For the last six years, officials in the Federal Reserve System and at the U.S. Treasury Department have been obsessed with their concern over liquidity. Ever since the financial markets started to come to come unglued in August 2007, government officials, especially those at the Federal Reserve System have believed that the response to the difficulties being experienced by financial institutions and financial market participants could be resolved if sufficient liquidity were provided to the banking industry and other financial groups.
Hence, the argument given for the Treasury's troubled asset relief program (TARP) and for the quantitative easy programs, QE1, QE2, and QE3, on the part of the Federal Reserve System.
The basic idea is that providing liquidity allows time for an institution to be able to sell an asset at a price that is not substantially different from the price the asset is accounted for on the books of the institution.
One of the purposes of the quantitative easing programs of the Fed is to help keep commercial banks open so that the banks to not end up "failing" but can be acquired by other commercial banks where their asset problems can be absorbed and diluted and the troubles get worked out. As a result bank failures have declined substantially, but the banking system as a whole has been losing about two hundred banks a year through acquisition with only a handful of failures.
Now, there seems to be a problem in the bond markets, especially in the area of corporate bonds. Financial institutions are arguing that changes in regulations, especially changes in capital requirements, have put bond-trading desks at risk. Seems as if bank inventories of bonds have dropped significantly over the past couple of years and this means that there is much less liquidity in the market than there was several years ago.
"US Treasury and Federal Reserve officials are monitoring the liquidity of bond markets after warnings from banks and institutional investors that the system has been weakened dangerously by new regulations." This was written by Tom Braithwaite, Tracy Alloway, and Gina Chon in the Financial Times.
It seems as if "Investors and banks have delivered warnings - including in a July presentation to the Treasury - that new capital rules and the Volcker rule that prohibits proprietary trading at banks are sapping liquidity from the wider bond market, and that the negative effects have been masked by the Federal Reserve's unprecedented bond purchases under quantitative easing."
The Treasury Borrowing Advisory Committee, a group that includes such traders as JPMorgan Chase and PIMCO, argued "Regulations have created multiple constraints likely to curtail trading when it is really needed." The situation is not obvious at this point in time because of the Fed's actions. Therefore, the testimony presented the view that there is a "potential for significant dislocation when the investor flows reverse," that is, when Fed tapering begins.
The problems are the new capital rules and the Volcker rule against proprietary trading.
"The Fed and Treasury are investigating but officials believe that liquidity was too cheap during the crisis and some change was desirable. They are also suspicious that the case - made by banks such as Citigroup and large institutional investors such as Fidelity - is overstated, with the drop in banks' inventories of corporate bonds skewed by the fact that the data include asset-backed securities."
In terms of the data: "Fed data show the inventories of corporate bonds held by big banks are down almost 80 per cent since their peak of $235bn in 2007. But Goldman Sachs analysts have estimated that the inventories are down 40 per cent from their pre-crisis peak, once other assets are stripped out."
Ms. Alloway has expanded on this brief article by a more substantial piece on the Analysis page in the Financial Times titled "Markets: The Debt Penalty." More specifically she writes, "Buffeted by new regulations and scarred from their near-death experience during the financial crisis, big banks have quietly retreated from the business of dealing in corporate bonds. This has reduced the amount of bond risk lurking on the banks' balance sheets. But some in the industry are worried that this shift in the structure of the $9.2tn market for companies' debt could help sow the seeds of a new financial shock.
And, as interest rates began to rise in May and continued on through the summer, people pulled money out of bond funds, including ETFs.
Ms. Alloway writes, "'When that happened, volume went to zero,' says Dan Zwirn, managing partner of Arena Investors, a hedge fund focused on special-situation lending to companies."
To indicate the "liquidity" situation in the corporate bond market, Alloway quotes the following figures. The average daily trading volume in the corporate bond market is only $18.2 billion, and this in spite of the fact that there has been almost $800 billion of new issues this year. The average daily trading volume in the U.S. Treasury market is $655 billion. But note, the two markets are not that different is size: the corporate bond market is $9.2 trillion in size and the U.S. Treasury market is $11.3 trillion.
So here is another issue that has to be weighing on the minds of the members of the Open Market Committee at the Federal Reserve. Could the Fed create a "liquidity" event in the corporate bond market if they taper too quickly ...
But, I would add that this market situation is not the only one that the Fed has to consider as it thinks about exiting quantitative easing or even thinks about having to remove all of the liquidity it has injected into the banking system over the past four years. As mentioned earlier, there are still nearly 600 commercial banks on the FDIC's problem bank list. And, as we found out during Congressional testimony during the financial crisis, there are maybe two times this many banks that are also in difficult straits even though they are not listed as problem banks.
There are, I believe, lots of reasons why Federal Reserve officials may not want to taper too rapidly. The Federal Reserve may now be in a position where they have few, if any, "good" choices in front of them. That is, as alluded to above, a lot of situations that now exist have been covered up by the Fed's concentration on providing liquidity to the financial markets over the past six years. It is like Warren Buffet comment about what is revealed when the tide goes out. You find out who is not wearing a swimming suit.
By treating every problem of the past six years as a liquidity crisis that required the Federal Reserve to pump more liquidity into the banking system other problems have been hidden, some for quite a few years. By not dealing with these other problems in a timely manner, people only postpone the day when the problems must be dealt with. Maybe this is another reason why the economy is not more robust than it is. Maybe many businesses know that these problems still exist but have not really had to deal with them because they have been "bailed out" by all the liquidity in the market. Maybe these businesses are not willing to commit to new initiatives because they know they still have many old situations that have to still be worked out. But, continuing to pump more liquidity into the market doesn't seem to be improving things.