A question of liquidity and simplicity. Mr. William H Gross, Managing Director of the Pacific Investment Management Company LLC one of the largest specialty fixed income managers in the world, with more than $692 billion in assets under management, put it quite succinctly in his latest investment outlook.

Simplify, get basic, explain things to a public and yourself in terms of what can be understood. The maze of financial structures that now appear to be unwinding were created by youthful financial engineers trained to exploit cheap money and leverage who showed no fear and who have, until the last few weeks, never known the sting of the market's lash. They are wizards of complexity.

He notes that having just turned 63, he is a professor of simplicity.

Liquidity risk. Recently, many finance publications, financial media shows, and investment market experts have opined that the subprime credit market problem has been exacerbated by lack of liquidity.

In any orderly market, there has to be a willing buyer and a willing seller who effect a transaction based upon a consideration, generally cash, tradable securities, or the like.

When one side of this simple equation is upset in one small sector, for instance, economic pricing from market forces will bring about an acceptable valuation in fairly short order. The transaction may then become a done deal.

However, if many instruments for sale (subprime mortgages) do not have an understandable value or the price is tied to other securities that are dropping in value, buyers will opt instead to place their cash in the highest credit issues available until the overall market demand/supply determines an acceptable risk, value and price. There can be many reasons for the inability to measure the value of a marketable security: investor perception, corporate profitability, changes in global market forces and competition, accounting irregularities and so on.

Corporate liquidity dries up. In the case of subprime mortgages, reports of increasing individual mortgage holder defaults raised serious concerns about not only the value of these instruments, but eventual repayment.

Composite Case in point: SureBet mortgage company is established in 2003 and quickly dominates its field in lending to 'less than perfect credit' applicants, all of whom have dreamed of owning their home. SureBet sells reset adjustable rate mortgages with no money down to these individuals. The interest rate is manageable at that time, say five percent, but because they are adjustable rate mortgages, the rate will be set one percent higher each year, which means that the monthly payments will increase as well. The premise is that the homeowner mortgagee will earn more money each year and can keep up with these increasing payments.

SureBet is on supercharge. Each day, it closes 20 mortgage applications; loans the money to purchase the homes from their revolving bank credit line (or uses their depositor's cash); and then bundles these loans together for sale in the secondary capital market. Investors want these securities for the monthly interest payments, and the eventual return of the principal. They are considered higher risk, but the interest yield is terrific.

As the years go by, market interest rates are increased, the rate set on the mortgages goes up, and the monthly payment becomes a severe burden because the homeowner has not obtained a higher-paying job. They default, along with many of their neighbours.

This scenario creates a liquidity crisis and an equity valuation crisis for SureBet Mortgage Company. As investors balk at purchasing the debt and their bankers pull back on credit line cash, they are unable to keep cash flow generation.

Their second cash source, the discounted price sale of the homes they have repossessed grinds to a crawl as many like scenarios and conditions take over those neighbourhoods.

Their third cash source, their depositors start transferring cash out to other 'perceived safer' institutions.

With adequate resources, and back up credit such as white knight contributors, many of these larger strong companies will survive, but not SureBet. Their employees are made redundant and the doors are closed.

In a simplistic sense, this is one mortgage company's story. Investors who hold these asset-backed or mortgage backed securities that are considered less than prime (Fannie Mae and Freddie Mac only handle high grade mortgages) are also struggling with paper losses in value, inability to generate consistent cash and decisions as to sell or hold.

Recognising that ultimately markets will settle this issue out as they have over time with every other market crisis, central banks and the US Federal Reserve have made cheap cash available to keep liquidity revolving. Once again, cash is king.

Individual liquidity - the most important component of planning for security. Individuals working on a financial plan understand that the first item on the agenda, that is discussed (and verified) is the amount of liquidity (ready cash) that needs to be kept available. Often called the liquidity bucket, contingency buffer, or keeping one's options open, fiduciary responsibility as a financial advisor mandates that if the client does not have sufficient liquidity, investing in capital markets is not recommended.

In fact, in retrospect, it is a no contest vote, precisely because of the kind of volatility that we have seen portfolios experience in the last six weeks. Having your financial plan implement adequate cash retrieval processes (without penalties and other administrative inconveniences) is the first step in establishing financial independence for some very sound reasons:

• You are able to ignore dips, slides, and short-term ramp ups in your portfolio and in global markets;

• You are not forced to redeem perfectly decent investments at fire sale prices, and

• You are able to fund emergency payments such as your mortgage without jeopardizing your financial future.

If your individual plan reflects this liquidity strategy and your portfolio is well managed through diversification, then the best action is to take no action, in the short-term.

The example above is general, illustrative in nature and cannot be relied upon or used for any specific planning purpose.

Martha Harris Myron CPA CFP® is an internationally qualified dual citizen (US and Bermuda). She is a Wealth Manager at Argus Financial Limited, specializing in investment advisory services and comprehensive financial solutions for private clients planning for the good life and lifestyle transitions. DirectLine: 294 5709 Confidential email can be directed to marthamyron@northrock.bm

The article expresses the opinion of the author alone. Under no circumstances is the content of this article to be taken as specific individual investment advice, nor as a recommendation to buy/ sell any investment product. The Editor of the Royal Gazette has final right of approval over headlines, content, and length/brevity of article.