A mere two months ago, the financial world was being treated to pontifications about “abundant liquidity” or even “a flood of liquidity,” which would guarantee a firm market bid for risky assets and narrow spreads. Suddenly, in the wake of the subprime mortgage bust, we are confronted instead with a lack of bids, non-functioning markets, and widening spreads. Now we hear discussions of a “liquidity crisis.” What happened?

The first part of the story reveals the difference between financial models and reality. Subprime mortgage-backed securities were based on the models of investment banks and the credit rating agencies. Their resulting junior tranches, sold to yield-hungry investors around the world, were highly leveraged to credit losses being worse than the models expected. Many investors added to this risk financial leverage, using short-term borrowings in the form of repurchase agreements or commercial paper. The resulting structure thus became hyper-leveraged to worse-than-expected scenarios.

'Liquidity' is a misleading metaphor. Financial liquidity is not a substance—if it were, there could not have been an excess of it two months ago and a dearth of it now.

And, indeed, the reality of subprime credit defaults and losses has turned out far worse than financial models predicted. It recalls Moore’s Law of Finance: “The model works until it doesn’t.” As a result, more than 80 subprime lenders have gone out of business in less than a year. Virtually all remaining lenders, including all the major ones, have now cut back drastically on subprime lending and raised credit standards. This reduces the availability of mortgage credit and reduces the demand for houses. At the same time, homebuilding companies are experiencing large losses, steeply falling sales, and pessimistic outlooks. The for-sale inventories of new houses, existing houses, and condominiums are all high.

It is evident that an excess supply of houses combined with reduced demand equals a trend of falling house prices. The models used to analyze the risk of subprime securitizations include house price appreciation (“HPA” in the trade lingo) as a key factor. But on average, the reality has now become house price depreciation.

What will happen if house prices fall much more than the models thought they could? Falling house prices tend to trigger higher mortgage defaults, especially if loans were made with small or no down payments, or were made to speculative buyers. Higher defaults lead to credit tightening, which helps induce falling house prices, which cause more defaults, etc. This can be a vicious cycle, and it inevitably spreads fear through the financial markets.

That fear is heightened by uncertainty over the value of subprime securities, which prompts several questions typically associated with financial busts (to which the answers are never clear): What are subprime securities worth as assets to an investor? What are they worth as collateral to a lender? In leveraged funds, are they worth enough to pay off the debt? If so, what’s left for the equity investors? What does value mean if there are no or very few buyers? How can assets be “marked to market” if there is no active market? Should everybody’s portfolio be marked to fire-sale prices? What happens if everybody does that at once and numerous insolvencies result? Who is actually broke and who isn’t?

Liquidity is about group belief in the solvency of counterparties and the reliability of prices.

With these questions being debated once again, we also realize that, as Walter Bagehot wrote in his timeless financial classic Lombard Street (1873), “Every great crisis reveals the excessive speculations of many houses which no one before suspected.” Our current crisis is true to form.

All these factors and fears bring us to the second part of the story: Everyone becomes a conservative at once. When every bank and investing institution, not to mention all the individual managers, try to protect themselves by avoiding risk, the result is to make liquidity disappear and increase risk.

To understand this, we must recognize that the term “liquidity” is a misleading metaphor. It suggests there is some substance which could “flow,” could be a “flood,” could “slosh around,” or could be “pumped” somewhere (to use a number of common expressions). But financial liquidity is not a substance—if it were, there could not have been an excess of it two months ago and a dearth of it now.

Instead, “liquidity” properly understood is a figure of speech. It is verbal shorthand for the following situation: “A is ready and able to buy an asset from B on short notice, at a price B considers reasonable, which usually means C is willing to lend money to A, which means C believes A is solvent (and that the asset is good collateral), and if A is a dealer, both A and C must believe the asset could readily be sold to D, which means A and C believe there is an E willing to lend money to D.”

In other words, liquidity is really about group belief in the solvency of counterparties and the reliability of prices. During a boom, financial actors are confident that they are masters of modeling—so liquidity is abundant. During a bust, they are far less certain about what assets are worth—so liquidity has vanished.

This dynamic can be summarized by the Plank Curve (shown right), which represents the amount of liquidity in the market as a function of uncertainty and fear. (The name of the curve derives from its resemblance to the path of a man walking the plank.)

The current liquidity crisis won’t last forever. Losses will be taken, risks reassessed, models rewritten, and revised clearing prices discovered. A, B, C, D, and E will get back to trading and lending. “Liquidity” will return. And when it does return, financial actors will probably soon take it for granted once again.

Alex J. Pollock is a resident fellow at the American Enterprise Institute. 

Image by Darren Wamboldt/The Bergman Group.