If you’ve followed markets closely over the past seven or so years, you know that “liquidity” has been a hot topic.
As with most hot topics, the debate has at times been contentious. Part of the reason these conversations turn testy stems from the fact that “liquidity” is a somewhat amorphous concept. When the definition of the very thing being discussed admits of ambiguity, it’s impossible to determine who in the discussion is “right” and who is “wrong” because the conversation is about something for which there is no universally accepted definition. And so people talk past each other whether they mean to or not.
This is why the liquidity discussion often dead ends. What is liquidity? Is it the ability to transact in size? Is it tight bid-asks? Or is it simply the ability to get the hell out of dodge in a pinch without taking an enormous haircut? That suggests the meaning changes depending on the urgency of the situation and indeed the urgency of the situation determines how liquid (or, alternatively, how “illiquid”) markets are.
This debate has taken on a special significance in the post-crisis world. One of issues I’ve been pounding the table on for years (long before I was Heisenberg) is the idea that HY and EM debt ETFs suffer from a horrific liquidity mismatch. They offer intraday liquidity (or, more appropriately, the illusion of intraday liquidity) to investors, but the assets the ETF shares represent are not liquid. Again: these products promise intraday liquidity against underlying assets that aren’t liquid.
That works as long as flows are diversifiable. That is, as long as PMs are able to trade portfolio products (i.e. one manager is seeing inflows while others are experiencing outflows), everyone can dodge the underlying markets for the bonds. However, if the flows become unidirectional (i.e. everyone is selling), it becomes difficult to understand how the bonds themselves won’t have to be sold.
The answer, according to ETF sponsors anyway, lies in the “miracle” of the creation/destruction process. But if you kind of step back from the technicalities and approach it from a common sense perspective, the inescapable reality seems to be something akin to the now famous quote from Howard Marks ca. 2015: “an ETF cannot be more liquid than the underlying and we all know the underlying can become quite illiquid.”
There were reports in the summer of 2015 that ETF providers were lining up emergency credit lines to tap in the event of large redemptions. Recently, we learned that some HY mutual funds are actually using HY ETFs (specifically HYG) as a liquidity sleeve. That seems absurd. They are effectively treating HYG as a cash substitute, allowing them to have their cake and eat it too by staying fully invested via a junk ETF that they’re also saying is cash.
The post-crisis regulatory regime complicates this by making dealers less willing to serve as middlemen. If they aren’t there to step in and inventory the bonds in a pinch, well then there are real questions as to what the market would look like for some of this debt should a firesale ensue.
At a more basic level, all of that implicitly suggests that we may be thinking about things the wrong way when it comes to debt. That is, the risk of lending someone money is that the money won’t be paid back. But now, the risk associated with debt isn’t as much about the borrower’s ability to repay, but rather about whether the debt itself is salable. Liquidity, then, has replaced the idea of responsibility with the idea of salability. In that scenario, insolvency becomes a function of liquidity. That is, borrowers can persist in a state of pseudo-insolvency as long as there is liquidity for new debt they might issue to pay back the old debt. Once the securitization machine gets revved up, this becomes endemic/systemic.
Then one day, the charade collapses as the idea of responsibility reasserts its dominance over salability. Then there is a liquidity crisis.
How do policymakers respond? Well, in 2008 they injected a massive amount of liquidity. See the problem with that? It’s circular “af“.
So that’s the context for the following excerpts from a new note from the best strategist on Wall Street, Deutsche Bank’s Aleksandar Kocic. His latest is chock-full of notable analysis and to do it justice, it really needs to be broken down into separate posts, this being the first.
What you’ll read below is from a section called “The Dark Side Of Liquidity: From Responsibility to Salability.”
Allow us to reiterate that this is just the latest example of Kocic summarily relegating pretty much every other attempt to expound on an important subject to the dustbin of history. These notes are so far beyond anything and everything produced by other desks that comparisons are no longer possible. Simply put, Kocic is peerless.
Via Deutsche Bank
Dark side of Liquidity: From responsibility to salability
“There are no bad bonds, only bad prices”. This sentence, which earned its undeserved notoriety during the peak of the 2008 financial crisis, is probably the most eloquent summary of the functioning of the financial markets.
