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How a liquidity crunch affects global economies

(NEW YORK) A capital crisis that roiled Wall Street on Thursday and took nearly 400 points off the Dow Jones Industrials has the potential to impact regular people on Main Street as well. Here are some questions and answers about exactly what a ‘liquidity crisis’ is and how it impacts global economies.

Q. What is a liquidity squeeze and why should I care if the Wall Street banks are having troubles?

A. Think of what people call ‘liquidity’ in the financial markets as being something like a faucet. When water pours from it at full blast, you can get a glass of water quickly and easily. But as the water pressure falls, it becomes increasingly difficult and takes more time to fill up a glass.

In periods of liquidity, there is plenty of trading, and big institutional buyers and sellers easily move into and out of stocks, bonds and other instruments. But during a ‘liquidity crisis’ the big banks get nervous about risk and become more cautious about doing deals and making trades. They’re less likely to extend the easy credit that has fuelled the economy in the past few years, and that makes it more difficult to match buyers with sellers. That is what happened to markets around the world on Thursday.

The fallout from a liquidity crunch causes a ripple effect. The most immediate impact is that loans could become harder to get. But troubles can spread to the wider economy, hurting people’s investments and endangering their long-term financial plans. If banks are not lending and no one will extend credit to anyone else, markets seize up and economic growth disappears.

Q. Why are these big firms so easily affected?

A. Major financial institutions can absorb hefty losses without toppling. However, liquidity concerns cause institutions to become reluctant to lend money to other banks. Loans between banks on an overnight basis, one of the primary ways they fund their operations, have become more expensive as concerns arise about their ability to repay the loans – and that forces costs up.

Banks also bring debt offerings to the market on behalf of their clients. But if investors are reluctant to buy them, many times the banks will be left holding the debt.

Q: How do central banks inject money into the economy?

A: As an example, the Federal Reserve carried out a US$12 billion one-day repurchase agreement and a US$12 billion 14-day repurchase agreement. In a repurchase agreement, or ‘repo’, the Fed arranges to buy securities from dealers, who then deposit the money the Fed has paid them into commercial banks.

The cash infusion adds stability to the market, and fosters more buying and increased cash reserves. When the banks get this unexpected windfall of deposits, it increases their confidence that there is enough money to fund operations and make trades.

Q. I thought this was an American problem. What’s the deal with Europe, and should we be worried about China and Asia too?

A. The sub-prime mortgage mess might be a problem in the US as risky borrowers default on their loans and banks become increasingly shy about offering credit. But it impacts European and Asian players who invest heavily in bonds and other products made up of pools of mortgages.

European investors were said to be heavily involved in two hedge funds operated by Bear Stearns that are now bankrupt after bad sub-prime bets. The announcement by BNP Paribas that it was blocking investors from taking their money out of some mortgage-exposed funds raised the spectre of a widening impact of US credit market problems.

These high-yield investments have been attractive because they offered big returns, and that caught the interest of investors globally.

Q. Aren’t the bad sub-prime loans contained, and what kind of impact would this have for regular Americans if they’re not?

A. Defaults in the US$2.6 trillion sub-prime mortgage market have caused many homeowners to lose their homes, while scores of others have reined in spending to keep on top of their payments. There has been some indication that fears about the housing industry have caused borrowers to watch their wallets. And that’s evident in the US economy, with retailers reporting sluggish sales figures in July.

 

Source: Business Times 11 Aug 07

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