Friday, August 10, 2007

Read My Lips: "Liquidity" "Risk Assessment"

We should have known from the start. The bears have left the campgrounds and headed for Wall Street.

The morning after the Dow's first 3% drop, President Bush and his economic advisers marched out to urge investors to stay calm.
Why so much fuss over a 3% drop, not even a third of the way to a market correction?

Did the White House know something the rest of us did not?

In further urging calm this week, the President gave up plain, Texas talk, as The New York Times reported:
Mr. Bush, who has a master’s degree in business administration from Harvard, confidently used phrases like liquidity, risk assessment and market adjustment to describe complex economic conditions. Asked about collapsing housing markets, and the risk of them declining further, Mr. Bush said: “In a way it’s a necessary reaction to a flood of liquidity that came into the market in the past couple years.” That was financial jargon referring to the past several years of easy money, some of it from overseas, at low interest rates.
All that liquidity encouraged borrowing against a classically illiquid asset. Most times the owner of, say, a $700,000 home can sell it fairly easily, given good location, etc. Occasionally, though, the real estate market dies. In a few years the house will probably again be saleable for $700,000 or more. But for the moment: no bidders. At any price. That's illiquidity.

Stocks and bonds, by contrast, are liquid assets. They trade daily in volumes our ancestors could not imagine. Investors hopes and fears may cause prices to fluctuate wildly, but marketable securities can always be bought or sold.

Well, almost always. Packages of subprime mortgages and derivative securities suddenly seem as illiquid as . . . houses. From Paul Krugman's NY Times column($):
What’s been happening in financial markets over the past few days is something that truly scares monetary economists: liquidity has dried up. That is, markets in stuff that is normally traded all the time — in particular, financial instruments backed by home mortgages — have shut down because there are no buyers. This could turn out to be nothing more than a brief scare. At worst, however, it could cause a chain reaction of debt defaults.
The President expects "risk assessment" (better late than never!) will allow such securities to be traded again. But that assessment could produce a lot of downside volatility and make a lot of hedge funds and investment firms look considerably poorer.

Opportunity knocking?
For investment counselors seeking new clients, volatility is a plus, in moderation. Gyrating markets rattle the cages of affluent investors who, in calmer times, feel disinclined to seek help.

Too much volatility is another story. If investors panic, typically they want to do nothing but sell out and park their cash in money market funds.

If they read this Wall Street Journal story, even MMFs may be too scary. Turns out that some of the commercial paper bought by money market funds was sold by "conduits" and backed by, yes! subprime mortgages.

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