Liquidity as a principle becomes problematic when it comes to debt markets. It confuses two different concepts and becomes a source of systemic risk. Liquidity transforms the risk of default (inherent to every act of credit) – the ability that the debtor may not be able to pay back his debt — into the risk that the securities representing the debt find no purchasers. It replaces responsibility with salability. This is the liquidity/credit rotation. The logic behind liquidity/credit rotation is that if no one is to take responsibility for the risk run – if this risk is distributed across variety of investors– then everyone risks and everyone stands to gain more. Although this seems rational and acceptable, effectively it represents an implicit (and involuntary) risk tax when embedded in the social contract, especially in the context where profits are privatized and risks socialized.
Securitization allows implementation of this program, but at the same time, it opens the door for credit risk to become systemic. A very simple and, at the same time troubling, consequence of liquidity/credit rotation is that a potentially insolvent borrowers might, in principle, be able to cover their debts by issuing more securities by borrowing more as long as their debt can be sold. In effect, liquidity is a market referendum on the debtor’s solvency determined by a highly diversified risk profile of a wide range of investors under conditions of asymmetric information. How does this work in practice? For example, sub-prime is synonymous with conditionally insolvent. However, 15 years ago, subprime borrowers were considered financeable only because their debts were saleable. That went on even when they were no longer solvent and it ended with a liquidity crisis — at that point, no debt, except for the highest grade, could be transacted. Policy response that followed was defined around the idea of unprecedented liquidity injection that lasted for seven years.
From this example, a simple pattern emerges: We start with liquidity as a principle which leads to a sequence of events that escalates into a liquidity crisis, response to which is then an aggressive liquidity injection. At this point, we have to ask the logical question: How does one imagine that a massive liquidity injection solves a liquidity crisis which has been caused by excess liquidity?
Anyone who is used to logical thinking has to reflect on the circular causality of such a scheme and its inherent fragility, awareness of which inevitably creates a state of mind where liquidity becomes a mode of consolidation — it consolidates all problems into a single one: How to get liquidity and how to get more of it. The obsession with liquidity – the desire to hold money — the unwillingness to part with it and invest, is the market’s referendum on the future. The awareness of this reality is spontaneously suppressed — although it is implicitly acknowledged, it remains unspoken and becomes effectively the knowledge that does not know itself.
Latent illiquidity and tail risk
Liquidity alone, however, is not the biggest problem. Rather, it is liquidity in combination with regulatory environment and other market forces that creates crises. Once again, the example of subprime crisis offers a useful illustration. In the middle of the 00 decade, it was the excess liquidity fostered by a long period of low rates, together with the absence of regulatory restrictions, fueled by securitized markets that triggered a bubble in which Fed tightening was ineffective. Lax regulations create transmission mechanism between liquidity and leverage. However, the key mechanism behind bubble formation is the existence of an asset (in the case of subprime crisis, real estate) which converted leverage into inflation. Under those conditions, the Fed had no choice but to hike and burst the bubble before inflation did it. The forced unwind of leverage was responsible for the transformation of conditionally insolvency into unconditional illiquidity.
To avoid a repeat of similar outcomes in the future, excess liquidity has to be encountered with stricter regulatory conditions. In that way, one prevents the system from overleveraging — regulation is a circuit breaker in the nexus between liquidity and leverage.
While liquidity on the exchanges has been on the rise, there has been a buildup of illiquidity due to structural and regulatory changes and dealers’ disintermediation. Nominally, policy response a la post-2008 can create something that resembles tail risk – that part seems almost unavoidable because risk had not disappeared, it had only been moved around across different balance sheets. As a part of deleveraging process, leverage of financial and household balance sheets has been considerably reduced, while government and corporate leverage has increased. The figure below shows the leverage across different sectors of the economy expressed as a percentage of GDP.
As a result of these changes and eight years of accommodation, there is currently more than $2tr of duration parked in mutual funds, not all of it very liquid. This is happening at the same time as regulatory restrictions are limiting dealers’ ability to extend liquidity in a way they used to. If we use the ratio of mutual funds to dealers’ holdings as an expression of latent liquidity deficit, we see what appears as an alarming trend: This ratio has been on a steady rise since 2007 and has increased from about 3 to nearly 30 during the last ten years.
Anything that would force a disorderly unwind of this trade presents the biggest tail risk and the challenge of its managing requires creation and maintenance of the environment which ensures that: 1) probability of unwind remains infinitesimal, and 2) even if triggered, unwind cannot be realized. Managing these two barriers is likely to remain one of the main objectives of any policy making.