The Liquidity Trap

In the 1970’s I worked at a large bank.  At that time long term Treasury securities were yielding about 7% and savings rates were 5%.  I thought "how could I get some of that 5% money and invest in those 7% Treasury Bonds and make the 2% spread?"  On a million dollars that would yield $20K per year.  Times were stable then but I was too young to be a credible player and raise enough money to make it worth the time.  I figured out that the only way I could be assured of a "guarantee" was to have long term investment dollars corresponding to the Treasuries and that was the problem.  I needed to "hedge" my bet.

I have often said that "Cash is king".  Why?  Because cash has no liability attached to it (except the macroeconomic view of currency devaluation).  For 25 years we have been told that "Cash is not king" because investments would yield higher returns than cash sitting on the sidelines.  To a degree that is true.  Historically, real estate has been a good investment.  Classical man’s thinking suggests that you take your cash and buy up real estate.  There IS a caveat!  You must have the cash flow to support the payments.  What would happen if you lost your source of cash flow?  You must maintain a reserve to handle those unforeseen circumstances.  There is where the problem lies today.

Investors got greedy.  The Federal Reserve sustained the credit bubble long enough that those who have never experienced a severe economic downturn became lax in maintaining sufficient cash reserves.  They were lulled into increasing their leverage with the false assumption that the profits would continue forever.  They were wrong!

Investment banks sold risky securities (Collateralized debt obligation CDO) and then sold insurance (Credit Default Swaps CDS) to get them classified as investment grade securities.  All parties "winked" and deemed them good.  The problem with this scenario is "cash".  The investment banks classified the insurance as "Swaps" rather than insurance.  Why?  Cash.  If they called these instrument "insurance" then they would have to maintain cash in the form of "capital" to assure repayment if the "insured" (the buyer of the CDO) lost money.  They did not put any cash back to cover the CDS liquidity trap.  Now that the underlying security (all those sub-prime mortgages) are going bad, the "insured" want their money.  The cash is gone hence the bailout.  All the bonuses paid by the investment banks over the last 10 years were pumped up by the revenue generated from these transactions.  Treasury Secretary Paulson enjoyed bonuses paid by Goldman Sachs during this time.

To date, Americans have lost over 2 Trillion Dollars in retirement accounts.  With this reduction in liquidity, many will not retire as planned.  The government was lobbied by big business to steer the country away from "defined benefit" plans where the company was required to put money in retirement accounts and guarantee retiring employees a consistent cash revenue stream at retirement.  They moved the investment decisions from professionals managing the retirement funds to millions of individual investors managing their own accounts.  Who do you think would do the best job of investing?  With increased investment in the stock market, liquidity suffered.

Most people lived during the Great Depression tended to invest in liquid investments such as bank CD’S.  They understood the liquidity problem.  You may be wealthy on paper but if you can’t make your house payment, you’re broke!  As those who lived during the Depression die off, the values of the time tend to die with them.  The Federal Reserve punished those savers by reducing the interest rate to unrealistic levels.  This had the effect of promoting cheap credit and encouraging the masses to general "illiquidity" and increased leverage.  What were they thinking?

Money is departing the market in epic proportions.  Everyone is raising cash.  The stock markets around the world are in the midst a fire sale.  Too many sellers and not enough buyers cause a precipitous drop in stock prices.  How long will it last?  Until all of the excess credit that has been extended over the last 25 years returns to normal levels, the markets will be volatile.  If the market must swing to the opposite extreme, a global recession will result

Once again, "Cash is King".

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