The possible ripple effects
A capital crisis that roiled Wall Street on Thursday and took nearly 400 points off the Dow Jones industrial average has the potential to affect people on Main Street as well.
Here are some questions and answers about what a “liquidity crisis” is and how it affects global economies.
What is a liquidity squeeze and why should I care if the Wall Street banks are having trouble?
Think of what people call “liquidity” in the financial markets as a faucet. When water pours from it at full blast, you can get a glass of water quickly and easily. But as the water pressure falls, it becomes increasingly difficult and takes more time to fill up a glass.
In periods of liquidity, there is plenty of trading, and big institutional buyers and sellers easily move into and out of stocks, bonds and other instruments.
But during a liquidity crisis, the big banks get nervous about risk and become more cautious about doing deals and making trades. They’re less likely to extend the easy credit that has fueled the economy in the last few years, and that makes it more difficult to match buyers with sellers. That is what happened to markets around the world Thursday.
The fallout from a liquidity crunch causes a ripple effect. The most immediate effect is that loans could become harder to get. But trouble can spread to the wider economy, hurting peoples’ investments and endangering their long-term financial plans. If banks are not lending and no one will extend credit to anyone else, markets seize up and economic growth disappears.
Why are these big firms so easily affected?
Major financial institutions can absorb hefty losses without toppling. However, liquidity concerns cause institutions to become reluctant to lend money to other banks. Loans between banks on an overnight basis, one of the primary ways they fund their operations, have become more expensive as concerns arise about their ability to repay the loans -- and that forces costs up.
In addition, banks bring debt offerings to the market on behalf of their clients. But if investors are reluctant to buy them, many times the banks will be left holding the debt.
What did the big government banks do Thursday to ease the problem?
The Federal Reserve pumped $24 billion into the U.S. banking system. Meanwhile, the European Central Bank made a record cash injection of $130 billion into its markets to increase liquidity and shake off credit fears.
How do central banks inject money into the economy?
As an example, the Fed carried out a $12-billion, one-day repurchase agreement and a $12-billion, 14-day repurchase agreement. In a repurchase agreement or “repo,” the Fed arranges to buy securities from dealers, who then deposit the money the Fed has paid them into commercial banks.
The cash infusion adds stability to the market, and fosters more buying and increased cash reserves. When the banks get this unexpected windfall of deposits, it increases their confidence that there is enough money to fund operations and make trades.
I thought this was an American problem. What’s the deal with Europe, and should we be worried about China and Asia too?
The sub-prime mortgage mess might be a problem in the U.S., as risky borrowers default on their loans and banks become increasingly hesitant to offer credit. But it affects European and Asian players who invest heavily in bonds and other products made up of pools of mortgages. These high-yield investments have been attractive because they offered big returns, and that caught the interest of investors globally.
European investors were said to be heavily involved in two hedge funds operated by Bear Stearns that are now bankrupt after bad bets on sub-prime loans.
The announcement by BNP Paribas that it was blocking investors from taking their money out of some mortgage-exposed funds raised the specter that the U.S. credit problems will have a wider effect.
Aren’t the bad sub-prime loans contained, and what kind of effect would this have on regular Americans if they’re not?
Defaults in the $2.6-trillion sub-prime mortgage market have caused many homeowners to lose their homes, while others have reined in their spending to keep on top of their payments. There has been some indication that the fear about the housing industry has caused borrowers -- even those with perfect credit -- to begin watching their wallets. And banks have raised rates and lending requirements even for borrowers with good credit.
And that’s already evident in the economy, with retailers reporting sluggish sales figures in July.
