The Liquidity Rub

As the debate over what to do in response to the mortgage crisis heats up, one term that folks will hear a lot is the term "liquidity". It may or may not be a term that laymen can understand so first let me explain what it means that we have a liquidity problem in the mortgage market.

Most people think of banks as an entity so flushed with cash that it is almost endless. Now, while a bank has a lot more money than the average Joe, in fact, this perception is very overstated. While they have more than enough to fund most any loan that comes in their doors, they don't necessarily have enough to hold onto each loan. That is one reason that loans are sold from one institution to another so often. In fact, banks approve loans usually with the plan of selling it to some other entity. By doing this, they have enough money to fund the next loan. This is what we refer to as liquidity.

Banks have several options as far as places that will take loans off their hands. Other banks are one option, or they can package their loans and turn them into bonds. If they are prime loans, these bonds are insured by Fannie Mae. Sub prime loans are packaged together and sold as Mortgage Backed Securities.

Now, currently the problem is that so many of the loans that would make up the portfolio of any bond that isn't backed by Fannie Mae are in default or late that no one wants to buy these bonds. If they do, it is for a significant discount, 70 cents on the dollar and less. Since banks never intended to hold onto most of these loans long term, when they can't sell them, this creates a liquidity crisis. This phenomenon is happening not only in sub prime but another sub category called non prime. These are any loans over $417,000, the limit for Fannie Mae and Freddie Mac loans.

Thus, the crux of the so called liquidity crisis is that so many of the loans of portfolios, other than prime, are bad loans, that no one wants to buy the group. Since the group can't be sold, banks have a liquidity crisis.

The rub is that in order to get liquidity back into the market these portfolios must extricated as many of these bad loans as possible. The problem with the loans is that they are attached to bad borrowers. Borrowers got loans they never should have and now they can't pay them back. In order to get liquidity back, these borrowers must be removed from the portfolios. The only way to do that is for them to sell or for banks to foreclose and replace them with good borrowers. Now, since most of these borrowers owe more than their property is worth, option one is no longer an option. So, the rub is that the only way to get liquidity back is for these borrowers to be removed forcefully, through foreclosure. The only better option is a financial tool known as short selling.

Of course, this is not something anyone can propose, and politicians have fooled themselves and the public into believing that liquidity can be created through other means. For instance, the Dodd/Frank bill plans on having the federal government buying up about $300 billion of these loans with FHA money. Now, that may in fact flush the banks with cash, but all it will do is create a liquidity crisis in FHA. Just because someone else buys these loans doesn't suddenly make them good loans. If n one else is willing to buy these loans, government mandating FHA to do it isn't going to solve the so called liquidity crisis. Now, FHA will have a bunch of loans that aren't going to be paid back. Since FHA is a government entity this will of course create a liquidity crisis directly for the tax payers themselves.

The crux of the matter is this. We got into this mess because irresponsible banks gave loans to irresponsible borrowers. Everything that happened after that is sophisticated financial mumbo jumbo. The only way to resolve it is for these irresponsible borrowers to be removed from their mortgages. They should have never gotten them in the first place, and the only way to fix things is for them to be removed. Since they can't sell, the only solution is one no one wants to talk about. Unfortunately, the only way to bring liquidity back to the market is a solution that no one wants to have happen.