My first answer is that I can’t really say. The problem with liquidity-driven market crises is that they depend not so much on the inherent volatility of a market as they do on the degree of leverage of those who are in the market that is under stress and what else they own. So it is difficult to trace the path and determine the ultimate impact of a liquidity event without knowing who owns what.
This point is best illustrated with the LTCM crisis. LTCM was an ultimate victim of the Russian default even though they had no exposure in Russia. The problem was that many of those who did have exposure in Russia during the default also held instruments similar to those that LTCM held.
But, that said, if someone pushes the point, (and it does happen), my focus for potential crisis is in the same arena where nine out of ten people are focused: mortgages and credit markets. I will discuss the credit markets another time, but given the recent events with subprime mortgages and the troubles at Bear Stearns, this market is worth a few thoughts now.
The mortgage market has the two characteristics I voice concern about in my book. Many mortgages instruments are complex, and many people in the mortgage market are levered. The leverage that is the greatest concern is not that of the hedge funds that trade in these instruments, but the leverage of the homeowners. Many homeowners push the envelope – in some cases misrepresenting their financial situation in the process.
Suppose interest rates climb a few percentage points, triggering increases in the monthly payments for those holding adjustable rate mortgages and some of the other exotic types of mortgages. And suppose that in the process the economy slows down, so that homeowners do not see the increase in their income that they anticipated when they took on the mortgage. We will see an increase in defaults and forced sales.
Most people want to have one primary home, but few want to have two, so prices might have to drop a lot to entice the buyers, especially if the prospects for speculative gains appear diminished. And a decline in housing prices can have a secondary effect for the market, because many baby boomers are using their home’s appreciation as a store of wealth for retirement. If they cannot pull in the cash they had anticipated from their home, their next stop will be their equity investments. If this happens, the result of a mortgage-driven liquidity crisis will be to depress the stock market. Think again of LTCM – if you have to generate cash and you can’t sell what you want to sell, you sell what you can sell.
What will be unusual about a mortgage-based liquidity crisis is that it will progress in slow motion when compared to the usual liquidity crisis. It could play out over the course of years; I would say it will occur in “demographic time”. This will not only be because of the time it takes for housing transactions and mortgage foreclosures, but because part of the equation really is demographic – the behavior of the baby boomers moving toward retirement.