Those of you who are long in tooth might remember the days when Dr. Doom, aka Henry Kaufman, chief economist of Salomon Brothers, could move the market. Kaufman was intellectual, articulate, and insightful. I remember as a summer associate listening to his section of the Monday morning meeting at Salomon. You could hear a pin drop when he spoke.
Although Kaufman’s sobriety has gone out of fashion, he has a hard-to-match perspective on the bond markets. In an opinion piece in the Financial Times, “The Dangers of the Liquidity Boom,” he discusses how the distinction between credit and liquidity has been blurred, and how it has led market participants to have exaggerated confidence in ready access to credit.
One illustration of the sort of sloppy thinking that worries Kaufman is the way that various pundits have argued that there is noting wrong with America’s declining and recently negative savings rate, since individual net worths are increasing. The appreciation in asset values means that consumers need to save less.
But when a crisis hits and a household needs funds suddenly, a rise in the value of one’s home or IRA is not as easily monetized as liquid assets. A strategy of selling or borrowing against assets presupposes that asset values are stable and that credit is available and reasonably priced.
In an interview with the Financial Times, Chuck Prince, chief executive of Citigroup, made this insightful remark: “When the music stops, in terms of liquidity, things will be complicated. But as long as the music is playing, you got to get up and dance. We’re still dancing.” Mr Prince was hinting at a conundrum investors and policymakers face as we float in a sea of liquidity.
Why do our financial institutions hear music in expanding liquidity? One reason is that the concept itself has been liberalised since the second world war. In the postwar years, liquidity was by and large an asset-based concept. For companies, it referred to the size of cash and very liquid assets; the maturity of receivables; the turnover of inventory; and the relationship of these assets to total liabilities. For households, liquidity chiefly meant the maturity of financial assets being held for contingencies along with funds that reliably would be available later in life. Today, companies and households alike often blur the distinction between liquidity and credit availability. It is now commonplace, when envisaging assets present and future, to think in terms of access to liabilities. Money matters but credit counts.
This new mindset has been abetted by at least three important structural changes. One is the tidal wave of securitisation that engulfed financial markets in recent decades. Conversion of non-marketable assets into marketable ones on a massive scale has changed the nature of financial assets as well as financial behaviour. Through securitisation, a vast array of assets once locked up in the portfolios of investors and lenders has been packaged, sold and resold alongside more traditional assets. Long-standing credit instruments have been joined by a long and diverse list of new ones, many extra ordinarily complicated, even arcane. The sharp increase in tradable assets has stimulated risk appetites, eroded traditional concepts of liquidity and fostered the expectation that credit is always available at reasonable prices.
Technological change also has bolstered the easy-credit outlook now common among investors. As markets have been linked globally by information technology networks, financial information flows nearly instantaneously, computerised trading is spreading and transactions are executed almost without delay. Investors can access financial data and participate in markets around the world and around the clock. This encourages a notion that markets for credit are always available and with near-perfect information.
These two developments – securitisation and the seamless interconnectivity of markets – have brought intricate quantitative risk-modelling to the forefront of financial practices. Securitisation generates market prices while information technology appears to hold out the promise of quantifying pricing and risk relationships. The potency of this combination – its effect on risk taking – cannot be overstated. Armed with complicated modelling techniques, powerful computers and reams of historical market data, growing numbers of investors have become entranced with the dream of scientific rectitude. Few recognise, however, that such modelling assumes a constancy in market fundamentals that is illusory.
No big financial institution wants to step off the dance floor while the music of liquidity is still playing. Doing so prematurely would risk the loss of enormous profits to competitors, declining earnings, eroding market share, employee dissatisfaction with bonuses and disgruntled shareholders. Executives are therefore loath to rely on judgment and reason in risk management. Rather, they are driven towards risk quantification and modelling, with their clear-cut timelines, aura of scientific certitude and lure of near-term profits.
The common practice of marking to market poses hidden risks amid the vast array of securities flooding the market. Marking to market overstates values and gives investors a false sense of comfort. When liquidity seizes up, no one can truly claim that the last quoted price in organised markets or quoted by dealers in the over-the-counter market is the real market value without considering other factors.
Today’s abundance of liquidity offers many short-term profit opportunities. But if the quality of debt continues to deteriorate, pressure will mount to expand the concept of liquidity even further, perhaps to absurd dimensions, and markets could turn the liquidity polka into a sombre march.