Market Meltdown: It’s All About Liquidity

Financial markets are melting down this week, with the Dow down nearly a thousand points from its all-time high (set just a few weeks ago), large hedge funds imploding, computerized trading schemes posting big losses, and Jim Cramer blowing up on national television. Okay, the last one isn't at all unusual.

The trigger for this seems to have been hinted at a few weeks ago when we learned that it wasn't just subprime mortgages going bad, but the prime ones too. To be sure, default rates on prime mortgages are still much lower than on the toxic waste (just a few percent), but that default rate has more than doubled in the past year. That has led a lot of institutional investors to start questioning the value of the bonds they hold which are backed by various slices of mortgages.

Market trauma like this is always about liquidity--that is, the ability to find buyers and sellers for the financial instruments at hand. What's happening this week is that there are no buyers for mortgage backed securities of any sort, because nobody's confident about what they're actually worth.

Check out these quotes from this morning's Wall Street Journal:

From Alain Papiasse, head of BNP Paribas's asset-management-services division: "The market for the assets has just disappeared. Since the start of this week, there are no prices for instruments that carry, directly or indirectly, some types of U.S. assets."

From James Glassman, senior economist at J.P. Morgan Chase: "People are less willing to take the types of risks that they were before."

When liquidity dries up and prices become uncertain, markets move quickly, irrationally, and become much more correlated than usual. Usually this is because of panic selling, though occasionally (as happened at the peak of the tech stock bubble in 2000) markets move up because of panic buying.

This becomes self-reinforcing since, while some investors may be forced to sell (because of redemptions or margin calls), investors aren't usually forced to buy.

I'm not surprised to see that hedge funds and computerized trading schemes are failing in this scenario: rather than seeking inherent value, those types of funds try to exploit slight trading inefficiencies in the market, and their models implicitly assume no difficulty finding buyers and/or sellers. When liquidity disappears, the underlying assumptions of the trading model break down, and losses pile up very quickly. My observation (hedge fund marketing materials aside) has been that hedge funds and quantitative traders tend to make money during fairly normal market conditions, but underestimate the risk of abnormal markets and lose lots of money when things go sour.

So what's next? It's hard to tell, but right now the damage is limited to financial markets, with hyper-aggressive hedge funds and similar vehicles being the most vulnerable. Because of the way mortgages have been sliced up and repackaged, there's little bits of subprime paper hidden in lots of unexpected places, and right now the tide is going out so we're just discovering who's been swimming naked.

The worst case scenario is that investors and lenders become so risk averse that it becomes difficult or impossible for even the highest quality borrowers to get a loan. That could lead to a significant recession, since it would make it hard to buy a house, start a business, or maybe even get a credit card.

The best case scenario is that in a day or two bargain hunters swoop in and start buying some of the bad loans at deep discounts. Some hedge funds will lose money, and a few will shut down completely, but the damage will be limited to a handful of big institutional investors who can afford the losses.

The most likely scenario (as always) is somewhere in between: after a few months, debt markets will reach a new equilibrium, interest rates will tick up a point or two and lending standards will tighten incrementally, but fiscally prudent people and small businesses will still be able to get loans fairly easily. Most of the hedge fund gunslingers will shut down or become much more cautious, but life will be largely unaffected for most people.