature and meaning of liquidity.
I've wanted to write about liquidity for a long time, but have been waiting for the right opportunity. Now is the time.
Given my background and training as a banker, and having worked as a banker through the horrendous 1974 credit contraction, I have gained a unique perspective. Though unique now, it wasn't so when I started in banking in the late 1960's.
I was trained by experienced and savvy people who had worked as bankers through the Great Depression, so my mentors had an entirely different point of view than most of the people today managing banks and for that matter, companies too. It was a perspective my mentors gained during the tough times in the 1930's, and was one they would repeatedly share with me and other new recruits.
Their point of view about bank credit was built upon one simple principle. Namely, borrowing has the same fundamental characteristics as fire. While both can be useful tools, both are also potentially dangerous. Therefore, it is incumbent upon both the lender and the borrower to tread lightly and proceed carefully whenever credit is extended.
In short, it is the perspective of those people who understand that borrowing money is not liquidity, which is a fundamental financial insight that has been largely lost in recent decades. And we are now seeing the consequences of that lost knowledge, as banks, mortgage lenders, hedge funds and even money market funds are caught up in the growing financial crisis that is making headlines around the globe.
Yes, it is a crisis, and it is one that is likely to get worse. It is a contagion, and it is spreading quickly in today's highly interconnected and over-leveraged financial landscape. There is a chain reaction among companies and people who thought they were liquid, but who in fact are 'blowing up' having now learned instead that they were vulnerable to defaults, reneged payments and other similar events. So instead of being liquid, they were in effect dependent upon promises that have been broken.
An article in The Wall Street Journal on August 15th by the esteemed Henry Kaufman picked up on this very point. After analyzing why the perspective on liquidity that now prevails is different from previous decades, he goes on to say:
"These structural and institutional changes have, in turn, encouraged a new understanding among market participants of liquidity. In the decades that followed World War II, liquidity was by and large an asset-based concept. For business corporations, it meant the size of cash and very liquid assets, the maturity of receivables, the turnover of inventory, and the relationship of these assets to total liabilities. For households, liquidity primarily meant the maturity of financial assets being held for contingencies along with funds that reliably would be available later in life. In contrast, firms and households today often blur the distinction between liquidity and credit availability. When thinking about liquid assets, present and future, it is now commonplace to think in terms of access to liabilities. This new mindset has been abetted by the tidal wave of securitization -- the conversion of nonmarketable assets into marketable assets -- that swept across the financial world in recent decades. This flood of marketable assets not only has eroded traditional concepts of liquidity, it has stimulated risk appetites and fostered a belief that credit usually is available at reasonable prices.
The important point that many are now finding out is that credit is not always available at any price. From time to time it completely disappears.
Banks take away lines of credit. Banks default on their commitments to lend. I saw it happen in 1974, but in contrast to Mark Twain's characterization, I described it as a water tap. The tap was wide open in good times, and quickly turned off in bad. Here's an example of how banks operate, which is from The Globe & Mail in Canada on August 14th:
"Foreign banks are walking away from their commitments to provide liquidity to the Canadian commercial paper market, a development that means more trouble for independent players in the $120-billion sector. Deutsche Bank refused late Monday to backstop two commercial paper programs that are part of funds administered by National Bank Financial. This decision raises the possibility that the two commercial paper programs may go into default."
If those programs do go into default, the chain reaction of blow-ups spreads. Everyone who viewed their ownership of that commercial paper to be 'liquid' and maybe even 'risk-free', have now had their liquidity reduced.
What's worse, if they were relying on that commercial paper to pay off its obligations, they may be in a difficult position, which could send them scrambling for alternatives to replace their lost liquidity. This consequence is not idle speculation. Here's what Bloomberg reported this past Friday:
"Barrick Gold Corp., Ivanhoe Mines Ltd., and other Canadian resource companies will have to wait to get their money out of short-term investments after a credit crunch froze part of the asset-backed commercial paper market. The mining firms are among investors who bought commercial paper from Coventree Inc. and other non-bank dealers that failed to roll over debt this week and were unable to get emergency funding from lenders. "I'm sure there's a few more out there with this kind of exposure because everyone's been telling them it's a secure form of investment," said Kerry Smith, an analyst at Haywood Securities Inc. in Toronto. Miners such as Redcorp Ventures Ltd. may be forced to delay projects if they can't get access to cash tied up in these commercial paper funds."
