The Liquidity Gap
November 2, 2015 6:30am by Barry Ritholtz
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So the FDIC insured banks will not pick up any and all securities if there is a panic. Excellent, because that is not their job. The reason bonds have higher returns than cash is that they carry a risk. You are not supposed to have “liquidity” and be able to sell your garbage papers at any and all times without much of a loss. Bonds should carry a real risk of real loses, and that is why you get higher rates on them.
What we learned in 2008 is that no matter how much freedom you give the banks they will not provide liquidity when it is most needed. What their managers will do is take huge risks, that create a crisis, and then stick it to the tax-payers.
So thank you regulators. Banks are no longer providing the liquidity that was not their job in the first place. Now lets ban them all together from soaking themselves in the drug call “repo markets”. It is a risk that should not be FDIC insured. Glass-Steagall or bust.
«The reason bonds have higher returns than cash is that they carry a risk. You are not supposed to have “liquidity” and be able to sell your garbage papers at any and all times without much of a loss.»
That’s very agreeable, but what really matters is not that the bonds be actually risk-free, but they be considered risk-free for capital ratio and regulatory purposes, that is they be pretend-risk-free or in common terms be rated as “AAA”. I’ll explain.
There is a little known (outside the financial industry) reason why risk-free bonds are the Holy Grail for finance speculators: they enable nearly infinite-leverage via “rehypothecation” (this is where the repo markets enter the scene) of collateral.
If you borrow $1 billion you are normally expected to post collateral, in the form of risk-free bonds. Lending collateralized by AAA bonds is normally considered risk free, so it does not tie up much if any capital of the lender, boosting leverage. Now where does the borrower find the collateral? Well typically they *rent* it from someone else for a fee. Now the lender that has made the $1b loan and received the rented collateral out to another borrower. This is called “rehypothecation”. In the USA lending out collateral is perfectly legal in the measure of 80% of the collateral; in London, that competes with New York, it is 100% (or at least until recently). Really. 100%. That means that via several round of “rehypothecation” a chunk of risk-free AAA bonds can give rise to extraordinarily high levels of leverage, as lending backed by AAA bonds does not in practice need much if any capital backing.
It is a fantastic magic-money-tree for the bonus pools of financial speculators, and they are complaining really loudly because they want various government to hand them out as financial welfare stacks of pretend-risk-free (which really means that the government takes unlimited liability) AAA bonds to fuel a new round of fantastic levels of effective leverage.
So the same $1 billion of treasuries can be used as collateral for 10 different reckless real estate speculation of $1 billion each ?
So what happens when all 10 goes south and become worth less than 30 cent on the dollar ?
And people are worried about money being printed by the Fed – it seems to me they should be a lot more worried about banksters printing money.
«So the same $1 billion of treasuries can be used as collateral for 10 different reckless real estate speculation of $1 billion each ?»
Entirely by random coincidence most (all?) “national champion” banks have their rehypothecation offices in the City of London, where AAA goes further than elsewhere :-).
«So what happens when all 10 goes south and become worth less than 30 cent on the dollar ?»
Lehman, Bear-Stearns, AIG, Citigroup, etc. could tell you :-).
«worried about money being printed by the Fed»
That’s non trivial, but small, only a few trillions here and there. As one famous chairman of the Defense Appropriations Committe said, a billion here, a billion there, and then it sums up to real money, nowadays in finance replace “a billion” with “a trillion” :-).
«– it seems to me they should be a lot more worried about banksters printing money.»
Credit policy, that is leverage policy, is far more important than “monetary” policy. “money” is whatever sellers accept as payment, and for example banker’s “checks” are therefore the main form of money.
When a bank lends someone some money like $500,000 to buy a house or $10 billion to buy a company they just “credit” the lender with the ability to issue “checks” drawn on the bank for up to $500,000 or $10 billion, and since banks are “creditable” the sellers of the house or the company accept those “checks” as payment. The $500,000 or $10 billion don’t come from anywhere, they “just happen” :-).
