No, bad assets do not necessarily imply widespread liquidity problems; just liquidity problems related to those bad assets. Let me compare two separate financial events to make a distinction between a Liquidity Crisis and a Bad Asset Crisis.
When Long Term Capital Management imploded back in the Fall of 1998 we saw a true Liquidity Crisis. LTCM had a bunch of illiquid assets that were being marked down as hedge funds ganged up on the positions they were trying to unwind. When the Fed lowered rates and put together a plan with the major investment banks to organize an “orderly liquidation” of LTCM’s assets the Liquidity Crisis slowly disippated. LTCM’s investors lost a bunch of money but the markets returned to normal functioning in a relatively short period of time. That’s because LTCM’s assets were being undervalued in large measure BECAUSE OF the lack of liquidity as opposed to a problem with their underlying fundamental values. LTCM’s trading strategies were seriously flawed but the underlying values of the assets weren’t imperiled. Even companies with good credit were having problems rolling over their credit lines during the Fall of ’98. That’s not the case right now.
Flash forward to today. Most of these mortgage-related assets whether they are MBS’s, CDOs, CDO-squareds, etc. etc. have VALUES that are materially impaired because people aren’t paying their mortgages as originally expected. Furthermore, prices are deteriorating because the underlying assets were overvalued to begin with. So, even if you improve “liquidity” it isn’t going to improve the intrinsic value of the underlying assets that are causing the problem right now, as much as some would like to believe the contrary.
A Liquidity Crisis is a “pricing” issue. A Bad Asset Crisis is a “value” issue. Now, yes, you could argue that we have liquidity issues right now. But that’s not the root of the issue. The root of the problem is plain and simple bad assets. The two problems are related, but there’s a distinction between them.
