Mon, 29 Sep 2008

Panic

Investments are always comprised of a mixture of liquid and illiquid investments. Investment houses (banks, mutual funds, hedge funds, insurance companies) all have certain expectations of their customer's demand for cash. They keep enough liquid investments (cash, treasury bills, short-term bonds) to be able to supply this demand. But they make more money off the illiquid investments (they have to pay more in order to persuade people to tie up their money).

The problem in a panic is that the investment houses run out of cash. If they can, they'll refuse redemption. "Sorry, but you can't get your cash back right now." If they're obligated to supply cash, then cash is king. Whomever can supply them with cash will end up owning them, or a considerable portion.

This panic is going to be worse than usual, though. Ordinarily, in a panic, most institutions have sound finances. Parties with cash are more than happy to purchase the illiquid but sound investments. This time, nobody really knows what investments are sound. That means that the people with cash are going to demand a higher price for their cash than usual in a panic. Once that happens, some of the institutions will have valuations lower than their cash demands. In other words, bankrupt.

Much pain ensues. Anybody wise enough to be holding cash will be in a very good position. Many (most) of these investments are productive investments, and for pennies, or even dimes on the dollar, are definitely worth buying, even if you have to buy some investments with zero value. Everything has a right price.

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