Liquidity Crisis Hampers Financial Rebound

One crucial element in understanding and fixing the financial crisis is liquidity. That waterfall of cash that has buoyed the global economy in recent years has gone dry. Getting capital flowing again is proving to be an enormous, and so far unsuccessful, challenge.

Liquidity basically refers to movement. Imagine a faucet: When it's opened, water flows out to where it's needed. The seizing up of the credit markets has basically dropped the water pressure for the whole economy. A lot of companies are opening their faucets — and nothing's coming out.

Economy's Pump Houses Tapped Out

"Money is like the tap water in the economy, and normally you have two different pump houses that supply it," said Pete Kyle, an economist at the University of Maryland.

Traditional lending by banks is one pump house, Kyle said; the other is what's called the "commercial paper market." Companies use that to go straight to investors and borrow money outside the banking system.

"Today, you're seeing that that commercial paper market, that extra supply of liquidity, is just not available."

With that pump house down, banks are in a tough spot. And that is not good for the economy: "I'm predicting a pretty severe recession," Kyle said.

Case Study: Marriott Hotels

As an example of how it all fits together, take the Marriott hotel company. It's a good, solid business. Marriott Chief Financial Officer Arne Sorenson explains that in a normal month, the firm would borrow about $900 million through that commercial paper market.

"You could think about that as being, you know, $30 to $45 million a day that would come due. And we'd go into the markets and we would, in effect, renew that — we'd roll it over," Sorenson said.

Marriott uses that money to pay employees, contractors who are building new hotels and so on. Then, three weeks ago, Lehman Brothers failed. That spooked investors in money market funds, which have several trillion dollars to invest. They usually buy a ton of commercial paper — in effect, lending money to big companies like Marriott. But money market funds stopped doing that.

"During that week, the commercial paper markets seized up," Sorenson said. And losing that source of liquidity has taken a toll on Marriott's business.

"In at least two hotels under construction and getting near opening in 2009, construction has stopped," Sorenson said.

Plans for other hotels have been scrapped in recent months because of the situation in the credit markets, he said — including a 2,000-room hotel in San Diego that now will not be built.

"There probably are already tens of thousands of those jobs that would have been created that probably have been lost," he said.

It's not a life-threatening problem for Marriott. The firm had a backup line of credit with a bank, so it can keep making payroll — and it's in good shape, Sorenson said. The biggest corporations usually have more options.

Banks 'Hoarding Water'

But back to the tap-water analogy: Companies like Marriott suddenly need billions of dollars in extra liquidity from regular banks. Many of those banks are already short of cash because of losses in the housing bust, so they're a lot less willing to lend money to everybody else.

"The banks are hoarding water because they are afraid people are going to come and demand water from them," economist Pete Kyle said. "So they keep as much in supply as they can."

And in an environment like this, "The people that need the money the most will get it the least," said Bob Froehlich, vice chairman of the mutual fund arm of Deutsche Bank.

He says liquidity is so scarce right now that things could get much worse very quickly. He thinks many small- and medium-size companies could start falling apart and laying off a lot of people.

"Companies that are solid companies do not have the cash flow to be able to meet payroll — that's the magnitude of the crisis we're facing," Froehlich said. "There has never ever ever been anything like this in the 33 years I've been in the business."

Fed Sends In Tanker Trucks

That's why Treasury Secretary Henry Paulson looks like he hasn't slept in weeks. The government is scrambling to fix this liquidity crisis before the fallout gets worse.

It has been lending to banks and is now lending directly to all kinds of companies to meet that demand for liquidity.

"The Fed is saying, 'We're gonna be the firemen here and we're gonna put our hoses into the system and start pumping water out of our trucks, or out of our reserve system,' " said Kyle, who has been watching all this closely.

He says the Great Depression happened in part because the government didn't respond quickly enough to a credit and liquidity crisis. But he just can't see that happening again. He thinks the credit markets will soon get back under control. He thinks we're headed for a tough recession, with unemployment rising above 8 percent, but nothing really cataclysmic.

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