"Injecting Liquidity"

I have received a comment/question in response to my last post on Freddy Mac and Fannie Mae...

The two questions are:

1) What does it mean when someone says "injecting liquidity"?
2) Does the US Govt's action mean that they will carry all the risk of losses from these institutions?

Let us start with 1)

In my book I define liquidity as:

"In financial markets this normally refers to how easily an asset can be converted into cash. Therefore notes and coins are the most liquid financial asset. In general the more liquid an asset, the lower is its return".

See page 156.

If we apply this to the US Mortgage market the US Authorities are providing a massive amount of cash to provide some urgently needed money into the US Banking system. They hope that this will mean that banks can once again start to offer home loans and this will act to prevent a further fall in US house prices. This is vital as it is this fall in US house prices that started the whole credit crisis in the US. It has resulted in US Banks (and others around the World) to be left holding billions of dollars worth of bad loans (mainly mortgages). So the US authorities are hoping that this cash injection will restart the US housing market and restore confidence to financial markets. It now looks like they are going to go much further with their plans to buy-up billions of dollars of these mortgage loans to save further banks from going under. This explains the sharp rebound in equity markets this morning.

And now to question 2)

The short answer is yes! The US government is putting a huge amount of money at risk to save both Freddy Mac and Fannie Mae. But what choice did they have? If these two institutions had failed the impact would have been very serious. It could have led to mass bank bankruptcies and a US depression much like the 1930s. This was just too big a risk.

Thanks for the comment and I hope I have answered your question.

Kevin