The only limits to credit expansions are on the borrower side the interest rate they have to pay, and on the lender side the capital/assets (loans) leverage ratio imposed by regulators, because the lenders have limited capital (the the past several years most “national champion” banks have had negative capital, that is they have been trading while insolvent, but accounting fraud has been legalized, and bankruptcy and criminal laws suspended, after 2007-2008, but only for big “friends of friends” financial corporates).
For many types of loans the ratio is 0, that is no capital is needed, that is lending if freed from stupid constraints. Among the 0 capital/loan ratio (or equally ridiculously low ones) are lending to EU sovereigns and IIRC most cases of lending collateralized by AAA “paper”. Which has created what I call the debt-collateral spiral.
In practice the Fed, the BoE, the ECD, and respective treasuries and finance ministries have reinvented wehat used to be called wildcat-banking, but fortunately only for “national champion” banks whose executives donate generously to government parties and/or offer fabulously well paid “strategic advisor” jobs and “consultancy contract” opportunities to retired central bankers and ministers of finance (or viceversa).
PS The central bank of central banks, the BIS, that designed the capital/loans ratio regulation *framework*, has recently written in a rather testy tone this reminder, which is really funny (or not!):
http://www.bis.org/publ/qtrpdf/r_qt1312v.htm
«In the European Union (EU), authorities have allowed supervisors to permit banks that follow the IRB approach to stay permanently on the Standardised Approach for their sovereign exposures.
In applying the Standardised Approach, in turn, EU authorities have set a zero risk weight not just to sovereign exposures denominated and funded in the currency of the corresponding Member State, but also to such exposures denominated and funded in the currencies of any other Member State.»
«risk-free bonds are the Holy Grail for finance speculators: they enable nearly infinite-leverage via “rehypothecation”»
pragcap.com/you-cant-handle-the-truth-2
«Assume a customer of the prime broker has pledged $100 million in securities against a debit balance of $50 million, resulting in net equity of $50 million. The prime broker can now rehypothecate up to 140% of the client’s debit balance or $70 million. In other words, the prime broker can borrow $70 million against collateral that has already been used by the customer to secure the original loan and it doesn’t stop there. Successive rounds of rehypothecation are permitted; however, if you think this is a bad practice, it is about to get a great deal worse.
In the UK, unlike the US, there is no cap on rehypothecation. No prize for guessing the game the global investment banks have been up to. By moving the majority of their prime brokerage activities from New York to London, it has been possible for investment banks to dramatically scale up of what is an enormously profitable business activity during good times but what has the potential to create havoc when markets go haywire.»
But it gets worse, but never mind, let’s celebrate the booming markets and buying financial assets on margin :-).
Thanks for making some excellent points.
This is the usual dissembling between “liquidity” and “solvency” typical of propaganda from the sell-side, and it appears regularly on B DeLong’s blog too.
The argument above is not there is insufficient “liquidity”, which is badly defined, but there is insufficient supply of guaranteed zero-risk investments with significantly positive returns.
But of course! What kind of enormous sucker is going to provide a large supply of guaranteed zero risk investments with positive returns? It does not make sense. Any such sucker will be destroyed by compound interest eventually.
But the basic problem is that pre-crisis a lot of financial assets, for example senior tranches of CDOs on mortgages, where presumed to be guaranteed zero-risk positive return magic-money-trees.
The problem overall is that there are a lot of unrealized capital losses in the financial systems of the world, that like in Japan post-1990s have not been resolved, but hidden (the “bezzle” as it was named by JK Galbraith many decades ago).
The USA have legalized accounting fraud by changing accounting standards (FAS157) to mark-to-whatever for hard-to-value instruments. The Fed Board has tried to soak up and hide in their balance sheet and off it a lot of those capital losses, and Congress and the Treasury have handed out to banks welfare worth hundreds of billions to pay for those capital losses, but that the Fed balance sheet is still huge and that FAS157 still legalizes accounting fraud shows that there are still many unrealized capital losses around.
Given that because of accounting opacity and other reasons it is not clear where these massive unrealized capital losses are festering, every investment has to be deemed insolvent but for contrary proof. Therefore presumably actually safe investments, that is investments in places like Switzerland or highly transparent and profitable multinationals, “pay” negative returns: they are really not interest, but custodian fees.
