Understanding Liquidity Risk

Liquidity Risk is another term that has been circulating around this financial crisis. The problem is that some asset that you want to buy or sell is thinly traded so you either cannot purchase, borrow, or sell as expected. Such thinly traded markets may at times require you to pay a hefty premium to participate.

This is the current situation with Mortgage Backed Securities. There is not a liquid market for these instruments, so banks cannot sell them without taking a huge cut in price from what they believe they are valued at. Remember, while markets help discover the appropriate prices for securities, these prices are also affected by supply and demand. The fact that a dollar is worth, well, a dollar, doesn’t matter if there is no one to trade with. You might have to take 90 cents in order to find someone willing to make the trade, even if fair value says a dollar is a dollar. In highly liquid markets arbitragers exist to, in effect, provide liquidity and profit from even the tiniest mispricings. Those willing to take a position in illiquid markets usually gain a premium compared to liquid analogs, such as off-the-run and on-the-run treasury bills.

So, is this new? Has Wall Street never seen such illiquid markets? Hardly. Richard Bookstaber’s wonderful Book, A Demon of our Own Design, details several situations where this has happened before and why it might happen again. I’ll use one of these as an example, Long Term Capital Management. Bear Stearns and Lehman Bros were both victims of an inability to find funding or dispose of assets due to illiquid markets in the exact same way as Long Term Capital Management was. As Demon describes, LTCM basically built its business on being short illiquid and long liquid trades. Since illiquid positions are harder to open there is a premium to be had for companies willing to be illiquid. Since these securities can, in some cases, be hedged with highly liquid positions it was in theory a free way to make money.

Eventually, these markets can turn against you, even against all logic about fair value, and force you out of your position.Again, Lehman & Bear were both in the same situation. They needed to sell assets but buyers knew they were trying to liquidate and withdrew their orders. They would only buy assets on these markets (highly illiquid, they knew who they were trading with) at very steep discounts, knowing that either they bought them at discount now, or during the bankruptcy hearing. Only through the JP purchase could Bear Stearns hope to keep itself halfway alive.

I’d recommend checking out  A Demon of our Own Design if you’re interested in understanding Liquidity Risk and how it affects large institutional investors, investment banks, and hedge funds. It is an engaging read and not as techinical as it might appear at first blush.