September 10, 2007
The Ins and Outs of a Liquidity Crisis
A big financial crisis does much to spread the notion that the interests of Wall Street differ from the interests of Main Street. The ‘liquidity crisis’ of the past few weeks, with its difficult jargon and complex financial instruments is a prime example. Unfortunately, the notion that this ‘liquidity crisis’ represents a failure of markets is exactly the wrong lesson to take away from this experience. In a nutshell, here’s why.
In the past very few years, mortgage lenders ranging from the George Bailey-type Savings and Loan to national lenders developed loan options that made them money and allowed lots of families to buy homes who would not qualify under the traditional 20% down payment mortgage. We’ll call these ‘subprime’ loans, even though the vast majority of the borrowers are today happily sitting in their homes, making payments, building equity and appreciating the joys (and woes) of home ownership. A small minority of these borrowers made unwise purchases. Perhaps they could not afford the loans, or were unprepared for increased payments in adjustable rate mortgages. Some simply lost their jobs.
Some number of homeowners who were the recipients of ‘subprime’ loans now face foreclosure. Home foreclosures are unfortunate. They result in a family losing a home, they cost banks money, and they cost local governments. But, for each of these losers, a new home owner emerges, and often gets a nice deal on a foreclosure. No real wealth is destroyed, nothing to spawn a crisis emerges. And, so for the larger economy, the small increase in the foreclosure rate (nationwide just a few homes out of each thousand) is hardly a national crisis. So where’s the problem?
After making the subprime loan, mortgage companies like to sell debt to other financial firms. A common way to buy debt is to package different kinds of debt together, balancing the risk and return. So, an attractive debt package will include corporate loans, credit card debt, and home mortgages – the latter being the safest of the three.
The problem emerged once word got out that many home mortgage loans were going to foreclosure. But here’s the thing of it. The problem isn’t that lots of homes would foreclose, the problem is that nobody really knows how many homes would foreclose, and consequentially how much less their packaged debt was actually worth. It was this uncertainty (not risk) that led investors to pull their money out of financial firms. This was the ‘liquidity crisis.’
So, the problem isn’t lots of foreclosures, it is simply that buyers of debt don’t know how bad the problem might be. Here’s where our national financial system aids markets in resolving their problems. The Federal Reserve Bank (the nation’s banker to bankers) responded by providing lower cost loans to these banks until their losses could be sorted out. It’s really that simple. In the end, any crisis has largely been averted.
There’s certainly more fallout from the subprime market mess. Money will be harder to borrow, selling homes might get a bit more difficult, and the Federal Reserve might opt to ease the money supply as a way to forestall a slowing economy. But, there’s no crisis akin to the Great Depression around the corner. So what’s the lesson? Our financial markets work well, and the ongoing resolution of the so called ‘liquidity crisis’ are the best evidence to date of the strength of markets.
About the Author
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