Friday, March 6, 2009

A Big Lie in the Banking Crisis: “It's a Liquidity Problem.”

I remember hearing this line early on, months before the catastrophic Lehman Brothers meltdown, when credit markets were starting to tighten. It later became all the vogue when the banks claimed they couldn't sell their stockpiles of crappy assets. At least not for a “fair” value.

“Liquidity problem” is a clever banker’s smokescreen. It basically means there's not enough liquidity, or money, available to meet the broader demand. That's the problem that you darkly hint of when you say things like, “credit markets are frozen.”

For a pathological finger pointer, it's a great excuse. You're not the one to blame. It's the system. “In a normal, liquid market, these assets would sell for much more,” the banker whines.

Now, if the banking industry can convince the government that the problem really is liquidity, here's what happens: The government cuts interest rates as low as zero and sets up a bunch of emergency credit facilities. (Sound familiar?) The market is awash in money. The liquidity problem goes away. The country is saved!

If injecting funds this way doesn't cure the ill, then you have to consider a different, and more likely, possibility: it isn't a liquidity problem at all. It's a bubble-deflating problem under which the assets could keep losing value, very easily.

Parse the banker’s statement to see what he's really saying:
Original: “In a normal, liquid market, these assets would sell for much more.”
Translation: “In a bubble market, these assets sold very well at a higher price. That helped make them more liquid as investments. Now the assets (securities often backed by home mortgages) aren’t desirable because of their complexity and housing price declines. But we're not willing to lower our price, so we'll blame liquidity.”