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Monday, March 05, 2007

Fed's Warsh on Liquidity

by Calculated Risk on 3/05/2007 02:18:00 PM

Governor Kevin M. Warsh spoke in Washington, D.C. today: Market Liquidity: Definitions and Implications. Excerpts:

Consider liquidity, then, in terms of investor confidence. Liquidity exists when investors are confident in their ability to transact and where risks are quantifiable. Moreover, liquidity exists when investors are creditworthy. When considered in terms of confidence, liquidity conditions can be assessed through the risk premiums on financial assets and the magnitude of capital flows. In general, high liquidity is generally accompanied by low risk premiums. Investors’ confidence in risk measures is greater when the perceived quantity and variance of risks are low.

This view highlights both the risks and rewards of liquidity. The benefits of greater liquidity are substantial, through higher asset prices and more efficient transfer of funds from savers to borrowers. Historical episodes indicate, however, that markets can become far less liquid due to increases in investor risk aversion and uncertainty. ...

Therefore, I wish to advance a simple proposition: Liquidity is confidence.
Let me discuss sources of liquidity of the U.S. financial markets. By my proposed definition, we must ask what forces have increased liquidity (read: confidence) in the United States over the course of the last couple of decades. I will turn, first, to two key drivers of liquidity: rapid financial innovation and strong economic performance. A third important source of liquidity--resulting from the excess savings of emerging-market economies and those with large commodity reserves--has also found its way to the United States in pursuit of high risk-adjusted returns. We must judge the extent to which each of these three liquidity drivers are structural or cyclical, more persistent or more temporary. Understanding the sources of liquidity--and the causes thereof--should help inform judgments about the level and direction of market liquidity. In so doing, we may better understand its implications for the economy and policymakers alike.

First, liquidity is significantly higher than it would otherwise be due to the proliferation of financial products and innovation by financial providers. This extraordinary growth itself is made possible by remarkable improvements in risk-management techniques.
The second factor, perhaps equally persistent, supporting strong investor confidence in U.S. markets has been our economy’s strong macroeconomic performance. Researchers have documented the so-called “Great Moderation” in which the U.S. economy has achieved a marked reduction in the volatility of both real gross domestic product (GDP) and core inflation over the past twenty years or so. In theory, reduced volatility, if perceived to be persistent, can support higher asset valuations--and lower risk premiums--as investors require less compensation for risks about expected growth and inflation. In this manner, confidence appears to beget confidence, with recent history giving some measure of plausibility to the notion that very bad macroeconomic outcomes can be avoided. The Great Moderation, however, is neither a law of physics nor a guarantee of future outcomes. It is only a description--an ex post explanation of a period of relative prosperity. If policymakers and market participants presume it to be an entitlement, it will almost surely lose favor.
Warsh suggests "Liquidity exists when investors are confident in their ability to transact and where risks are quantifiable". And although Warsh does not mention the mortgage market, subprime or otherwise, by his definition liquidity is drying up in the subprime mortgage sector.