Monday, August 13, 2007

Today's word of the day: liquidity

As in this Markets 101 summary by Mr. Econ, Pres. George W. Bush:

Another factor one has got to look at is the amount of liquidity in the system. In other words, is there enough liquidity to enable markets to be able to correct? And I'm told there is enough liquidity in the system to enable markets to correct.

And, George, how does liquidity affect the market? George? Mr. Bush? Are you paying attention, George?

In market-speak, it's hard to imagine a more troublesome word than liquidity. It's positive. Most people know that much. But what does it actually mean? Definition 1: liquidity refers to the ease at which an asset can be converted into cash. In other words, how fast you sell your car/ballooning house mortgage/baseball card collection/equities portfolio in exchange for cash or a cash equivalent? Guess what? Equities are not all that liquid. While easier to unload than, say, baseball cards, you still need a third party to arrange the transaction, and this person needs to find a buyer. And secondly, do we really want to send the message to jittery investors that the best way out of this mess is to sell their shares? Of course not.

In terms of dud mortgages, they are even less liquid. Only the most daring investor would snatch up sub-prime loans. And, again, does the president want to be sending a message to strapped homeowners, regardless of their unworthiness, that they should just walk away from the new home, let somebody else pick up the loan?

Definition 2: our ability to cover our liabilities with cash. This is the bearish term (a less frequent usage during the current 25-year bull market), and certainly what the president's advisors were thinking when they whispered the term into Dubya's ear. It's certainly in our interest to know that the giant hole covered by negligent lending practices can be covered elsewhere by investors to produce that 'soft landing' effect we are now praying for. This remains to be seen, of course, though there are positive early signs thanks to that other market mechanism too dull for TV financial journalists to fuss about: monetary policy. Still, questions persist, including: You say there is enough liquidity now, but what if the crisis worsens? Will the central bank white knights continue to bail out the market?

Extricating ourselves from the sub-prime mess requires a thoughtful response, not dashing out hollow phrases and terminology to gloss over the troublesome parts. If not, we might start hearing a new word: panic. And everyone knows what that means.

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