Clearly, if projects are delayed, economic activity suffers. Companies and people who were counting on the work related to the now-deferred project will need to find new work and other sources of income. Multiply this result by hundreds - if not thousands - of times and the contagion spreads, as it has in countless banking crises throughout monetary history.
What is happening today is not new, but all kinds of excuses will be offered by apologists for the true culprits. In fact, we are already seeing some of that. For example, this weekend's edition of The Wall Street Journal says:
"The recent market turmoil is rocking investors around the globe. But it is raising the stock of one person: a little-known economist whose views have suddenly become very popular. Hyman Minsky, who died more than a decade ago, spent much of his career advancing the idea that financial systems are inherently susceptible to bouts of speculation that, if they last long enough, end in crises."
What's left unsaid is the reason for the speculation. It is of course the flawed and inherently fragile monetary system used today, in which banks lend money recklessly when the tap is wide open. The result is that money is used in speculative ways, like building condos in Miami that far exceed demand.
This real reason for malinvestment is something that you will never see in the mainstream media. For that you will need to read the Austrian School economists like Ludwig von Mises. It was his student, Murray Rothbard, who wrote the following in March 1991 as the S&L crisis was drawing to a close:
"What is the reason for this crisis? We all know that the real estate collapse is bringing down the value of bank assets. But there is no "run" on real estate. Values simply fall, which is hardly the same thing as everyone failing and going insolvent. Even if bank loans are faulty and asset values come down, there is no need on that ground for all banks in a region to fail.
Put more pointedly, why does this domino process affect only banks, and not real estate, publishing, oil, or any other industry that may get into trouble?...The answer is that the "bad" banks are vulnerable to the familiar charges: they made reckless loans…or their managers were crooks. In any case, their poor loans put their assets into shaky shape or made them actually insolvent. The "good" banks committed none of these sins; their loans were sensible. And yet, they too, can fall to a run almost as readily as the bad banks. Clearly, the "good" banks are in reality only slightly less unsound than the bad ones.
There therefore must be something about all banks…which make them inherently unsound. And that something is very simple although almost never mentioned: fractional-reserve banking…Only if all the deposits were backed 100% by cash at all times (or, what is the equivalent nowadays, by a demand deposit of the bank at the Fed which is redeemable in cash on demand) can the banks fulfill these contractual obligations.
Instead of this sound, noninflationary policy of 100% reserves, all of these banks are both allowed and encouraged by government policy to keep reserves that are only a fraction of their deposits...that results in our system of permanent inflation, periodic boom-bust cycles, and bank runs when the public begins to realize the inherent insolvency of the entire banking system.
That is why, unlike any other industry, the continued existence of the banking system rests so heavily on "public confidence," and why the Establishment feels it has to issue statements that it would have to admit privately were bald lies...That is, everyone would find out that the entire fractional-reserve system is held together by lies and smoke and mirrors, that is, by an Establishment con...The banking system, in short, is a house of cards."
Indeed, and the house is coming down again. Only time will tell whether there will be a complete collapse or just another tremor. Regardless, many people will learn the lesson of 1974 that liquidity does not mean one's access to bank credit.
Then depending how deep this crisis becomes, they may also learn the lesson of the Great Depression, which was rife with defaults and broken promises. Namely, gold is the only money that offers true liquidity because it alone has value that is not dependent upon a promise. That's why central bank balance sheets show gold as their most liquid asset.
A gram of gold is unique because it is a tangible asset. A dollar, euro or yen - indeed, every national currency - in contrast is a promise (i.e., a liability on the balance sheet of some financial institution). What's worse, those promises can themselves be dependent upon the promises of politicians and those whose vested interests they serve - which does not mean you and me.
I eventually left banking in 1980. I had had enough. I had seen enough broken promises by banks to its customers to make me realize that I no longer wanted to be part of it.
To be honest, I never planned to make a career in banking, and instead saw it more as an opportunity for training and experience. In that regard, my 11-year banking career met my objective and that of many former banking colleagues, who today like to joke that our old bank 'trains the best and keeps the rest'.
So to conclude, when it comes to liquidity, think first and foremost about gold. Then consider the safety and reliability of financial assets, all of which are dependent upon someone's promise. Lastly, avoid the mistake that so many are making today by thinking that liquidity is access to bank credit.