Here's Why Trouble Is Brewing

Buried in Citi's 4Q earnings release which has $18bn of writedowns is this nugget:

In addition, the company is continuing to reduce its Consumer-based holdings of mortgage-backed securities, and other assets held in its Securities and Banking business. Overall, in the fourth quarter, the company reduced its GAAP assets by approximately $176 billion, representing approximately 7.4% of its balance sheet.

Citi is deleveraging. Banks are the biggest creators of liquidity. As banks reduce their balance sheets, liquidity goes down. People who are saying that liquidity will be created because Fed is cutting rates do not realize who creates liquidity. It is not the Fed - it is the banks.

The asset backed commercial paper market has shrunk from $1.2 trillion in August to $800 billion now. That deleveraging plus Citi's deleveraging = $576billion of liquidity that has vanished. Ane here in India, investors are getting excited about $20 billion of FII flows.

Comments

[dsilisk:]

Its not liquidity if the banks are holding it, hoping to make money off it. Its only liquidity if banks are using it to supply cash to the businesses and people who need capital. $576B in liquidity didn't disappear. $576B in money that these banks made up on paper disappeared. They never had this money to begin with. They "loaned" out money that didn't really exist based on a 10% reserve on their sheets, and when the risk of default rose, they "wrote off" the same money.

If you can magically "write off" money, then it makes sense that they had to magically "write on," or invent, these resources to begin with.

Also, we are suffering through this downturn mostly because we have TOO MUCH liquidity. Its instantaneous capital that puts poor people in million dollar houses, that funds businesses which aren't profitable, which makes people feel they don't have to save, so we end up with a negative national savings rate.

Liquidity didn't disappear. The bank's finances just got an injection of reality. Its about time.

Supply and demand. There is an oversupply of pretty much everything in this economy, including liquidity and volitility. Correction to market equilibrium is the appropriate course of action, as painful as that may be to investors.

2008 Jan 15 12:52 PM

[User 140418:]

"The bank's finances just got an injection of reality."

That's the same as saying that $576B disappeared.

Thanks, Gaurav, for this article. I've read a lot of articles filled with gloom and doom about the coming US recession. This is the most ominous, especially because you caught the fine print.

Things that should come in bold print are always put in fine print, if they convey bad news.

2008 Jan 15 04:10 PM

[WAKEUP:]

You are correct. The water hole is indeed drying up. I am at a loss as to why more people cannot see this simple truth.

2008 Jan 16 08:27 PM

[thannagan:]

That FII of $20B is real money - the $576B was just paper (that some used to think of as a monetary asset). No real liquidity (defined as cash and cash-equivalents) was lost in those write-downs.

2008 Jan 17 12:20 AM