Thursday, March 15, 2007

Liquidity and Credit are oftn confused

The Short View: Dr Doom’s diagnosis

Kaufman had no words of reassurance. But Dr Doom did have a clear diagnosis.
The problem lies in the changing definition of liquidity. After the war, liquidity was an “asset- based concept” – companies’ cash on hand and so on.
Now, Kaufman said, “firms and households alike often blur the distinction between liquidity and credit availability.
Money matters but credit counts”.

Posted by lvmreader @ 07:34 PM (472 views)
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One thought on “Liquidity and Credit are oftn confused

  • The Short View: Dr Doom’s diagnosis

    By John Authers, Investment Editor

    Published: March 14 2007 18:40 | Last updated: March 14 2007 18:40

    Dr Doom is back. Henry Kaufman, the legendary chief economist for Salomon Brothers in the 1970s and 1980s, earned his nickname for gloomy (and usually correct) forecasts of higher inflation and interest rates. He turns 80 this year, and gave a speech in Wall Street on Tuesday night.

    The timing was perfect. US stocks had just sold off savagely, and Asian markets were about to suffer the same fate. Within hours the selling hit Europe, leaving indices sharply down for the year.

    Kaufman had no words of reassurance. But Dr Doom did have a clear diagnosis. The problem lies in the changing definition of liquidity. After the war, liquidity was an “asset- based concept” – companies’ cash on hand and so on. Now, Kaufman said, “firms and households alike often blur the distinction between liquidity and credit availability. Money matters but credit counts”.

    Securitisation and improved technology, he said, stimulated risk appetites, “fostering the attitude that credit usually is available at reasonable prices”. But risk-management models assume “constancy in market fundamentals,” and do not account for the market’s changing structure. Moreover, risk modelling is so profitable that it will spread, and become “in a word, riskier” – because aggressive models make the most money. Meanwhile “the reliance on judgment and reason will be pushed aside”.

    The speech could have been a comment on this week. Traders realised they had extended too much credit – particularly to the subprime sector – and reduced leverage wherever they could. Hence the uniform sell-off. Assets with little in common become almost perfectly correlated. Individuals and companies trade in and out of the stocks in the S&P 500, and in and out of the dollar and the yen, for many different reasons. They are two of the world’s most liquid markets.

    But they were perfectly matched on Wednesday, with the S&P rising as the dollar rose, and falling as it fell. The weight of money being managed by quantitative risk models ensured a tight correlation. As Dr Doom warned, reliance on judgment and reason have been pushed aside.

    Copyright The Financial Times Limited 2007

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