Brian Gaynor

Brian Gaynor

The collapse of Bear Stearns, the depressed housing market and the problems with ING's Diversified Yield and Regular Income funds have one thing in common, namely the bursting of the global liquidity bubble.

To understand this phenomenon we have to look at recent developments in the financial sector which are best illustrated by the accompanying graph of global liquidity.

International liquidity comprises four basic ingredients: power money (notes and coins), broad money (cheque accounts, credit cards etc), securitised debt (mortgages and other packaged products) and derivatives (futures, options, swaps etc).

Forty years ago power and broad money accounted for almost 100 per cent of global liquidity but they now represent only 12 per cent with securitised debt and derivatives accounting for 13 per cent and 75 per cent respectively.

The financial sector, particularly Wall St, is populated by Masters of the Universe who have invented a huge number of new and complex ways to increase liquidity.

These include:

* Securitised products. Banks used to keep mortgage loans on their balance sheets but they now package them into bundles of 50, 100 or more mortgages and sell them to individuals or institutions through investment products.

Securitisation allows financial institutions to create more and more loans without having to raise additional equity capital.

* Derivatives are another form of leverage as they allow investors to obtain an economic interest in an asset for a relatively small outlay.

For example, investors can obtain an effective 1 per cent economic interest in Telecom through derivatives for a fraction of the cost of a 1 per cent shareholding in the company.

* When Tokyo housewives invest 100 million in New Zealand because of our high interest rates they effectively create $1.2 million of new liquidity in this country.

The 100 million doesn't disappear from Japan as it continues to be a financial asset as far as the Japanese investors are concerned.

The top two trapeziums in the inverted pyramid have grown dramatically in recent years as a myriad of innovative securitised products and derivatives have led to a huge increase in global liquidity.

This surge in liquidity has been the catalyst for a borrowing binge that has resulted in a sustained rise in asset prices, including property, sharemarkets and commodities.