Friday, August 10, 2007

Credit crunch continues

We don't have a lot of history concerning credit crunches so it may be hard to make generalization on how this event will spread and how it will stop. The current crisis has now moved way beyond a simple liquidity problem within the sub-prime market. The continued turmoil suggests that my earlier comments about limiting the Trichet put were misplaced. This event is having more contagion than what may have been the case just a week ago. The surprise closing of funds in France because of sub-prime debt suggests that the US housing debt crisis has a strong international dimension.

We do know that while providing more short-term liquidity is helpful, it is like emergency room triage. It may stem the bleeding and temporarily stabilize the system but it will not solve the problem. The solution to a credit crunch is for a willingness for banks and investors to supply credit because they believe they are being compensated for risks. If the perceived probability of a default is so high that the yield compensation is not there, credit will not be extended. These are simple concepts.

The current problem is that if you do not know what is in the portfolio of some of these funds, you will sell your holding. This is like a primal response to danger. The is some noise in the bushes. You do not wait to see what it is. You in the opposite direction. It may be nothing but the cost of being wrong is too high.

This primal response causes a liquidity crisis if there are no buyers of the paper that is being sold. The liquidity crisis in one area then has carry-over to other markets. If you cannot sell the illiquid investments get rid of what you can that is liquid. Raise cash and await more information.

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