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Summary:
Firms are said to be liquid when they are able to meet current obligations or short-term demand for funds. A firm is said to be solvent but illiquid when its assets exceed its liabilities but it is unable to liquidate assets rapidly enough to meet current obligations. Markets are said to be liquid when a large volume of financial securities can be traded without price distortions because there is a ready and willing supply of buyers and sellers. Liquid markets are a sign of normalcy. In August 2007, liquidity abruptly dried up for many firms and securities markets. Suddenly some firms were able to borrow and investors were able to sell certain securities only at prohibitive rates and prices, if at all. The liquidity crunch was most extreme for firms and securities with links to subprime mortgages, but it also spread rapidly into seemingly unrelated areas. The stock market experienced unusual volatility and investors rushed to buy the safest of all investments, U.S. Treasury securities. On August 31, Federal Reserve Chairman Ben Bernanke noted that "[a]lthough this episode appears to have been triggered largely by heightened concerns about subprime mortgages, global financial losses have far exceeded even the most pessimistic projections of credit losses on those loans." The spread of disruptions from housing into other debt markets is an example of financial contagion, or systemic risk. Contagion spread among non-bank institutions: mortgage lenders, hedge funds, and issuers of various types of securities, including commercial paper, asset-backed securities, structured products, and debt supporting leveraged buyouts and takeovers. As fear of risk has increased, these institutions saw sources of credit vanish and struggled to meet existing financing commitments, to post additional collateral, and to cope with portfolio losses. Some financial institutions, primarily mortgage lenders and hedge funds, have been unable to resolve liquidity problems and have closed. In the months ahead, there may be more failures. Central banks, including the Federal Reserve, have responded by providing liquidity -- injecting cash into the banking system and lowering interest rates -- in order to prevent financial disruptions from slowing real economic growth. While financial "paper losses" have no direct effect on output or employment, there are channels through which changes in financial conditions may be transmitted to the real economy: for example, tight credit and equity markets restrain business investment in plant and equipment. In the wake of the liquidity crunch, policymakers may consider several areas for reform. Could regulation have prevented current problems in the mortgage market? Should credit rating agencies, like Moody's and Standard & Poor's, be subject to more oversight by the Securities and Exchange Commission? Should the non-bank institutions that have been central to this episode be subject to greater regulatory supervision or information disclosure requirements? This report analyzes the causes, progress, and broad policy issues raised by recent liquidity problems, but does not address proposals to alleviate distress in the housing sector.
