Thursday, April 5, 2007

The Equity Conundrum Part IV: Liquidity and Leverage – How Deep Does the Rabbit Hole Go?

“As I see it, disintermediation, securitization, and globalization have rendered the monetary aggregates — which largely represent the liabilities of depository institutions — less useful measures of overall financial liquidity than in the past. I’m sympathetic to the idea that with Japanese rates at just 50 basis points, the yen remains the funding currency of choice for global carry trades — but I have no idea how to gauge their importance.”

Richard Berner, Morgan Stanley, March 5, 2007


When one of Wall Street’s premier economists has “no idea how to gauge (the) importance” of just one aspect of liquidity (the Yen carry trade), then one has to wonder if anyone has a clue as to just how wide and deep the liquidity rabbit hole goes. Based on the dozens of programs that I have conducted for numerous analyst societies, the answer is NO ONE KNOWS just how levered global liquidity is. Take, for example, the fountains of unregulated money: hedge funds and private equity.

It is estimated (again, no one knows for sure) that hedge fund capital is in the $1.5 trillion range. Private equity is guesstimated at around $1 trillion. The guesstimates on leverage of these pools of capital is anywhere between 4 to 8 times. That interprets into $10 to 20 trillion of hot-to-trot money. Now, add to this equation the fact that NO ONE KNOWS just how extensive derivatives are levered off these numbers. And this is just about hedge fund and private equity capital.

Then there are the burgeoning capital reserves of central banks, the cash hordes of corporations, and ever-gushing capital flows into oil exporting countries. To this we can add the monetary policies of the world’s central banks, banks, non-banks, and other financial institutions. Now plug in the multiplier effect.

So, when it comes to getting a handle on liquidity and leverage, Richard Berner is not alone. In fact, despite conducting dozens of seminars involving more than 50 experts and spending countless hours researching the subject, I have yet to meet, hear, or read about anyone who has more than a general clue as to just how extensive the liquidity and leverage binge is. Have you?

Investment Strategy Implications

In and of itself, liquidity isn’t a bad thing. Nor is leverage. In fact, they are necessary components of properly functioning economies and markets. But there is an Alice in Wonderland quality to those who sanguinely dismiss any and all concerns over this mountain of money, its application, and its opaqueness. More dangerous, however, is the fact that the people who should have a handle on the subject, such as Ben Bernanke, don’t. (And, if Gentle Ben and others do know, they aren’t saying beyond “trust me”.)

There is a Greek proverb, “All things in moderation”. It is hard to imagine that liquidity and leverage today is being used in moderation. Deals abound. And risk premiums and credit spreads remain low - despite predictions of mean reversion, an increase in volatility, and a reduction in the correlation between asset classes and their components.

If the wheels come off the global bull market train, look to liquidity and leverage (and the failure of the world’s policy leaders to act when they could) for the answer to the train wreck.

How deep does the rabbit hole go, Alice?

(Note: Liquidity and leverage, along with Globalization and market fundamentalism, are themes that I will return to regularly. Have a good weekend.)

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