The “L” Word – Liquidity

Excerpts below from an article in the WSJ concerning liquidity is a very good discussion of the subject. The issue that has been mentioned on this blog a number of times about liquidity is that “it is there until it isn’t”. If you want to understand the stock market it is important to understand the “L” word.

A flood of money sloshing around the world the last few years has helped drive up the price of everything from commodities and stocks to junk bonds and emerging-market debt. The catch phrase for all this money is "liquidity." Now that the markets are in spasm, it makes sense to look at where the liquidity came from and where it is going.

Money is created by central banks, and amplified by the institutions that use it -- banks, hedge funds, investors. The more confident they are, the more easily it flows. The liquid world leaves everyone with more investment, and also more debt.

Low interest rates are a sign money is cheap and easy. Central banks like the Federal Reserve have been the primary liquidity mop the past few years, boosting interest rates to clamp down on inflation after unleashing a liquidity gusher back in 2001, after the Sept. 11 terrorist attacks. Japan's central bank has stoked the liquidity furnace; it still has rates below 1%. Hedge funds, banks and pension funds borrowed the cheap cash and deployed it around the globe.

Today, fear is another liquidity sponge. It tightens the lending that drives liquidity. Mortgage lenders are clamping down on risky loans after a jump in subprime-mortgage defaults. Banks have started calling in collateral from hedge funds that dabbled in exotic securities linked to subprime loans. Meantime investors are thumbing their noses at banks trying to sell them loans or junk bonds used by private-equity firms to finance leveraged buyouts. It all means less money for investment.
"A necessary component of liquidity is risk taking. When market participants want to reduce risk, they don't make loans," says John Succo, partner of the New York hedge fund Vicis Capital. . . . .

. . . . The world's financial architecture is different now. The proliferation of hedge funds and derivatives has theoretically spread risk around, making a Long-Term-like event less likely. It's also far more complex. Unknown problems could lurk in today's derivative jungle, and quick fixes like the one that cured the Long-Term debacle might not be as effective.