THE GREY ANATOMY OF THE CURRENT CREDIT CRUNCH

Profit is the mother of invention in financial markets, but fear is the father of destruction. And unfortunately, they do tend to come in tandem. Periods of rapid innovation tend to be followed by some retrenchment when unintended consequences ensue. This is precisely what appears to be under way now. History suggests the fallout from liquidity crises in developed markets tends to be much less than anticipated in the heat of the moment. We do not claim to have all the answers as to how this will end, but there seems to be a lack of liquidity in reasoned and rational discussions at the moment, as well.

This paper outlines the current liquidity crisis from its origins in the U.S. housing market to the broader financial disruptions. The first two sections provide background on U.S. housing and its connection with the collateralized debt obligations (CDO) market. It then looks at the possible avenues for the present shock to further ripple through financial markets and how likely each scenario might be. It then goes on to examine why contagion into the broader economy seems unlikely at present, what possible paths for contagion exist, what indicators to look for, how all of this affects central banks’ current and potential responses, and the financial market response to previous U.S. liquidity crises.

Richard Kelly, Senior Economist
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