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Liquidity Crisis Explained

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By Tiddman
August 27, 2007

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In layman's terms, and perhaps a bit technical terms, can someone explain what's the deal with liquidity crunch?

A bunch of lenders provided sub-prime mortgages to people who fundamentally could not afford them by being extremely creative (i.e. reckless) with the underwriting terms. These lenders fooled themselves into believing they could make money at this by a combination of wishful thinking, the institutional imperative, and passing the buck.

This activity was so large and widespread that it created entire cottage industries of entities worldwide that invested in these securities, often with high levels of leverage.

The losses from these activities, though severe, were obscured and delayed by complex financial structures. When they occurred, they were fast and severe enough to bring a large lender from apparent health to bankruptcy in just a few weeks, fast enough that it caught virtually everyone involved by surprise.

There were numerous stakeholders in these financial instruments, many of which were not fundamentally sub-prime lenders, but who participated directly or indirectly in the securities. When they took their losses in sub-prime, out of either fear or necessity, they ceased substantially all of their other lending and investing activities, even if they were completely unrelated.

So for instance, an entity with $20 billion of capital at its disposal that lost $1 billion in sub-prime was now unwilling to put its remaining $19 billion of capital to work in any market under any terms. This started with sub-prime mortgages, and then spread to prime mortgages, and then corporate and syndicated debt. Thousands of individual deals (mortgages, corporate debt, etc) were in the works, but were frozen in mid-deal, as everyone got stage fright at once.

The market reacted to this sudden disappearance of a market by raising rates. This in turn caused a significant mark-to-market decline for existing debt of all types. So deals that were actually completed and secure were now worth less than they were just a few days ago. Entities that have to mark portfolios to market (which is to say most entities that invest in debt) took impairments ranging from 2% to 10%. With leverage levels ranging from 2x to 10x, this means impairments ranging from 4% to 100%. Even if the impairment is temporary, this kind of impairment can lead to margin calls and forced selling, which further depresses the market.

The timing of this was particularly interesting, it started to happen in mid-June, and there were probably only 2 or 3 weeks of problems included in most Q2 reports. Q3 is almost 2/3 completed and it is safe to assume that there are more impairments coming, but we aren't going to see the figures until probably 60-90 days after the end of the quarter. So there is a long time before we'll see any data, leaving everyone to wring their hands, and this is vacation season as well.

So, due to a combination of factors, markets that are completely unrelated to sub-prime residential mortgages are distressed. The default rates on corporate debt, for example, are among the lowest in 10 years, meanwhile these debt instruments are suffering impairments severe enough to put other companies out of business.

Countrywide's CEO Angelo Mozilo probably said it best; aside from sub-prime there is no substance to this form, but form becomes substance if it goes on long enough. Nobody is willing to be the first person to jump back into the pool after the thunderstorm -- the weather is fine, the sun is shining, the wind is not blowing, and the water is warm and pleasant, but nobody wants to be the first one in. Nobody is willing to commit any cash to any new deals of any kind, no matter how secure.

The Fed lowered rates and opened "the window", but the large banks in their infinite pride did not step up to the window and take advantage. Meanwhile, the interest rate environment wasn't so hot to begin with, being flat and inverted for some periods, so it wasn't a great time to lend money anyway.

Some pretty simple things are required to break the deadlock, basically someone has to step in and commit money to what are now absurdly high yields on absurdly high quality credits, and confidence has to return to the markets and people need to start doing business again. It is as if everyone is pulling a Rip Van Winkle at the same moment.

There is precedent for these kinds of market shut-downs; there was reportedly a 30-60 day shut-down in 1998 the last time sub-prime blew up, but the lifeblood of capitalism eventually started flowing again...