(2/2) Central bank impotence and market liquidity - By Henry C K Liu

(Here 1/2)

What is market liquidity?
After all, what is market liquidity? Economists refer frequently to liquidity in the abstract, yet in reality, liquidity is difficult to define and even more difficult to measure and almost impossible to restore because it is hard to know where the weak links are.

On Wall Street, liquidity refers to the ability to buy or sell an asset quickly and in large volume without substantially affecting the asset's price. Shares in large blue-chip stocks like General Electric used to be considered liquid, a description long since rendered invalid because of market volatility.

Of the several dimensions of market liquidity, two of the most important are tightness and depth. Tightness is a market's ability to match supply and demand at low cost (measured by bid-ask spreads) quickly, while market depth relates to the ability of a market to absorb large trade flows without a significant impact on prices (approximated by volumes, quote sizes, on-the-run/off-the-run spreads and volatilities). When market participants raise concerns about the decline in market liquidity, they typically refer to a reduced ability to deal without having prices move against them, that is, about reduced market depth.

Cycles of liquidity crises have been a recurring feature of financial markets. Commonly used indicators of market liquidity are notoriously imperfect as reliable measures of liquidity conditions. While conditions in the autumn of 1998 were indeed identified as reflecting the adverse shock of the 1997 Asian financial crisis to liquidity in financial markets, liquidity indicators seemed to suggest that, with the notable exception of the US government bond market, liquidity conditions were broadly restored to pre-crisis levels within a short period in the US.

However, the usual indicators typically capture only a single dimension of market liquidity and none of them were forward-looking in nature, making it difficult to draw any conclusions as to how long-term future liquidity conditions were being shaped by responses to current liquidity stress. Bubbles are the bastard children of liquidity overshoots.

While idiosyncratic factors might be cited as being responsible for the perception of low liquidity in specific markets, reduced market liquidity is unlikely to be a purely conjuncture phenomenon. From a financial stability perspective, some of the structural factors at work can be highlighted, focusing on developments bearing on liquidity conditions in the integrated global financial system at three different levels, namely:
1. Firms: developments at the level of major financial firms participating in the core financial markets.
2. Markets: developments in the structure and functioning of markets themselves.
3. System: developments across the global financial system as a whole, such as the systemic effects of credit derivatives.

Liquidity and credit risks Such structural developments may have served to reinforce the links between liquidity and credit risks, but also the distinction between normal conditions and abnormal conditions and between normal times and times of stress when confidence declines. The current challenge is one of returning an abnormal economy of excess liquidity to an economy of normal liquidity without extinguishing the flame of liquidity entirely.

The period of stress will be the time it will take to work off the excess liquidity, to turn the liquidity boom back to a fundamental boom. It is not possible to preserve the abnormal market prices of assets driven up by a liquidity boom if normal liquidity is to be restored. All the soothing talk about the fundamentals of the economy being strong notwithstanding the debt bubble is insulting to the thinking mind.

This is a debt economy fed by a liquidity boom. When the liquidity boom turns to bust, all the strong fundamental indicators such as corporate earnings will wilt from a debt crisis. Asset value cannot be held up by simply adding excess liquidity forever without creating hyper inflation. Also, some liquidity problems, such as those caused by a loss of market confidence, cannot be solved by merely injecting money into the financial system, which in fact will only add to the problem. Restoring market confidence requires a rational restructuring of the economy to absorb excess liquidity.

Liquidity risks underpriced
Many market participants had felt that pre-Long-Term Capital Management (a major hedge fund that collapsed in 2000 from wrong bets on Russia sovereign bonds rising in value above US sovereign bonds) liquidity risk in many credit markets had been under-priced, and that the underpricing led financial institutions to underestimate liquidity risks with a "liquidity illusion" mentality.

Such underpricing inhibited developments that would enhance the market's ability to retain liquidity in times of sudden stress. There were indeed several occasions since the LTCM crisis, such as the September 2006 collapse of Amaranth Advisors, which lost nearly $6 billion in a single week after a highly leveraged bet on the future price of natural gas prices blew up, when conditions in some markets turned adverse but liquidity, which typically declined sharply in the midst of the crisis, proved to be rather resilient.

