So what is the point of "Liquid Assets"

In my previous post I clumsily laid out some ideas which are either wrong or blindly obvious to a first year econ student. My main point was that it seems that cash flow and time horizons are very important for thinking about how people view money at the micro level. It might be fine to look at the total amount of a loan and see whether it is rational for someone to take that loan. But in general when people say that looking at total values is the best thing to do they are using the word should. At times it seems that people think that should has the same logical force as is.

But back to the main point. What seems to be the case in the housing boom and bust is a policy of easy money over an extended period of time when easy money was a bad policy. After 2001 there was an immense stimulus put into the economy by a combination of low interest rates from the fed, large tax cuts for the wealthy, and a lack of suitable investment opportunities. Microsoft kept enormous amounts of cash on hand for years in part because of their regulatory difficulties but also because, as they kept saying, that they didn't have suitable places to invest. That is in part the reason that they were able to release the original Xbox and treat it as a trial run, in order to understand the gaming console market.

With so much money shifting around, and with most equities performing horribly, bond yields at historical lows there had to be somewhere to park all this money to get a decent return. In comes credit default swaps. A credit default swap simply is a contract between two entities that essentially insures the value of a bond or security in case of default. So if I own a bond I can pay you some amount of money over time and if the bond defaults then I give you the bond and you pay me face value of the bond. Or if I don't actually own the bond you can give me the face value minus the market value of the bond. Lets say the market value on a 5 million dollar bond is 15 percent of face value and I don't own the bond, then you would pay me 5,000,000-(.15*5,000,000) or 5,000,000-750,000.

In the first case where I actually own the bond then a Credit default swap is a hedge against default. In the second it is a speculation on the default risk of a particular entity. Since you don't have to own the underlying asset that the CDS then that market is inherently inflationary. I can sell multiple CDS's on the same debt if I believe that the risk of default is low. If the risk is misjudged and mispriced then things like Lehman brothers and AIG happen.

Now what in the world does this have to do with the Mortgage backed securities market. When a bank or mortgage company originates loans it doesn't keep them on their books normally. What they do is throw them all into a trust and sells shares on that trust. This is normally thought of as a good thing because it makes an illiquid asset, a house, into a liquid asset and gives the bank more capitol to produce more loans. The shares are normally broken down on the basis of payment schedules. A total amount of money comes into the trust from payments on the mortgages. You first pay the AAA security holders who receive the least return. Then you pay the BBB holders and then the CCC holders. Each receives a higher payment due the higher risk of not receiving a payment. These are normally considered safe because of general stability of the housing market and the fact that housing defaults were primarily considered a function of the mortgage minus the value of the house. Considering that general housing prices where rising then the total risk of default should be low enough for the pricing of risk.

Now part of the problem is the complete shenanigans going on in the market where BBB tranches where being repackaged as aaa bbb and ccc tranches. But the largest problem is that everyone lost their mind when pricing risk. The total CDS market was sitting at around 60 trillion dollars thats $60,000,000,000,000. The total world economy in 2007 was 54 trillion dollars. That is to say there wasn't enough money in the world to cover all of the credit default swaps. Remember that the swaps where also only covering a certain percentage of total outstanding debt in the world because thousands of people could have a swap on one bond.

If the total value of swaps on 1% of bonds worth $1 is $100,000 then a one percent default rate is a thousand dollars. The risk profile of the total market is hugely magnified.

Other factors to consider are the tax decrease to zero on housing sales around 2000 which significantly changed the yield curve for a buyer and seller combined with the absurd run up in housing prices created incredible liquidity in the housing market.

How does this post and the last one work together. All of the factors involving CDS's and MBS's created a cheap loan environment which allowed for increased liquidity in the housing market making it possible for speculation to occur in a traditionally speculation free environment. Combine that with the limited time horizon of most buyers and sensitivity not to total price but cash flow considerations. It should not be suprising that not only where housing prices becoming absurd but that a fundamental mispricing of risk on both the institutional investor side and the home buyer (which we should actually expect) where the main factors.