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.

Capitalism has Failed, Long Live Capitalism!

Capitalism has failed us. At least that is what I’ve heard on TV, Radio, and on the web. Our banks have failed us, deregulation has failed us, free market capitalism has failed us. We need the government to step in and help us out.

Deregulation, free market Banks are failing or about to fail. This will impact huge swaths of the economy. All because these banks made bad home loans to people who couldn’t afford them. Sure, the government encouraged them to make these loans. Hell, the government created two trillion dollar entities to help make loans affordable. And then law suits and threats were brought against banks who wouldn’t make loans to low income minorities calling this racist business practices.

Regulation has covered what kind of assets banks must hold, elevating rating agencies to lofty positions in deciding which securities were bankable and which were not. Driving these organizations to take obviously risky mortgage backed securities, created out of Frannie and Freddie mortgages, on to their books to boost returns. Free market drove consumers to these banks with their higher returns, leaving more responsible companies with no choice but to join in.

Now these banks are looking for the government to step in a buy these securities. Why? Because the free market won’t at the prices the banks are asking. Free marketers say no, leave them to dry. What will happen? Banks will stop lending to poor creditors, highly tightening their lending standards. Some small banks will fail. Small businesses will fail to make payroll. Some decent people will get turned down for home and auto loans.

Wait, we say. We don’t want that. We don’t want the turmoil of the free market. We also don’t want a bailout. We just want affordable housing, easy credit, and no bailouts. So, here we are. Decrying a bailout. We say that Capitalism failed us when we never really had a free market in housing or capital structure. Surely the solution to this is not a bail out, but more regulation on capital and government intervention in housing and credit.

Capitalism did not fail us, we failed capitalism by doing our damnest to undermine it. Turmoil is part of capitalism. Difficulty obtaining loans by poor creditors is part of capitalism. The failure of banks is part of capitalism. We don’t want the downsides of capitalism, just the economic boost. If we truely want to come out of this, we need to stomach our way through this mess and let Capitalism work its invisible hand.

Else, we need to stomach the massive costs to dig ourselves out of the mess we created. Yes, all of us. From Bankers down to personal mortgages we’re all responsible for this mess. We cheered the housing subsidies, tax breaks, and GSEs. We lauded the fair lending and capital regulations which distorted market incentives for banking. We rejoiced at limitations of bank ownership by private companies. And here we are, complaining that for all our meddling something still went wrong. If we can’t stomach the pain then we have to take the bailout pill.

Ultimately, Capitalism has not Failed. It worked exactly as many experts have been saying all along.

The Bailout We Deserve

All the discussion has been about the Bailout being targeted at big wall street bankers. Implying that the government is going to spend 700 billion on helping those poor bastards with their yaht and third home payments. Luckily our Congress is fighting back against these big wigs and they’ve attached enough strings on the bailout package that there is now a chance that nothing will get done. Down with the Wall Street bailout, up with the Main Street bailout.

The problem is that this IS a Main Street bailout. The idea is to provide liquidity by purchasing toxic assets off of banking balance sheets. Yes, these are the same toxic assets that poor risk management has caused billions in losses at banking institutions. This will provide enough liquidity for normal business and interbank lending. Additional, this will (hopefully) send Banks back to making mortgage loans to people without enough to money to make down payments, credit cards for people with more debt than they make in a year already, and student loans to C students to get full rides at State Colleges. Guess what, big bankers, CEOs, and Wall Street titans are going to do pretty well of off this.

Cancel the bailout, it won’t hit the Wall Street titans or the big banks. They’ll just cut down on low probability lending and ride this one out. It’ll be a rough couple of quarters but they’ll come out ok. And they’ll still make more a small fortune. However, the small businesses that need to make payroll are going to have to cut back. Maybe delay a payment or two. Small banks that need to borrow money from larger ones to shore up their balance sheets are going to be left in the wind. Walmat will have no problem accessing temporary funding for their operations, but Ted’s Hardware probably will.

Other plans, such as mortgage restructuring plans are going to benefit those Wall Street big wigs too.

Now, I think there are plenty of things that can and should be changed in this bailout bill. However, with the popular rhetoric about “Bailout for Wall Street” I suspect we’re not going to get the bailout we need. We will however, get the Bailout we Deserve.

WSJ: Blame Fannie Mae and Congress For the Credit Mess

Great Opinion article at the WSJ

Blame Fannie Mae and Congress For the Credit Mess – WSJ.com.

If the Democrats had let the 2005 legislation come to a vote, the huge growth in the subprime and Alt-A loan portfolios of Fannie and Freddie could not have occurred, and the scale of the financial meltdown would have been substantially less. The same politicians who today decry the lack of intervention to stop excess risk taking in 2005-2006 were the ones who blocked the only legislative effort that could have stopped it.

Book Review: ‘The Age of Turbulence’ by Alan Greenspan

A very belated review of Alan Greenspan’s book put out last year: The Age of Turbulence: Adventures in a New World. Known for writing inscrutable Federal Reserve statements he has composed a book containing invaluable insight into the economy, government, and monetary policy.

The maestro uses the first two thirds of the book detailing his own history. He details his education, starting an advisory firm, and working with the government. Read this book for this section alone. His insight in to the function of government with regards to markets and economics is invaluable. He sat at the levers of financial control during boom and bust, under Republicans and Democrats, and did so remarkably well. His one mistake, which he analyzes in the book, is holding rates down too long after 9/11.

The final third of the book presents a road map for economic policy and economic future of the United States.  When the book was released last year, this was the portion that received the most negative reviews. He was seen as missing the point, causing the problems, and woefully inaccurate. What a difference a year can make. While this section can be a bit dry at times, he does make a compelling case for our future troubles regarding social security and medicare.

Finally, I know in today’s political climate there are many people that will skip a book like this simply because it was written by a self described Republican. The book is very non-partisan, reflecting the way Greenspan worked during his time on capital hill. The only slant the book takes is the natural one from a free market economist towards libertarian ideals, but this is relatively minor. For the most part anything of political sensitivity is appropriately guarded and nuanced so that no reasonable person would disagree.

How does a Reverse Auction Help Banks?

Banks are in desperate need of capital and the Paulson proposed bailout plan is looking like it will buy distressed assets using a reverse auction mechanism. Capital, if you’re unaware, is things like deposits, CDs, savings accounts, equity, and cash on hand. The amount of capital limits the amount you can lend. Giving banks more capital (by allowing them to sell distressed assets) will allow them to lend, easing the credit crunch.

So, How Does a Reverse Auction Work?

A purchaser organizes the auction, first by setting the time, place, and the type of good or service that will be purchased. Sellers arrive and bid downward during the auction the amount they’re willing to provide their good or service at. Once completed, the lowest price good or service is purchased. A similar mechanism is used for Bid & Proposal work for the government and contracting.

Banks don’t want to sell at these prices, will they participate?

Ultimately, we’re going to have to overpay for the first few auctions if we want to attract banks to the facility. After that, it will only matter if banks are willing to participate at the prices the facility grants and willing to go along with the terms imposed by the final version of the bailout bill. Now, if these auctions are combined with some form of equity infusion such as preferred stock sales, then we might see banks participate to get the equity and unload the mortgages. The combined cash and equity will give them more operating capital to work with at the expense of existing shareholders.

Ultimately we’re going to just have to wait and see if banks come to the facility to play ball or not as well as what terms ultimately get tacked on to the bill.