Low interest rates make borrowing cheap. The financial crisis was marked by mispriced risk, i.e. low interest rates relative to their underlying assets. Investment quality declined as firms pushed cheap debt to individuals (subprime mortgages) and companies (covenant lite loans). This boosted commissions and executive compensation soared.
When poorly screened borrowers started going belly up and underlying asset prices fell, liquidity evaporated. The cycle ramped up when investors began placing bets on who would default next, via credit derivatives.
Consider where we are today. WSJ reported
The Federal Reserve is justified in keeping rates near zero for now, and should be cautious as it considers raising them later this year given the potential economic costs of prematurely tightening financial conditions, a top former Federal Reserve official said Monday.Cheap borrowing, part of the cause of the crisis, became its solution. Nearly seven years later the risks seem heightened as liquidity crisis warnings abound:
Brian Sack, former head of the New York Fed’s markets desk and now senior vice president at hedge fund D.E. Shaw, told a conference sponsored by the National Association for Business Economics that despite recent strides in the job market, the economy was still far from fully recovered.
“I see plenty of reasons for rates to be at zero today,” Mr. Sack said. “We’ve had employment improvement but GDP [gross domestic product] growth is relatively moderate.
“Then you just have this calculus of the benefits and risks. When you’re at the zero bound it’s very costly to make a mistake in liftoff,” he said.
The Fed has left official borrowing costs near zero since December 2008 in an effort to jumpstart and support economic recovery from the deepest recession in generations.
Financial engineering that preceded the last two financial crises is back, International Monetary Fund warns
Investors across corporate bond markets are finding it harder to buy and sell company debt. And some investors are beginning to fear that the lack of liquidity will be the spark that ignites the next crisis in financial markets.
Companies that have been flooding the primary market with debt have met voracious demand from investors hunting for yield in the low rate environment.
The ultra-loose monetary policies pursued by the Fed, the Bank of England and the European Central Bank has resulted in a torrent of bond issuance in recent years from companies seeking to capitalise on rock bottom interest rates. “Now is the perfect time to borrow if you’re a company."
But the moment when bond investors change investment strategies and rush to sell bonds could soon be at hand.
U.S. corporate debt market increased 44.5 percent to $7.82 trillion since 2008, spurred in part by low interest rates. During the same period, asset managers have increased their corporate debt holdings from $246 billion to $1.45 trillion while new regulations have restricted banks’ ability to provide liquidity to the market. In other words, when the holders of these assets go to sell, there may be no buyers
It is not just company bond markets that have been affected. Sovereign debt may also be hit
Puerto Rico's top finance officials said the government of the US territory will likely shutdown in three months because of a 'looming liquidity crisis' and warned of a devastating impact on the island's economy.
Puerto Rico is largely reliant on hedge funds for its financing needs.
Faced with debt payments totaling about 1 billion euros to the International Monetary Fund on May 6 and May 12, Greece hopes there will be enough progress in the talks by next week to allow the European Central Bank to restore liquidity access for the country’s cash-strapped banks.
Greece will proceed this year with the sale or leasing of stakes in several strategic assets, including Piraeus Port Authority SA and 14 regional airports, according to Greek officials with direct knowledge of the matter.
I smell opportunity for private equity underwriters as stressed countries offload strategic assets on the cheap. Other areas vulnerable to liquidity crises include Zimbabwe, Latin America, specifically Venzuela, Ecuador and Argentina. China backstopped these countries, just as hedge funds once did for Puerto Rico.
Liquidity is supposed to dry up in a crisis, so a time out can occur and the market return at levels customers are willing to pay. It becomes problematic when a corollary market exists with investors placing bets on your demise or survival. That corollary investment option can cause big swings in the value of a country's debt or a company's debt/equity.
Something will happen to bring great joy or horror to debt and equity markets. The question is when. On that, I'm not betting.