Saturday, 18 August 2007

Liquidity Markets

Caroline Baum writing for Bloomberg points out that Bernanke of the FED is an expert on the Great Depression:
Bernanke [...] wrote in a 1983 paper for the National Bureau of Economic Research (``Nonmonetary Effects of the Financial Crisis in the Propagation of the Great Depression''): [...] ``the financial crisis of 1930-33 affected the macroeconomy by reducing the quality of certain financial services, primarily credit intermediation.''

Translation: Many commercial banks, considered efficient at allocating credit (they have a knack for differentiating ``good'' from ``bad'' credits), failed. The ones that remained solvent wanted to hold liquid assets or, if they were willing to make loans, charged a higher rate of interest.

Then and Now

``It was reported that the extraordinary rate of default on residential mortgages forced banks and life insurance companies to 'practically stop making mortgage loans, except for renewals,''' Bernanke said, citing the work of the late economist A.G. Hart.

Sound familiar? The rate of default isn't extraordinary just yet, but the mortgage market is contracting in leaps and bounds, starting with originations and ending with securitizations. The tentacles of the home-loan market are starting to strangle portions of the debt, equity and even the normally staid money market.

Bernanke is fully sensitized to the collateral damage damaged collateral can cause. Over and over in speeches during his stint as Fed governor from 2002 to 2005, he returned to the subject of the Great Depression, detailing where the Fed went wrong and what the Fed could have done to ameliorate the problems of the banks (provide liquidity or lower interest rates).
This is interesting as we are now in a true market for liquidity. Cash is a rare commodity at the moment and those people who have it are charging through the nose for it. The reason it's rare is that the market has woken up to their lack of knowledge of default probabilities both for securities and for their counterparties. A triple A rating doesn't mean much for ABS, and nor does a AA- give much comfort when attached to a broker/dealer in current conditions. Faced with this ignorance and in many cases plummeting or highly uncertain or both collateral values, the market is making people who want cash pay up for it. One ABCP conduit, for instance, with a (nearly full) guarantee from a very good credit quality sponsor and good quality assets was paying Libor plus 40 for one month CP this week. That's extraordinary if you think you can estimate the joint default probability of the assets and the sponsor and you are charging for that risk. It isn't if you have cash, they don't, they need it badly, and there is no one else they can go to. Then you can charge what you like...

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