Reasons for the Current Liquidity/Credit Crunch

Thought I’d write a short note to document the reasons for the current liquidity/credit crunch.

  1. Lack of risk controls in underwriting: Loans were given to weak credit without documenting income, balance sheets, and without appraisals. These weak credit folks typically obtain ARMs with a low teaser rate for a first few years, but adjust back up very significantly thereafter.
  2. Insufficient credit spread to account for potential delinquencies. Aggressive hedge funds drove out the traditional buyers by accepting the low spreads. Lots of cheap money also made that possible.
  3. Creative financial engineering also created riskier and riskier structures that end up being rated AAA (e.g. BBB and lower tranches that when put into a new structure, produces some AAA-rated bonds).
  4. Points 1 to 3 above were possible because of the housing market boom, specifically, home price appreciation. That allows for refinancing and resulted in fewer delinquencies than historical periods which affected the pricing of risk for models that used “recent historical data”.
  5. With the oversupply of homes, the housing prices tanking, “normal” delinquencies rates start to appear.
  6. Panic sets in, with re-pricing of MBSes at very low prices (with much higher delinquencies modeled in). Mortgage lending companies were unable to sell their mortgage pools due to doubts in the credit worthiness.
  7. Companies that financed their mortgage pools with short-term financing such as repos, start to get margin calls (since their mortgage pools tanked in value when marked to the panic market). Companies without sufficient liquidity declared bankruptcy (e.g. American Home Mortgage).
  8. The panic and over-conservatism of lending liquidity, spreads to other markets, e.g. commercial paper.


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