Excess Liquidity and the Leveraged Buyout Boom

The IHT reports that some of the private equity firms which depend on access to cheap credit with few strings are complaining about an excess of liquidity. While precise measures of liquidity are prone to error, it is clear that the amount of liquidity has been increasing rapidly. The Bank of England estimates that liquidity has doubled in the last four years.

The high price of oil, which shifts enormous resources away from the developed world to oil sheiks in the Middle East, has further exacerbated the liquidity troubles. And at least until now, China's trade surplus has gone largely uninvested. When China decides to mobilize its capital in the global markets, this will further spread liquidity.

Liquidity by itself is not a bad thing. Quite the reverse, many good investments in the past have gone unmade because of a lack of liquidity. But as the subprime mortgage market recently demonstrated, easy money leads to loose credit practices. The mortgage market is unique in its general low level of risk, but capital investments and leveraged buyouts can be very high risk. When cheap credit is extended largely without conditions, many more loans are extended than would be accepted otherwise.

Even the private equity firms themselves are concerned about the easy credit markets because competitors are encouraged to step in and bid up the price of acquisitions. These more expensive, more heavily leveraged investments then become much more risky and investors become less likely to profit.

Ironically, the Fed's chairman Ben Bernanke is currently receiving public pressure to lower interest rates in order to spur growth during a period of excess liquidity. In this environment, Bernanke is likely to leave interest rates alone for the seventh straight meeting. This will probably leave him looking indecisive and reduce his credibility in the short term, but the alternative is even worse. Bernanke can't give in to market pressures even if he will be praised in the short term.

Leveraged buyouts are fueling much of the mergers and acquisitions activity driving the stock market higher these days. The leverage is cheaper than ever thanks to excess liquidity. The liquidity would be fine in isolation, but unfortunately it is accompanied by loosened lending standards. Interest rates aren't likely to resolve the problem anytime soon, in spite of the housing bust. Hopefully the private equity gurus will have the intelligence to proceed cautiously. But don't hold your breath.