How Bad is the Liquidity Crisis?

How bad is it?

Lets take a simple example. Suppose you're short on cash to pay your bills, because you're between jobs; however, your pay checks will start up again in a month. Then, all you need to do is bridge that one-month gap, and you will survive your "liquidity crisis."

Today's liquidity crisis is founded on bad mortgage loans, which were used as collateral for creating credit that is 5-to-10 times the amount of the underlying value of the mortgages. The magic of leverage... remember, banks are only required to hold a fraction of their outstanding loan value in reserve, because it is very unlikely that everyone will ask for their money back at the same time. Unfortunately, people are effectively asking for their money back at the same time, because they realize the collateral (mortgages) are turning sour. But the banks don't really have that money; the reserves are just a fraction of leveraged loans, hence a liquidity crisis on a large scale.

So, how bad is the liquidity crisis? In the simple example above, of being between pay checks, the "crisis" wasn't so bad, because the funds started flowing again after a month. Aside from the obvious issue of scale, the large scale crisis can be measured in several ways.

First, it is a crisis of leverage. If you a bank has 1 million cash dollars in its vault, and uses that as "reserve" on loans of 10 million dollars, it's taking a risk everyone will demand that $10 million in cash at the same time. it doesn't exist. Only $1 million in cash exists.

Second, if, suddenly, everyone finds out that the $1 million in "cash" is actually bonds "backed up" by mortgages, and those mortgages are bad loans, and they might never see "cash" again, they get panicky and start asking for the cash now... but again, there is no "cash," just worthless mortgage backed bonds.

Now, if only those bonds had some worth, then the panic would end. We'd be back to the normal mode of a fraction of reserves being held by the bank, with the unlikelihood that everyone would demand cash simultaneously.

So, like waiting for the next pay check, "how bad" depends on how long until those mortgages become solid again. One estimate has it as a long gap to fill. Referring to the increasing number of bad loans, Doug Duncan, Mortgage Bankers Association Chief Economist says:

We expect another two to four quarter[s] of modest rises in delinquencies. And foreclosures lag one to two quarters behind that.

So, the current reserves, based on mortgage backed securities, have at least a year's worth of increasing rates of defaults left to play out before the rate of defaults begins to taper off.

That's a very large time gap to fill. We can expect a bail out on the backs of tax payers.

Sources:

Best and Worst U.S. Housing Markets, Forbes, Matt Woolsey, August 22, 2007.