When the stock markets open Monday, no doubt you will hear the term "bank liquidity" again, just as we did on Friday. Last week, when Bear Stearns announced it had "liquidity" problems, the market dove downward and analysts used that that word as if everybody understands what it means. I doubt they do.

The story is so important that the Fed, in a rare weekend move, dropped a key interest rate Sunday evening by a quarter of a point. That followed an unusual deal to buy out Bear Sterns. What a weekend!

What is liquidity?

Banks and investment firms try to balance between how much money they need on hand to do daily business and how much they have invested -- to make more money.

Think of it like your savings and checking accounts. Your checking account must have enough in it to pay your bills, but you also want to keep money in your savings account to earn interest. You don't want to keep too much in a low- or no-interest checking account, but you do need enough in there to give you the cash you need to function. In a larger way, that is how banks work.

The Federal Reserve Bank explains liquidity this way:

Bank liquidity refers to a bank's ability to meet its obligations at a reasonable cost when they come due. The point at which a bank becomes illiquid is hard to determine. At that point, the bank may find it difficult, if not impossible, to raise funds quickly at any cost.

Except for failing banks that experience a deposit run, few banks ever reach the point of being totally illiquid. Instead, most banks operate in some middle area, balancing their need for liquidity with their need for earnings. (All else being equal, more liquid assets tend to provide lower returns than do less liquid assets.) Over time, this balance may shift one way or the other depending upon circumstances. What may have been an appropriate level of liquidity when loan demand is low may not be adequate when demand is high. What once may have been a coveted funding source may be displaced by another.

So what caused last week's stock market problems?

MarketWatch said:

Dow Jones Newswires reported on the Securities and Exchange Commission's decision to extend emergency funding to Bear Stearns:

SEC officials said in a statement that they had been monitoring Bear Stearns's financial situation on a daily basis in recent weeks, and had no cause for alarm earlier in the week. Bear's holding company capital exceeded regulatory standards at the end of February, and information supplied by Bear Stearns to the SEC on Tuesday showed the holding company had a "substantial capital cushion," according to the SEC. As of that date, the firm had more than $17 billion in cash and unencumbered liquid assets, the SEC said.

"Beginning on that day, however, and increasingly throughout the week, lenders and customers of Bear Stearns began to remove funds from the firm, despite its stable capital position. As a result, Bear Stearns's excess liquidity rapidly eroded," the statement says.

Could Bear Stearns' problems cause further unrest? Yes it could, but that's not certain. Last week, analysts predicted that Bear Stearns would be acquired by another firm, and on Sunday, The Washington Post reported that a deal to do just that had been reached over the weekend:

After a weekend of marathon negotiations in New York and Washington, the central bank undertook a broad effort to prevent key financial players from going under, including the unprecedented offer of short-term loans to investment banks and an unexpected cut in a special bank interest rate.

As part of the deal, J.P. Morgan Chase, a major Wall Street bank, will buy Bear Stearns for a bargain-basement price, paying $2 a share for a venerable institution that still plays a central role in executing financial transactions. Bear Stearns stock closed at $57 on Thursday and $30 on Friday. J.P. Morgan was unwilling to assume the risk of many of Bear Stearns's mortgage and other complicated assets, so the Federal Reserve agreed to take on the risk of about $30 billion worth of those investments.

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