Why I Write About It

Those two or three of you who regularly read this blog may be wondering why I'm spending so much time talking about the markets and the liquidity crunch. Here's why:

Mish explains it all here. But the short version is that the current problems are not really a "liquidity crunch". That's the symptom. The real problem is risk repricing. That means that the markets have finally figured out that there is real risk in lending money to those who can't pay it back. As long as house prices went up, the risk was low as the assets (the house) could cover the loan. But with defaults, the dynamic changes and people begin to have to walk away from over-extended loans.

That is happening.

The next shoe to drop is a spiral effect. Here's an example:

Nicholas Schor and Liza Losada-Schor were ready and willing to spend up to $850,000 on a house in Maryland. That was a month ago, when the rate on their mortgage would have been as low as 6.25 percent.

But a sudden shift in the mortgage market means that the couple -- he's a psychiatrist, she's a clinical nurse psychotherapist -- now face a rate of more than 7 percent [or higher if they can even get a loan], reducing their buying power even though they have solid credit. That's because in the past few days, rates on loans for more than $417,000, known as jumbo loans, have shot up.

"I'm sort of surprised that even though we have excellent credit and excellent income and are putting down a 20 percent contribution that the banks aren't able to offer better rates for folks who seem to be a more reliable investment," Schor said.

People, facing higher costs and bigger obstacles simply remove themselves from the buying market. That depresses asset prices (on everything that requires credit including business, deals, IPO's et al.), causes more defaults which dries up more liquidity. It is also known as a deflationary spiral.

In case you didn't realize it, this is exactly what happened during the Great Depression. If the markets can't stabilize, the decline continues. Are we headed for that? I certainly hope not. But anyone who tells you we're not is as foolish as anyone who definitely says we are. That's why the situation bears close scrutiny.