Where Did All the Liquidity Go?

During the boom that preceded the economic collapse of 2007-2009, the expression “the world is awash in liquidity” was frequently heard when speakers described the state of the economy. The expression meant that money was freely available to almost any borrower. The list of suitable borrowers included sub-prime home purchasers, private equity firms paying more than the “normal” premium for a corporate buyout, and seriously ill companies trying to refinance their way out of default. Money was there for everybody and the loan terms (interest rates, covenants, and repayment requirements) were extraordinarily pro debtor. Even more remarkable was the way the premium for risk had vanished. In the search for yield, the spread over Treasury bonds for even high-risk securities became de minimis. From a high of nearly 15% over the Treasury bond rate in 1989 when the junk bond market collapsed, the rate fell in 2007 to as low as 1% over Treasury's. The purpose of this paper is to provide an explanation of how so much money was available and how the supply of funds has since dried up