Lately, I've been hearing people say that the world is awash in liquidity1. What they mean is that just about anyone can raise money on the cheap to buy nearly anything they want - from a house to a portfolio of commercial office buildings, or, if you prefer, from a cell phone to a cellular network. You want it? Someone will lend you the money to buy it. Is this an apt description of financial markets?
Financial conditions in the housing market no longer quite fit this description, although they did until recently. During the 1990s, housing prices increased at annual rates very near the overall inflation rate, about 3 percent per year. With the recession and weak recovery came lower short-term interest rates that stayed low for a long time. The federal funds rate sojourned in the range of 1 percent-1-1/2 percent from 2002 to mid-2004. When the FOMC finally did move to raise its funds rate target in 2004, it did so at a measured pace. Short-term interest rates rose, but longer-term rates did not increase proportionately; as a result, the yield curve flattened out. Interest rates in many other developed economies were relatively low as well.
The root cause of the low-rate environment may well be the global savings glut that is still being driven by developing economies and oil-producing nations. Simply put, some nations cannot absorb all of their domestic savings domestically, and therefore look for investment opportunities elsewhere. The global savings glut depresses the real rate of interest and leads central banks to lower their interest rates lest their monetary policies become too restrictive.
Low interest rates made housing more affordable, but several other circumstances undoubtedly helped. Financial institutions have become more adept at marketing home equity lines of credit, and consumers have become more willing to tap into these lines to meet their needs. Even if the house itself is not necessarily more liquid, the equity in it is. The transaction costs of taking out these lines have fallen steeply over time, making the house a more attractive asset.
Another financial innovation that has made houses more attractive to investors is financial institutions' ability to price credit and duration risk more discretely. They can package mortgage loans in pools with specified risk profiles and match them with lenders who have similar risk profiles. Tailoring mortgage pools by risk profile creates a more efficient mortgage market for homebuyers and investors, reducing funding costs and minimizing the outright rationing of credit to risky borrowers. Other things equal, more credit will be extended, more housing demand will be satisfied in the marketplace, and houses will command a higher price.
As measured by the OFHEO Index, house prices started increasing at a rate of about 5 percent in 2000, accelerated into the 6 percent-8 percent range for the next several years, and then really took off. House prices soared into the 10 percent-15 percent range in 2004, 2005, and early 2006. And these national averages mask exceedingly large price increases in the hottest housing markets in the country.
As with the stock market's boom and bust in the second half of the 1990s, many people recognize that an asset's price can keep rising only as long as it keeps generating more income or more potential future income. At some point, the asset's ability to satisfy this condition becomes so doubtful that lenders pull back. When this happens, a liquid market can become illiquid seemingly overnight, exposing highly leveraged market participants to loan repayments and limiting their ability to sell the asset without sustaining a loss. The more people rush to the exits, the more prices would have to fall to clear the market, thus exacerbating the situation.
We are in the midst of a substantial housing market correction, with no telling how long it will take for the supply of available houses - which swelled much faster than usual during the past few years - to become more closely aligned with the diminished demand for them. It is not clear how much price adjustment will be required to restore balance to the market. Nor is it clear which investors stand to lose, and how much. Most of the highest-risk mortgage credit advanced in the last few years originated outside the commercial banking system, so it is difficult to know where the defaults will occur.
The still-unfinished saga of the mortgage credit industry should give us pause about investments outside of the housing sector. Investors are paying increasingly handsome sums for commercial and industrial companies, but many of these deals make economic sense only if the new owner can significantly enhance the property's value or if the asset's value appreciates greatly over time. These are risky propositions.
We are witnessing the deployment of global capital, intermediated through new forms of financial institutions using new kinds of financial instruments. Capital markets may be increasingly able to match risk-taking investors with equally risky ventures, and the inevitable failures may prove to be isolated and immaterial for the financial system as a whole. At the same time, the most recent declines in global equity markets and preferences for higher-quality investments may signal a recognition that from time to time, too much liquidity can transform assets into liabilities.
- As I completed this "Economy in Perspective," Federal Reserve Board Governor Kevin M. Warsh delivered remarks on liquidity at a conference in Washington, D.C. You can find his thoughtful remarks here.