Loss of liquidity, not insolvency, caused credit crunch - Thanks to a subscriber for this interesting account, by Anatole Kaletsky, of the ongoing liquidity problems in the credit markets. The full story is posted in the Subscriber's Area but here is a section:
The probability of the American GSEs defaulting remains essentially zero, as it has always been. If anything, the willingness of the US Government to stand behind these enterprises is even higher today than it was before the financial crisis. The market value of these bonds has fallen simply because they have turned out to be less liquid assets than previously believed - and liquidity has been recognised as a much more important and valuable characteristic than investors suspected until a few weeks ago.
Until last month, it was still widely assumed that the danger of illiquidity affected only inherently risky assets, such as sub-prime mortgages, complex derivatives and leveraged loans. But this assumption completely changed when the US bond insurers started to be downgraded in January. Suddenly, ultra-safe municipal bond prices plunged to levels normally associated with the riskiest junk bonds. This was not because the Port Authority of New York or the California Water Board suddenly looked like defaulting. It was simply because municipal bonds became illiquid as investors were forced by regulations to dump them into a market with no bids.
After the municipal meltdown, forced sellers of top-quality mortgages, and even of government-backed GSE bonds, suddenly could find no buyers. It was this disappearance of liquidity - not a growing risk of default by borrowers in the non-financial economy - that caused the collapse of Bear Stearns.
By last week, the liquidity crisis had spread even to assets whose default risk was literally zero. A widely quoted story on Bloomberg read: "The risk of losses on US Treasury notes exceeded German bunds for the first time ever, amid investor concern the sub-prime mortgage crisis is sapping govern- ment reserves." The evidence cited was a sale of credit-default swap (CDS) insurance on US Treasuries, which implied a default probability of 0.16 percentage points, as against 0.15 points on German bonds. But what did these "probabilities" actually show? After all, Washington can always print the money with which it pays for its bonds - and, like all governments, invariably does so. Moreover, in the vanishingly improbable event that the US Treasury really did decide to stop printing dollars, would the underwriters of CDS insurance still be in business and pay up? What court would enforce a private CDS deal if contracts with the US Treasury were no longer in force? And what currency would such a judgement be paid in, since US dollars would no longer exist?
My view - I believe that Credit Default Swaps (CDS) are a useful invention which can be used to hedge default risk but that's about all. The ongoing situation in the credit markets which I have described as 'Model Myopia', (Comment of the Day March 6th) where the price of insurance against default is being used to evaluate the integrity of companies, can not persist, but it is creating value. Buying opportunities for investors capable of placing competitive bids in that market are available now and I have little doubt we will hear of a number of funds who benefitted enormously from this crisis over the coming months. "
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