Hidden relays of counter-party risk
However, some elements of recent developments, such as widespread financial consolidation, the increasing use of non-government and synthetic securities, particularly collateralized debt obligation (CDO) instruments, as hedging and valuation benchmarks, might influence the behavior of market participants in a way suggesting that market dynamics in times of extreme stress can change significantly and abruptly.

This has heightened concerns about credit risk, particularly the hidden relay of counter-party risk, which can undermine market participant willingness to enter into transactions and thus weaken market liquidity in market environments of heightened uncertainty. Other elements, such as aggressive collateralization practices and overdevelopment in risk management policies, which generally enhance market stability in normal times, could add pressure in times of extreme stress.

Price as a function of liquidity
Price is a function of liquidity which can be quite detached from normal value. Liquidity conditions offer a new paradigm as the key to understanding why and how the markets move. Liquidity is consistently a reliable indicator on which to base the timing of trading and investment decisions. Liquidity is the key determinant of the direction of the stock market, but it does not inform on fundamental value.

The aggregate capitalization of any market or market sector, whether stocks, real estate, precious metals, commodities, debt instruments etc is a function primarily of liquidity, with the economic value having only secondary impacts except when liquidity is neither excessive nor scarce. The total value of any market is impacted by its current liquidity trend, as technical analysts know.

Changes in the trading float
Liquidity can also be measured by the relationship between changes in the total trading float of shares or debt instruments in the entire stock and credit markets and the change in cash available for investment. Market liquidity has two components: the change in the trading float and the change in the cash available to buy. Liquidity analysis, in essence, is measuring change in the trading float of assets and tracking the movement of cash.

For the equity market, some analysts offer a daily liquidity number (Daily Liquidity Trim Tabs) that is determined by adding US equity fund inflows, two-thirds of newly announced cash takeovers, one third of completed cash takeovers and subtracting new offerings. Their longer-term analysis of the underlying trends in liquidity takes into account stock buybacks, insider selling and margin debt.

Mutual Fund Trim Tabs survey over 850 equity and bond funds daily. US stock market liquidity looks at flows into equity mutual fund that are not international specific. International equity and bond funds flows are determined separately. The Trim Tabs Market Capitalization Index measures the market value for all NYSE, NASDAQ and AMEX stocks. The AMEX is included but not listed. The Trim Tabs Market Cap Index does not include American Depositary Receipts.

Liquidity and income distribution
Liquidity analysis starts with the overall economy's cash flow. The best way of watching US cash flow is daily and month income tax collections. Higher income tax collections suggest higher incomes. The Internal Revenue Service reports that while incomes have been rising since 2002, the average income in 2005 was $55,238, nearly 1% less than in 2000 after adjusting for inflation.

The number of taxpayers reporting income of over $1 million grew by 26% to 303,817 in 2005 from 2000. This group, representing less than 0.25% of the population, reaped 47% of total income gain in 2005 compared with 2000. This group also received 62% of the tax savings on long-term capital gain and dividends of the 2003 George W Bush tax cut. Those making over $10 million received tax savings of nearly $2 million each. This group enjoyed a tax saving of $21.7 billion on their aggregate investment income. Some 90% of the working population made less than $100,000 in 2005. They received $318 each on average in tax savings from investment. Nearly 50% of the working population reported income of less than $30,000. Liquidity in US markets is driven by debt, not income, and most of the debt is sourced from foreign central banks.

Liquidity and market capitalization
The conventional "value" paradigm says that overall market capitalization is a function of the growth of aggregate cash flow of all stocks, and that the stock market discounts future earnings. This has never worked in reality. Market capitalization derived from price levels is always a function of liquidity as it is almost impossible for any central bank to match money supply growth with economic growth perfectly in the short term.

The conventional value paradigm is unable to explain why the market capitalization of all US stocks grew from $5.3 trillion at the end of 1994 to $17.7 trillion at the end of 1999 to $35 trillion at the end of 2006, generating a geometric increase in price earnings ratios and the like. Liquidity analysis provides a ready answer.

