Liquidity crisis

It may not be too much out of place to claim that all the recent financial market crises have their origins in liquidity problems faced by various categories of investors. In many ways, liquidity, or atleast the perception of liquidity, is the most critical determinant in global financial markets.

Every now and then a bout of "irrational exuberance" builds up on some asset or financial instrument or technology or an industry, and investors flock there in herds. A bubble builds up and over-investment results. Investors, even leverage their positions to be a part of the investment race. Then, suddenly reality dawns, sparked off by some event, generally some default, and the bubble gets pricked. The unravelling starts. Investors rush for the exit door in a mad scramble, and asset values fall precipitously. New investors naturally stay away, and all the sources of liquidity for the sector dries up. A liquidity crisis is experienced.

The Bank of International Settlements (BIS), in its latest annual report remarks, “There seems to be a natural tendency in markets for past successes to lead to more risk-taking, more leverage, more funding, higher prices, more collateral and, in turn, more risk-taking...Moreover, should liquidity dry up and correlations among asset prices rise, the concern would be that prices might also overshoot on the downside.”

A list of all the specific liquidity crises afflicting global financial markets

1. The household mortgage takers, especially those No-income-no-job (NINJA) sub-prime borrowers, felt the rising interest rates and the cooling housing market and saw their "income effect" due to home ownership disappear. With the cooling housing market, they found it difficult to repay their debts and started defaulting.
2. The mortgage lending companies, suddenly realised the true magnitude of the sub-prime portfolio. Mortgage lending dries up.
3. The Wall Street lenders and banks had purchased these mortgage loans as bundles of securitized Collateralized Debt Obligations (CDOs). With the collateral showing up as being of dubious quality, they stopped purchasing or lending on CDOs. This dried up the sources of revenue for the mortgage lenders.
4. The Institutional investors like hedge funds, pension funds, and private equity firms, had also piled up massive investments in CDOs. They had leveraged the CDOs to raise money from the Wall Street Banks. Now the Wall Street Banks refused to lend against any mortgage backed securities. Hedge Funds and institutional investors are choked off liquidity.
5. The Special Investment Vehicles (SIVs), set up as off-balance sheet entities by Wall Street banks and institutional investors, raise money from the market by issuing Commercial Paper (CP). Now the market for CP takes a hit, as investors become aware that some of these SIVs own mortgage backed securties like CDOs, some of whom may be of suspect quality. Investors for CP dry up. Wall Street banks and especially hedge funds and private equity firms, who rely on such SIVs to raise their investment capital, face liquidity crunch.

This complex and multiple entangled web of liquidity crises, is now being played out and nobody knows when it will bottom out. Till that happens, the Federal Reserve and other Central Banks will have no option, but to either keep lowering interest rates or atleast keeping them low. Even faced with inflationary pressures from both the high oil prices and weakening dollar (and hence costlier imports - important given the predominant role of consumption in US GDP growth), the US Federal Reserve could have limited room to manoeuvre with monetary policy. Given the rising commodity prices, especially "peak oil", it is no different in the other economies. The most important leg of the Impossible Trinity becomes defunct! Milton Friedman had famously said, "An easy money policy is an invitation to higher interest rates."