Institute for Financial Transparency

Shining a light on the opaque corners of finance


Great Liquidity Crisis Next Phase of Current Crisis

JP Morgan has already named the next phase of our current financial crisis.  They call it the Great Liquidity Crisis.  Their trigger for this crisis is the Fed unwinding its balance sheet.

The Information Matrix can be used to show why JP Morgan is worried.

                                      Does Seller Know What They Are Selling?
Does Buyer Know What They are Buying? Yes No
Yes Perfect Information Antique Dealer Problem
No Lemon Problem Blind Betting

In theory, the Fed’s quantitative easing policy only bought securities in the Perfect Information quadrant (treasuries and government guaranteed mortgage-backed securities).  By buying these securities, the Fed drove up the price for securities in this quadrant and gave investors an incentive (aka reach for yield) to purchase securities in the Blind Betting quadrant.

Now, the Fed is going to unwind its portfolio.  This will make more securities in the Perfect Information quadrant available for investors and end the incentive to purchase securities in the Blind Betting quadrant.

So the question JP Morgan is really asking is who is going to blindly bet on these opaque securities investors are no longer being forced to buy?  The answer is far fewer investors than are blindly betting on these securities today.

As the number of buyers in the Blind Betting quadrant shrinks, liquidity goes away and the Blind Betting quadrant becomes more and more prone to a renewal of the financial crisis (after all, those poorly underwritten mortgage-backed securities haven’t gone away and the risks banks are taking is still hidden behind a veil of opacity).

This is a renewal of the financial crisis that began on August 9, 2007 rather than a brand new financial crisis.  The reason it is a renewal is policymakers have still not been able to unwind all the programs they put in place to respond to the financial crisis.  QE is an example of these programs that haven’t been ended.