Between the end of 1994 and the end of 1997, the trading float of shares shrank, and from early 1998 through the end of 1999 the trading float was unchanged. Over those same five years the amount of money looking to buy that shrinking or stagnant pool of shares kept growing. The result was that market capitalization kept rising regardless of economic value, with a stock market up more than over three times in five years. It is clear evidence of the Quantity Theory of Money at work. It is called a liquidity boom, which also fed the housing bubble in recent years.

Money flow and liquidity
Money flows from buyers to sellers. If the buyers retired the shares or debt instruments purchased and the sellers, mostly portfolio managers, had to replace their holdings from a smaller market float (the number of shares outstanding in the market); that adds liquidity. If the sellers vend newly printed shares and use the cash for anything other than buying other shares; that reduces liquidity. If sellers suffer losses, liquidity is reduced by the transaction. A Federal fiscal deficit reduces liquidity, particularly if the spending is overseas, such as foreign war.

Liquidity and the impact of news
Liquidity determines how strongly news will affect stock prices. Positive liquidity can spur the market significantly higher when other indicators are positive and cushion the fall when those indicators are negative. Conversely, negative liquidity can dampen the effect of good news. When liquidity contracts on hopeful news, as the current market indicates, risk aversion is the driving force. Liquidity almost always stays in step with the market and visa versa.

Keynes' concept of a liquidity trap
For an economy subject to business cycles, the lower the present rate of interest, the larger, ceteris paribus, would be a future rise, the larger the expected capital loss on securities, and the higher, therefore, the preference for liquid cash balances. As an extreme possibility, Keynes envisaged the case in which even the smallest decline in interest rates would produce a sizable switch into cash balances, which would make the demand curve for cash balances virtually horizontal. This limiting case became known as a liquidity trap.

In his two-asset world of cash and government bonds, Keynes argues that a liquidity trap would arise if market participants believed that interest rates had bottomed out at a "critical" interest rate level, and that rates should subsequently rise, leading to capital losses on bond holdings. The inelasticity of interest rate expectations at a critical rate would imply that the demand for money would become highly or perfectly elastic at this point, implying both a horizontal money-demand function and LM (liquidity preference/money supply) curve. The monetary authority, then, would not be able to reduce interest rates below the critical rate, as any subsequent monetary expansion would lead investors to increase their demand for liquidity and become net sellers of government bonds. Money-demand growth, then, should accelerate when interest rates reach the critical level.

Keynes argued that there were three reasons why market participants held money. They hold cash for pending transactions purposes, which is what the quantity theory had always said. They also hold money for precautionary reasons, so that in an emergency they would have a ready source of funds. Finally, they hold money for speculative purposes. The speculative motive arose from the effects of interest rates on the price of bonds. When interest rates rise, the price of bonds falls. Thus when people think interest rates are unusually low, they would prefer to hold their assets in the form of money. If they invested in bonds and the interest rate rose, they would suffer a loss. Hence the amount of money market participants would want to hold should be inversely related to the rate of interest. Market participants will want to hold more money (liquidity) when interest rates are low than when they are higher, despite a loss of interest income.

Keynes' introduction of the interest rate into the demand for money has survived in modern finance, but not for the reasons he gave. Keynes was thinking in terms of a two-asset world: money, which earned no interest but which was liquid and had no danger of a capital loss, and bonds, which earned interest but which were not as liquid and which had a risk of capital loss. If one thinks not in terms of a two-asset world, but in terms of the range of assets which actually exist in the current financial world, there is no reason to hold cash balances for either precautionary or speculative purposes. These are assets that are both very liquid and interest-bearing, such as money market accounts and Treasury bills, plus all forms of options in structured finance.

Though Keynes' two-asset-class explanation of why interest rates influence the demand for money is outdated by developments, his other explanations are still sound. Money held for transactions purposes is much like inventory which businesses hold. A rise in interest rates will decrease the optimal amount of money as inventory, and a rise in the cost of re-monetizing will increase the optimal amount. Modern management has introduced just-in-time inventory which renders this argument mute. Most chief financial officers have also perfected just-in-time cash management schemes. The exception is that holders of money can live on it, which is not true for holders of most other inventories.

Liquidity and money velocity
When market participants hold cash balances, they may no longer hold their assets in a form that earns no interest, yet interest rates do generally tend to increase with less liquidity. If interest rates rise on non-money assets relative to money, the cost of holding money in terms of interest foregone rises, and one would expect market participants to try to economize on cash.

