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Liquidity in the markets

Let's take a look at how recent events in the credit markets have affected liquidity in the markets and the economy.

We've been hearing a lot about a credit crunch as deals dry up or get withdrawn in the LBO space. Investors lately have cut way back on the riskier forms of debt that tended to fund these deals.

Many have become very disillusioned by the recent fallout in the subprime mortgage bond and CDO markets. As Bloomberg puts it, "concerns over mortgage-backed securities have sapped investor appetite for other debt". You said it.

But some people don't think it's all that bad. Over at The Aleph Blog, editor David Merkel is of the opinion that the larger and higher quality sections of the bond market are well intact and functioning.

While he recognizes the crisis in the market, he feels that a crisis-style situation is mainly limited to "the exotic stuff", namely, subprime backed ABS, LBO debt and high-yield deal loans, and derivatives on subprime or "instruments like LCDX and CMBX".

Liquidity in the credit markets may have dried up, but we don't know for how long. As Merkel writes in his dissenting post, it may come back, slowly but surely, as it has in the past.

This is not an opinion shared by Doug Noland, who recently wrote of a "Credit Market Dislocation" that has accompanied the piercing of "The Great Credit Bubble".

Here's an excerpt of Doug's views:

I mostly downplayed the marketplace liquidity and economic impact of the housing downturn last fall and the subprime implosion this past February. My view of current developments is markedly different.

I cannot this evening overstate the dire ramifications for the unfolding Credit System Dislocation. There is today serious risk of U.S. financial markets "seizing up." A system so highly leveraged is acutely vulnerable to speculative de-leveraging and a catastrophic "run" from risk markets.

At the same time, the Bubble Economy and inflated asset markets - by their nature - require uninterrupted abundant liquidity. The backdrop could not be more conducive to a historic crisis, yet most maintain unwavering confidence that underlying fundamentals are sound.


Meanwhile, FT Alphaville has highlighted a Lombard Street Research report which notes the potential for "major stress" in US banking due to the subprime/CDO debacle.

Here's the summary of their findings:


The sub-prime/CDO debacle has a real potential to create major stress within the US banking system. It could well turn out that after frantic reassessment of the risk positions across financial institutions globally and further ructions, market players regain confidence of what the true size of the problem is. However, this is likely to take a while. In the meantime, it is reasonable to expect that the liquidity crunch will intensify as both supply and demand for credit suffer. Contagion across asset classes seems likely. Increased liquidity preference will cause the sale of assets, unlikely to be confined to one asset class.


But there's still the matter of "liquidity" in the sense of money and credit supply in the larger financial system and economy. Will recent events in the markets cause worldwide money conditions to tighten?


We'll take a look at this question and revisit the growth of global money supply in our next post. See you then.

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