Infusions of Liquidity: A Long-Term Solution or Short-Term Placebo?

Aug.13.07 | About: SPDR S&P (SPY)

The big news from last week was that the Central Banks in Asia, Europe and that the U.S. added liquidity to the money markets, in order to ease credit concerns. While the market’s reaction to this situation was lukewarm at best, there are some who welcomed it as a sign that central bank intervention will ease credit concerns, or that the Fed will cut rates in the near future. I’d like to disabuse this notion by asking a simple question: how will added liquidity or lower rates solve the bad business practices that created this situation in the first place?

I don’t see how additional liquidity or lower rates will help resolve the following:

  • Bad lending practices: Part of the reason we have so many foreclosures right now is that banks lent money to people they shouldn’t have, and lower rates won’t solve this problem.
  • Losses from bad loans and investments in debt securities: While lender losses from bad loans were a contributing factor, the real reason we have a credit crisis stems from institutional investors world-wide taking losses from mortgaged backed securities investments. Lower rates, and added liquidity from the world’s central banks is not going to turn those losses into gains.
  • Tightening of lending standards: This is a common complaint nowadays is that it’s harder to get a mortgage. While it’s unfortunate that some credit worthy borrowers aren’t able to get mortgages or have to pay higher rates, the end result should be fewer homeowners in foreclosure and decreased lending losses for the retail banks and mortgage lenders. While there are probably “some” overreactions on the part of the banks, strict lending standards are better than loose ones, and over the long-term they should be able to reach a happy medium. Lower rates shouldn’t cause the banks to forget how loose lending standards got them into trouble, as returning to the lending standards of old would result in a worse situation than we have now.
  • Consumers purchasing more home than they can afford: If you needed a 4% teaser rate to afford a home, and are now in foreclosure when your ARM reset, then it stands to reason that you couldn’t have afforded the home with a low, prime rate mortgage anyway. I have no problems acknowledging the fact that many borrowers were taken advantage of by their lenders, but it doesn’t change the fact that many borrowers took on more debt than they could manage. People don’t go into foreclosure because their bank is “oppressing them," they got into foreclosure because they have a mortgage they can’t afford.
  • The bursting of the LBO bubble: While lower rates will enable “some” troubled private equity deals to go through, it’s not going to make the banks rush to finance deals where the cash flow of the acquisition target is barely enough to service the debt. Cerebus’ purchase of Chrysler (DCX) is held up as an example of either the bursting of the LBO bubble or the credit crisis, but the fact remains that Chrysler doesn’t currently generate positive cash flow and sold for less than what Daimler-Benz paid for it. The credit crisis simply made the banks wake up and stop financing every deal the PE firms threw at them; lower rates won’t suddenly cause banks and bond investors to stop using some degree of common sense.
  • Over leveraging: Lower rates won’t stop Hedge funds and other institutional investors from purchasing debt securities backed by risky mortgages, assets, etc., over-valuing them via “mark to model” (AKA mark to made-up) valuation methods, and then borrowing against said over-priced securities and paying for it later. To put it another way, central bank intervention can’t stop people from making bad investments.
  • Central banks aren’t safety nets for investors who make bad decisions. The focus needs to be on addressing the underlying root causes of problems, not a short-term option that is more placebo than solution. Most importantly, low rates and an increased money supply caused this problem and it’s fatuous to think that low rates will solve the current problem and won’t cause a larger problem down the road.