A business, for example, could shift money from checking accounts into Treasury bills, or resort to loans instead of selling assets with high future value. It would be worthwhile to make more transactions into and out of interest-bearing assets to take advantage of the higher interest rates. When interest rates are very low, these transactions may not be worthwhile, and the business may be willing to let money lie idle for short periods in checking accounts. High interest rates thus increase the velocity of money. Interest payments do not disappear from the system; they go into the lenders' pockets, thus increasing liquidity. A liquidity trap tends to develop in a price deflation environment.

Liquidity and monetization of assets
Liquidity is the ability to monetize assets without causing prices to fall. Liquidity thus depends on more than just the availability of cash. It depends also on the availability of demand for assets, ie willing buyers. A liquidity crunch can develop even if there is plenty of zero-interest rate cash in buyers' pockets but every buyer is waiting for lower prices, causing assets to be illiquid, ie unable to be monetized without lowering prices.

It can also develop if buyers lose confidence in the future of the economy. Distressed assets cannot exit to cut losses at any price and they bring down prices of even otherwise good assets. This is what causes contagion which can start a downward spiral of self-fulfilling fear.

Liquidity and money depreciation
The ultimate effect of central banks injecting money into the banking system is the depreciation of money which now is fiat currency in all countries. When the European Central Bank injects euros into its banking system, the euro will fall against other fiat currencies, including the dollar, forcing the Fed to also inject money into the US banking system. This can quickly turn into a competitive currency depreciation game. For all central banks facing a liquidity crisis, the option is a market crash or a currency crash, or if central bankers are not careful, it can easily become a crash of both equities and currencies.

Unpaid debt destroys economic value
When debts are not repaid, financial value is destroyed, which will be expressed in falling asset prices. This loss of value will need to be reckoned in the economy. When individual market participants lose in a normal transaction, other participants normally gain from their losses. But when value is lost by debts unpaid, the creditor loses while the debtor gains by reducing his liability.

And if default debtors are bailed out as a class by the central bank, the issuer of money, creditors as a class lose relative to their position to debtors before debtor default, albeit the face value of the loss is reduced by the amount of the bailout. The cost of the debtor's virtual gain and the reduced loss suffered by the creditor is passed onto the financial system by the central bank bailout. It is more than a moral hazard problem of encouraging debtor future adventurism. The economy actually pays by accepting excess liquidity and financial friction against real growth.

Falling prices can be slowed down somewhat by the depreciation of money, but only up to a point, after which worthless money can add to the fall of real asset prices after inflation. That point is dangerously near at this very moment in the global economy to usher in a period of sustained deflation. The Federal Reserve added $52 billion in temporary funds to the money market through the repurchase agreement of securities, including mortgage-backed debt to meet demand for cash amid a rout in bonds backed by home loans to risky borrowers.

The Fed's additions were the biggest since the September 11, 2001, terrorist attacks. The additions came in three repo transactions of $19 billion, $16 billion and $3 billion. Losses in US subprime mortgages have been rippling through credit markets, driving interest rates higher and sinking stocks and seizing credit markets.

The Fed accepted mortgage-backed debt issued or guaranteed by federal agencies, so-called agency debt and Treasuries as collateral for the repos. Normally, the Fed does not accept mortgages as collateral for repo transactions but the move signals an attempt by the central bank to alleviate financing fears. Wall Street dealers are seeking the sanctuary of government bonds and are trying to sell their holdings of riskier assets, such as mortgages if buyers can be found. Until then, they may keep going to the repo market for overnight funds.

Hedge fund woes
In the past three weeks, the computer models that some hedge funds use to make trades to implement their strategies have been victimized by paradigm shifts. These models typically scan markets to spot tiny price discrepancies under normal conditions, and then place highly leveraged large orders to capture gains that add up to outstanding returns on capital. With unusual market volatility and disorderly markets, highly leveraged hedge funds can face margin calls from brokers that develop into fire sales of good assets in their portfolios.

