Kaufman believes that the problem is structural (which makes it much harder to solve), that investors are using liquidity as an answer to risk in two ways: they use market prices to help them assess risk (risk spreads and price trends provide useful information) and liquidity itself lets them assume more risk, since investors collectively believe they can always sell out if things get bad. As Kaufman reminds us, in the bad old days, banks and many investors expected to hold assets to maturity, It was inflation that led bond investors to start trading more as the real value of their assets suffered.

Now Hyman Minsky (and more recently Martin Wolf) would say what we are seeing is cyclical, that capitalism is prone to booms and busts. I imagine Kaufman’s response would be that regulators have a responsibility to modulate this process, and they’ve been largely absent (and perhaps even acting as enablers).

He looks to be/have been correct in his focus on securitisations dangers and their evolution.

From his 1986 book, Interest Rates, the Markets, and the New Financial World:

“Increased “securitization” of credit obligations is another development that has had unfortunate consequences…what was a “private” loan becomes part of a “public” marketable security. This loosens the link between creditor and borrower. In a nonmarketable relationship, the creditor is tied to the borrower for the life of the loan; of necessity, under these circumstances, credit scrutiny at the inception of a loan or investment is likely to be quite intensive. The same degree of credit investigation is not likely to take place when the relationship between lender and borrower is to be temporary. In a securitized arrangement, many market participants fail to distinguish between the essence of liquidity and marketability. Liquidity means being able to dispose of a financial asset at par, or close to it, while marketability provides the holder an opportunity to sell at some price. The illusion of marketability is that holders believe they will be able to sell their investments before a significant deterioration in credit quality is generally perceived. Thus the initial pressure to be highly circumspect in the creation of the obligation is absent. A world of relatively unrestrained credit growth is also encouraged by the use of credit lines and guarantees. These assurances lead investors to make commitments based on the strength of the guarantor and not on that of the borrower… The heroes of credit markets without a guardian are the daring – those who are ready and willing to exploit financial leverage, risk the loss of credit standing, and revel in the present casino-like atmosphere of the markets.”

It actually appears that at present “marketability” has been confused with his definition of “liquidity” i.e. that the fact that there has been/is a ready market, means one can transact quickly and therefore have liquidity (or the ability to transact at close to par). Liquidity risk has completely disappeared (liquidity illusion) and led to insufficient overcollateralisation and maturity mismatches.

Is this due to structure or to stage in cycle?

Thank you so much for this blog! I think it is terrific.