Wednesday, June 27, 2007

[Latest Global Dollar Liquidity Measure: +14.5% annual growth rate; latest Endogenous Liquidity Index: -5.3%]

Interesting and timely piece by Charles Dumas, chief economist at Lombard Street Research. Mr. Dumas analyzes the possibility of an "implosion of liquidity". That is certainly what our Endogenous Liquidity Index is suggesting: it fell another 2.4% yesterday on the heels of the surging VIX and rising credit spreads. Here's Dumas:

Banks' capital is about to be slashed, and with it excess liquidity in the global system ... Suppose the CDOs held by banks were valued at “market” rather than “model” levels (a fancy new euphemism for illusionary historic book values). Their capital would turn out to be lower. Preservation of capital ratios against loans would require fewer loans: liquidity would have imploded ... A bunch of hedge funds may have problems, but that is the tip of the iceberg for "Titanic" Wall Street. Who holds the toxic tranches? Answer: the originating banks and syndicating investment banks for the most part ... [The] much-trumpeted shift of credit risk off balance sheets was less than met the eye.

Given what's happening with credit spreads, there's little doubt that we are witnessing, at least to some degree, the scenario described by Mr. Dumas. But then Mr. Dumas himself acknowledges that "liquidity is a complex thing". And that leads to an interesting question: why does he omit the (still booming) funding liquidity?

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