What is Liquidity? (IV)

When I was a corporate bond manager, I often dealt in less liquid bonds. Why? They had more yield, I only bought those that my credit analysts liked, and I had a balance sheet that could hold them. I had the option of holding those bonds, but not the obligation of holding those bonds. As credit conditions improved in early 2003, to leave my successor with a simpler portfolio, I decided to lighten my holdings of bonds issued by a private bank. I held 35% of the issue, and bought most of it near the height of the panic.

I told my secretary, “The phone will start ringing off the hook in 30 seconds.” She gave me that usual sweet smile and said, “Okay, David.” I offered a chunk of the bonds 0.2% below the last trade in spread terms, without guaranteeing the level. To my surprise, I got a lot of bids rapidly, to the point where I said “whoa! there are too many that want these bonds.” I recalibrated my levels and offered a “supply curve” of bonds, where I offered more the higher the price went. I ended up selling 2/3rds of my holdings, and made significant gains for my client. The final trade was 1/2% tighter than my initial proposed trade.

Having traded small and microcap stocks, and traded illiquid bonds, I am less afraid of illiquidity than many are. Illiquidity is something that one can absorb, if he has a strong balance sheet and a patient disposition.

The great Peter Lynch would buy small cap stocks for Magellan, with strict orders on price. Then he would let them sit, while they gained in value on average. Marty Whitman buys in “safe and cheap” small cap stocks that are illiquid and holds them until their value is recognized.

If you have a strong balance sheet or patient investors, take advantage of it, and buy investments that are less liquid, where value may take a while to obtain.

But liquidity is not natural to all assets. Most things in an average person’s life will not be liquid. Your house and car are not liquid. It will take a lot of effort to sell them and buy a different house and car. So why should futures on property values be liquid, or residential mortgage-backed securities?

Well, debts that are very certain will always be liquid. Debts that are less certain will be liquid during boom-phases, and illiquid during bust-phases. In general, that is why AAA-rated asset-backed securities, which are usually “last loss” securities are fairly liquid, while lesser-rated securities trade rarely.

My point is that you can’t take illiquid assets and make them liquid. Assets are liquid because they are short term, where one knows the cash flow to be received soon.

Are public stocks, like Exxon Mobil, liquid? In one sense, yes. During the day, when trading is in session, and there is no news hitting the wire, then yes, quite liquid — one can get in and out of a position easily with little difference between the bid and ask. But, when news hits, or from the closing price to the next day’s open, the price can move considerably.

Over a long period of time, the shares of two companies in identical businesses, one publicly traded, and one privately held, could deliver the same value over a long period of time. The public company would have the ability to adjust its capital structure to buy in shares when they are cheap, and sell when they are dear, unlikely as that behavior is. The public company would adjust its debt levels more frequently, while the private company would likely keep debt high and equity low, to keep taxes low. The private company could act quietly and think longer term, subject to the constraints of their loan agreements. The public company would have more bumps to its seeming value from news events, including earnings releases.

For the holder of shares in the public company, though liquidity is available, the value of the shares will vary. For the public and private companies alike, liquidity for any large amount of the shares would be an event. And, aside from successful maturity dates, the same would be true of large amounts of debt — there might be a public market available for small amounts of it, but just try to buy or sell a big amount, and pricing conditions are rarely favorable. My example at the start of the post, where I sold 20% of the total issued amount for a favorable price, only happened because the willingness of investors to take risk increased dramatically since the last trade. Yield greed had set in.

But that brings up the other definition of liquidity — what does it cost to enter/exit fixed commitments? Tight credit spreads mean that corporations can (borrow) enter fixed commitments cheaply, and lenders, dearly. The same applies to Fed policy — a wide Treasury curve means that it is expensive to borrow long, and cheap to borrow short — but borrowers want more security than to have a short maturity leash.

But when lenders are scared, they gravitate to short loans and high quality — cash equivalents lent to the Treasury. If enough do that, short term yields get really low. They can even go negative.

I remember arguing with a visiting professor at Wharton back in 1990 that negative interest rates were possible. He told me I was nuts, people would sit on cash. I replied, “what if you can’t keep the cash safe?” Maybe I should have said, “What if it is inconvenient to transfer and guard several billion dollars in cash? There are costs to that as well.”

In a liquidity trap like we are in, short-term money managers that must have US Treasury collateral must bid for it, no matter what. They can’t move to cash. Cash to them is very short-term debts of the most creditworthy entity that they know — their Government, the one that controls the Fed, sorta.

But the volume of lending, particularly to smaller business borrowers is light. Is there really a lot of liquidity out there? Or, is it being used primarily by the US Government and its affiliates while the economy is weak? I think that is the case.

Liquidity is not magic; it can’t be created or destroyed — it just travels where it is needed. During booms, liquidity appears abundant because of loose monetary policy and high willingness to take credit risk. It seemingly disappears in the bust, as the marginal fixed income investor attempts to eliminate credit risk — liquidity then flows to the highest quality assets.

Liquidity is always around; it is only a question of where the marginal credit buyer has migrated. In the current environment, it is short high-quality obligations that are still king, and lower-quality longer obligations that trail, though not as badly as last winter.

I am sure that I will write more on this topic, should I live so long. My contentions are:

• Securitization does not create liquidity, it only redirects it.
• The Fed does not create liquidity, it only redirects it.
• The Treasury does not create liquidity, it only redirects it.

Liquidity is a function of human action. We all have to work and trade to survive. Liquidity is where people are transacting at any given moment toward that end. Structural changes in the economy, whether by the government or through private channels will shift where liquidity goes, but it will not change the amount of liquidity, unless the changes are so severe that the economy itself becomes much less productive.

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