What is liquidity?
It relates to the ease and speed required to turn an asset into cash. Most stocks are highly liquid – with a quick call to your broker or the click of a mouse, you can convert a stock into cash. A car is less liquid. It may take a few weeks or longer to convert to cash. A house – for the most part – is even less liquid. Under normal market conditions, it could take a couple months to convert a house to cash. In today’s very illiquid housing market, it’s taking many months and often longer than a year.
How does liquidity work?
Here’s an example. Let’s say a bank has $1 million. It divides the money by 4 and lends it to 4 home buyers. The bank then takes those 4 mortgages, bundles them together and sells them to convert them to cash. It then takes this new cash and repeats the process. The bank lends to individuals, small business, large business etc. The lending of money is the engine that drives the economy.
Here’s where things go bad. If those home owners default on their mortgage payments, the banks will have a problem selling the mortgages, and if they can’t convert the mortgages to cash, they'll have nothing to lend out. With no cash to lend out, the economy drastically slows down because everything is built on debt.
If people can’t borrow money to buy homes or aspiring entrepreneurs borrow money to start business or large businesses borrow money to fuel growth or hedge funds borrow money (margin) to invest, the entire economic system grinds to a halt.
What I’m saying is extreme. Money can always be borrowed…at a price. Interest rates are the “cost of borrowing,” and as the cost goes up, less borrowing takes place.
Why are these hedge funds going under or at least halting redemptions? Because they’re the ones that bought those bundles of mortgages from the banks. Those bundles are like junk bonds. The paying higher rates but the owner has to assume more risk. Those funds simply went too far. Instead of allocating a small percentage of their fund to risky subprime mortgages, they went overboard and took on too much exposure. Defaults mean they’re not being paid, and it’s not like they can turn around and sell them to another sucker.
Funds going under means nothing to me. It’s their own damn fault. But if banks can’t loan money or can only loan money at high rates (i.e. liquidity is drying up), our economic engine will drastically slow down, and its ripple effect will be felt everywhere.
That’s why the Fed needs to lower rates. That’s why Cramer went ballistic in the youtube video. The Fed needs to lower rates to grease the economic engine.
2 comments:
The liquidity infusions of today were basically a reduction in interest rates. I heard that the Fed funds rate closed at 4.85% bid, 5% offer. Money only cost 5% at the close today. Helicopter Ben saves the day by cutting rates without cutting rates. After that? We'll see soon enough.
i don't think we are out of the woods yet. The Fed showed a that they are clearly behind the 8 ball with the injection. that's why the didn't react too favorably in my opinion.
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