Hedge funds with market-neutral strategies have been wagering on high-quality stocks, or stocks that trade at low valuations based on various metrics, and betting against stocks that appear overpriced. The relatively conservative approach enables traders to feel comfortable in using leverage to boost returns. With unexpected margin calls from banks, they were forced to sell their holdings of high-quality stocks to raise cash, and closed out short trades by buying back shares of companies identified by models as overpriced. Others sold positions simply to become more conservative, in a volatile market.

Since market-neutral funds often are guided by similar computer models and share similar holdings, the actions magnified moves in asset prices. Funds that are normally pillars of stability in normal markets become detonators of instability in disorderly markets.

Concern shifted from hedge funds to banks
However, the Fed's actions reflected a shift of the focus of concern from hedge funds towards banks who loaned the hedge funds money to trade with leverage. Banks are also exposed to the problem of having committed credit lines to financial institutions with subprime exposure, such as mortgage lenders or specialist investment vehicles.

Banks have also arranged loans to risky firms such as buy-out groups, which they had planned to sell into a debt market that had evaporated overnight. An estimated $300 billion of unsold loans is sitting on bank balance sheets, gobbling up funds and pushing up reserve requirements. Banks themselves are facing problems raising funding in the money markets where investors are very nervous about lending money to anybody who might be potentially exposed to subprime losses.

And since it is hard to know who is holding subprime exposure, because these securities have been scattered around, banks are being blackballed in an indiscriminate fashion. This is a confidence problem that the Fed cannot do much about, short of offering to buy worthless securities that even a liquidity boost cannot restore fully.

Commercial paper crisis
In the US, asset-backed commercial paper, which comprises about $1.15 trillion of the $2.16 trillion in commercial paper outstanding, is bought by money market funds with conservative investors. The cash enables some selling entities to buy mortgages, bonds, credit card and trade receivables as well as car loans.

The commercial-paper market, a critical source of short-term funding for an array of companies, was becoming inaccessible for a growing number of companies since the beginning of August. There were also signs of trouble in parts of the currency market. The asset-backed commercial paper market, a crucial arena where financial institutions raise funds, has had no buyers in recent days.

This has been a recurring problem in this debt economy. On March 13, 2002, GE Capital launched a multi-tranche dollar bond deal that was almost doubled in size from $6 billion to $11 billion, making it the largest-ever dollar-denominated corporate bond issue up to that time. Officially, the bond sale was explained as following the current trend of companies with large borrowing needs, such as GE Capital, locking in favorable funding costs while interest rates were low.

On March 18, Bloomberg reported that GE Capital was bowing to demands from Moody's Investors Service that the biggest seller of commercial paper should reduce its reliance on short-term debt securities. The financing arm of General Electric, then the world's largest company, sought bigger lending commitments from banks and replacing some of its $100 billion in debt that would mature in less than nine months with bonds. GE Capital asked its banks to raise its borrowing capacity to $50 billion from $33 billion.

Moody's, one of two credit-rating companies that have assigned GE Capital the highest "AAA" grade, had been increasing pressure on even top-rated firms to reduce short-term liabilities since Enron filed the biggest US bankruptcy on December 2, 2001. Moody's released reports analyzing the ability of 300 companies to raise money should they be shut out of the commercial paper market. GE Capital and H J Heinz Co said they responded to inquiries by Moody's by reducing their short-term debt, unsecured obligations used for day-to-day financing. Concerns about the availability of such funds had grown that year after Qwest Communications International Inc, Sprint Corp and Tyco International Ltd were suddenly unable to sell commercial paper.

Moody's lowered a record 93 commercial paper ratings in 2001 as the economy slowed, causing corporate defaults to increase to their highest in a decade. One area of concern for the analysts was the amount of bank credit available to repay commercial paper. While many companies had credit lines equivalent to the amount of commercial paper they sold, some of the biggest issuers did not.

GE Capital, for example, had loan commitments backing only 33% of its short-term debt. American Express had commitments that covered 56% of its commercial paper. Coca-Cola supported about 85% of its debt with bank agreements, according to Standard & Poor's, the largest credit-rating company, which said it was also focusing more attention on risks posed by short-term liabilities.