While sometimes illiquidity can happen without insolvency, in our times the problem is insolvency, and illiquidty is the consequence: who wants to buy investments that may carry large unrealized capital losses?
So there is a choice of risky investments with positive returns, or nearly risk-free ones with custodian fees payable. Risk free investments with positive returns are a delusion, even if it was a popular delusion, thanks to the many AAA ratings given by the “entertainers” at the rating agencies, before the crisis exposed it.
Also this discussion is prone to dissembling because most people don’t think about that “liquidity” means, and it is certainly not the shysterism that is means “the ease of trading a financial security quickly, efficiently and as a reasonable price”, especially because of the absurdity of that “reasonable price”. Greek government bonds trade rather slowly and inefficiently at 80% of face value, and a lot more easily at 8% of face value. :-).
So I’ll volunteer here what I thinks is a much better insight that I have been thinking about for a while.
First let’s look at “trading”: actually trading is usually considered buying or selling, but in theory there is no distinction between the two: when I buy a book with cash, I am also selling cash and accepting payment of a book. But there is an instinct that tells us that most ordinary trades are not symmetric and one side usually is buying and the other usually is selling. Having thought about it it seems to me that the buyer is the side that becomes less liquid after the trade, and the seller is the side that becomes more liquid instead. Thus for example when someone gives a bank dollars in Atlanta to get euros in trade, that is called a purchase, and the bank is selling euros: dollars in Atlanta are more liquid than euros. Viceversa, if the same trade is done in Amsterdam, the banks is buying euros and the person is selling dollars, and the spread reflects that. In some cases both sides can become more liquid (or more rarely less liquid) in some respects at least.
Because of that liquidity is not symmetric either, and strongly depends on price. So in financial markets liquidity means the ability to *sell* securities for cash and for a good price. When in financial markets it is hard to buy “nobody” complains that they lack “liquidity”: actually “everybody” celebrates how fantastic market conditions are and the boom in prices. Where “nobody” and “everybody¨ here refer to “those on the sell-side and their paid-for representatives in government”.
Conversely in the “essentials” market liquidity means the ability to buy cheaply: when food is scarce the food market is illiquid, when food is plentiful and cheap that’s usually considered a good thing (but not by farmers or ranchers).
Similarly “liquidity” in the job market means very different things for workers and proprietors: when finding jobs that pay well is easy, the job market is liquid for workers, when finding workers at low wages is easy, the market is liquid for proprietors.
Thus liquidity properly defined depends on which side benefits and the price at which they can sell or buy. Put another way a market is liquid for a seller (or buyer) when they can find a lot of buyers (or sellers) at a price that gives the seller a profit. And as a rule markets are considered liquid when it is sellers that can sell at a profit to many potential buyers.
«And as a rule markets are considered liquid when it is sellers that can sell at a profit to many potential buyers.»
The better rewording of the “traditional” definition of “liquidty” is that there are many seller and many buyers at a price that makes buying and selling profitable to both. But as a rule “liqudity” is used to mean that there are many buyers at a price profitable to the sellers There are three overlapping reasons:
* Intrinsically, a seller is someone that is selling something less liquid to buy something more liquid (like money). Buyers instead are those who want to shift their a less liquid portfolio. In a situation where food is scarce, money is less liquid than food.
* For which side liquidity matters depends also on the relative elasticity of demand and supply: in many markets supply is quite elastic, and there are many fewer sellers than buyers, also because of economies of scale or scope. In particular in financial markets sellers can expand the supply of financial products without much difficulty (or scruples…).
* Consequently the sell-side market participants tend to have an obvious vested interest in restricting supply and boosting demand (making the market more “liquid” *for them”), and it is easier to coordinate their efforts to form a lobby to shape market rules accordingly.
BTW the whole discussion above is completely outside “neoclassical” Economics, where the issue of liquidity does not exist because markets clear for all time thanks to intertemporal “tatonnement” of one sort or another. Possibly this is precisely to avoid the inevitable conclusion that given different elasticities of supply to demand liquidity is as a rule asymmetrical, and when sell-side-pleasing arguments are made for “more liquidity” they really mean boosting demand, usually in the financial markets by advocating ever bigger leverage.