You might have heard about the markets having “liquidity” problems, but to the average Joe, this could sound like technical mumbo jumbo. I mean, how does liquidity in the markets affect you? Believe it or not, it can massively affect you. Besides inciting panic in the stock market, which probably has affected your investments since late February, lack of liquidity means there is less cash out there to lend. For a few weeks, this made it difficult for people already in a home purchase contract to close on the deal without paying a premium interest rate for their new mortgage.
Most conforming loans are made by a mortgage lender who fully intends to sell your loan on the secondary market, typically to a real estate investment trust (REIT) that takes capital from investors, ranging from ordinary people to big funds owned by the likes of Vanguard or Fidelity. The REITs also take out loans from big banks to buy more loans. Then, when people pay their mortgages, the cash from those payments flows through the REITs to pay off principle and the interest is distributed to shareholders as dividends. The principle in reinvested into new mortgages, and the cycle of life continues. The main investor draw to REITs is their high dividend yields.
In March, something crazy happened related to the Coronavirus crisis. Some of those big banks called the loans made to the REITs. Why? The banks were worried and wanted to get some cash to act as a safety net in case cash flows from operations waned significantly. The REITs didn’t envision being so unstable that the banks would ever call the loans due. At the same time, stocks like AGNC and MITT dropped by as much as 80%. MITT could not come up with enough cash to pay back the called loans, and many feared default. Lucky for the REITS, their knight in shining armor, A.K.A, the Fed rode in on their shining horses and bought up some of the REITs’ holdings at a discount, potentially staving off a wave of bankruptcies. This also shored up the mortgage market for future loans. This situation is a case-in-point on how delicate the economy is. Liquidity is everything.
Without the government providing free capital to all of these REITs and banks, mortgage rates would go much higher. This was the case for many years. I remember in the 2000s, a 5.50% interest rate was fantastic. A good rate in the mid-1990s was 9%. I also remember earning 4-5% on my ING savings account. I would be elated for rates on my savings like that now. I keep chasing a 1.40-1.70% yield on savings and the banks keep dumping the rates because they can get cash for less from the Fed. Banks make their money on the margins of what they pay out in interest and what they charge on loans and credit cards. When you deposit your money in a bank, the bank keeps a mandated reserve and can loan the rest. If they fall below this threshold at the end of each business day, they take an “overnight loan” from the Fed at the low, low rate that you hear about in the news constantly.
Liquidity makes the capitalist market ebb and flow. Many may talk badly about day traders or big fund managers, but the cash coming into the markets is what keeps prices real. If they were not there, trading every day, you would never be able to sell investments out of your 401(k) and retire. Everyday traders keep things going, even though some view Wall Street as criminal, the reality is most are out there working hard so that those who put money into the markets get a healthy return over the long term and can make their dreams come true. The alternative is Social Security, which we know isn’t enough on its own for most to live a comfortable life in retirement.
So, all hail liquidity! It’s essential for a smooth-running economy and stability for you and me. To work, it needs a good balance of those who want to lend or invest and those who want to borrow and pay back the principle and interest, as scheduled.
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Disclaimer: William owns AGNC and has recently traded MITT. He also owns shares of SRET, an ETF that holds a range of REITs. This article is not intended as investment advice. Please consult a licensed investment broker for complete investing advice that aligns to your risk tolerance.