In the first half of 2002, companies sold $107 billion of investment-grade bonds, up from $88 billion during the same period in 2001. The amount of unsecured commercial paper outstanding fell by a third to $672 billion during the previous 12 months. PIMCO director Bill Gross disputed GE's contention that the company's new bond sales were designed to capture low rates, but because of troubles in its commercial paper market. If the GE short-term rate rises because of a poor credit rating, the engine that drives GE earnings will stall. Gross dismissed GE earning growth as not being from brilliant management, former GE chairman Jack Welch's self-aggrandizing books notwithstanding, but from financial manipulation: taking on debt at cheap rates and using inflated GE stocks for acquisition.

GE had $127 billion in commercial paper as of March 11, 2002. That amounted to 49% of its total debt. Banks' credit lines only covered one-third of the short-term exposure. GE funds itself by borrowing commercial paper from investors in the marketplace, and the interest payments that it pays on those commercial paper instruments give it floating rate exposure, because they turn over frequently, short duration.

In Q4 2006, GE's total commercial paper balance was a little over $90 billion, a quarter of its financing. GE makes loans to customers, and a significant part of its loans to customers include fixed-rate payments of interest. So to match funds to its assets, to have fixed-rate interest costs to go with the fixed-rate interest income, GE enters into a basis interest rate swap. GE offsets the floating interest rate exposure to the CP and pays a fixed rate of interest to the swap counter-party to match funds its asset.

As of June 30, the US corporate bond market totaled $3.7 trillion in outstanding par value split 82% investment grade and 18% speculative grade. Across the pool of industrial bonds, the par value share of issues rated speculative grade is substantially higher at 31%. The par value of bonds maturing through the end of 2007 totals $194.9 billion. The bulk (95%) of this volume ($186.0 billion) consists of investment grade bonds with the remaining volume ($8.9 billion) residing at the speculative grade level.

Commercial paper outstanding fell $91.1 billion in the week ended August 15 to a total of $2.13 trillion, a weekly plunge that captured both bond and stock markets attention. The data, released on the Federal Reserve Board website, validated the trend that issuers were being forced to make orderly exits from the commercial paper market to obtain financing elsewhere.

CDO illiquidity
Collateralized debt obligations (CDOs) are designed to let some high-risk tranches take the first loss if any of the underlying debt defaults, while other "senior" securities only suffer losses after the riskier tranches are wiped out. In a typical CDO, senior securities can achieve credit ratings much higher than those of the underlying debt, sometimes triple-A, the same rating as US government securities.

The catch is that many CDO securities are infrequently traded and some are tailored by investment banks for specific clients, such as pension funds, and have never traded. Without a market price, valuation involves complex computer models and subjective assumptions. The credit crisis will hit the pension funds; it is merely in a matter of time.

Bear Sterns in July revealed large losses at two hedge funds that owned subprime-related CDOs, but had trouble quantifying the losses. Attempts to sell the instruments ran into trouble because few traders offered anything except very low, fire-sale prices.

This raised questions over whether hedge funds, investment banks and even pension and insurance groups know the market value of their structured credit holdings. As a result, the CDO market is closed, and access to credit, especially for leveraged buyout debt, has been severely curtailed. The news that BNP Paribas was suspending three funds underlined the valuation problem caused by a liquidity drought in the market.

Some senior US finance officials calculate losses in the subprime-related sector to be a containable $100 billion. The market seems to have a different opinion. The impact from uncertainty is now spreading to affect other debt markets, such as the corporate bonds and commercial paper market. That is creating severe trading losses and destroying confidence.

The politics of bailouts
Politicians are talking about taking measures to help households suffering from the subprime crisis to prevent as many as 3 million largely low-income households from losing their homes. However, that will not solve the crisis in the financial markets. In fact it may add to it.

But with the central banks pumping in money to help banks from failing, while families are evicted from their homes, is very bad politics in a election year. The central banks are giving financial institutions whose credit rating and cash flow are not much better than families with subprime mortgages, free credit cards with a subsidized interest rate and no spending limit for as long as needed, while these very same institutions are foreclosing on the homes of their customers.

This crisis will likely build to a crescendo just before the presidential elections. It's going to be a very interesting election. Will the credit crisis of 2007 usher in an age of popularism in US politics?


Henry C K Liu is chairman of a New York-based private investment group. His website is at www.henryckliu.com.

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(2/2) Central bank impotence and market liquidity - By Henry C K Liu