Liquidity

“Liquidity” is another magic word. I like it rather less than “friction.” In the debate on financial regulatory reform opponents of tight regulations use the word liquidity as a magic spell which, they hope, will make all inconvenient evidence and arguments go away (no links my claim is like saying the Sun emits light). The word is used with different meanings. Sometimes it refers to something which is definitely good, sometimes it refers to the effects of structured finance. This is an equivocation.

It wasn’t always this way. Like “friction,” “liquidity” has been used for purposes other than special pleading and obfuscation. I don’t know the history of the word, so I will start with a definition (which may not be the oldest definition) and explain how the word lost all useful meaning through over use. As with “friction” I think a good practical rule is to demand that anyone who makes an argument including the word “liquidity” be asked to rephrase it without using that word.

Long long post after the jump.

First money is liquid. Money is any asset which can be used to buy anything or pay and debt right now. Other assets are more or less liquid depending on how quickly they can be converted into money and how much that operation costs. One definition of liquidity (the only one which I accept) is the cost of a round trip money to the asset to money divided by the price of the asset.

When we describe the liquidity of an asset as a property of the asset, we are making a very strong totally false assumption. We assume that the proportional cost of the round trip is constant and does not depend on the amount of the asset purchased then sold. Of course this is nonsense. For extremely small purchases, the cost of a round trip is very high. Much more importantly the round trip costs of extremely large purchases can be much higher than the round trip costs of medium size purchases. An extremely large buy order drives prices up and an extremely large sell order drives prices down. It is this problem and no other which is being discussed basically every time a financier uses the word liquidity. They call an asset liquid when huge positions can be taken and unwound with low round trip costs. This sort of liquidity – large transaction liquidity – is not directly valuable to me or to 99.9% of people.

The main point of this post is to object to the equation of round trip costs for medium size round trips and huge round trips. However, the abuse of language is much worse. A third meaning of liquidity is the money supply. This is the sense in which Central banks are said to inject and remove liquidity via open market operations. Here “liquidity” means “liquid assets.” I don’t think this abuse of English is dangerous. It is just very mildly irritating.

However, and much more importantly, “liquidity” is also used to mean free cash flow. It is in this sense that people distinguish between an illiquid firm (which can be profitably rescued with a loan) and an insolvent firm (which can’t). The claim is that the problem for an illiquid firm is that its assets can’t be converted into money.

This is clearly a false statement. Nowadays all assets can be sold. Even in the past, firms could issue new shares. The problem for an illiquid firm (with this 4th meaning of liquidity) is that no one wants to buy its assets. The claim of the manager that her firm is illiquid is a claim that the asset prices are different from fundamental values.

The assets can be sold (as shares of the firm if need be) but people would not pay enough to cover the firm’s liabilities. This is not because the instrument called the public offering of shares doesn’t exist. It is because they don’t believe the assets are worth that much. The claim of illiquidity not insolvency always is the claim that investors are wrong about fundamental values. It hasn’t been a statement about available financial instruments since the invention of the joint stock limited liability company.

It doesn’t matter if the firm’s effort to liquidate its assets would drive prices down or if prices are already low. What matters is that the firm can’t get enough money for its assets to pay its debts.

For the purposes of this post, the point is that, other things equal, we would like firms to have a huge free cash flow. Using “liquidity” to refer to free cash flow gives the word positive connotations. The implicit suggestion is that market institutions such that huge round trips have low proportional costs will improve the cash flow of all firms. This suggestion comes close to being an explicit argument when the same person describes the recent crisis as a liquidity crisis and says that tighter regulations will reduce liquidity.

A fifth meaning of “liquidity” is “market thickness” or “trading volume.” I’m fairly sure the word originally described assets. Now it is often used to modify markets so thick markets are called “liquid markets.” This is actually fairly important, since market thickness is key to making the round trip costs of taking and unwinding a large position low. If I own 100 shares of IBM, the amount of money I can get for them depends almost not at all on trading volume the day I sell. A minuscule fraction of current market volume would be enough that I don’t drive the price down by dumping 100 shares.

The identification of round trip costs for huge and medium round trips leads many people to consider high trading volume socially desirable. Just try to imagine an explanation of why high trading volume is useful to someone who buys corporate bonds to save for her retirement or pay her children’s college tuition or buy a house. It is just assumed that market participants frequently take and unwind huge positions. The implicit assumption is that we should regulate so that the properties of the market please active traders. Most people do not believe that active traders are socially useful. The ambiguity of the word liquidity enables them to argue that the market should be designed for their convenience without their having to defend their claim to be socially useful.

Now an analogy – poker. The thing that smart professional poker players want most is not so smart poker players (fish, suckers etc). They want people who bet incorrectly so that they can take our money (they haven’t gotten any from me). Now, what about the smart traders who want liquid markets? Their view of the way markets should be is that, when they decide that an asset is underpriced, they can buy a whole lot of it at that too low price and, when they decide that an asset is overpriced, they can sell a whole lot of it at that too high price. I can see why they think this is good for them (I think they are often wrong, because they don’t have rational expectations). I can’t see why we should feel obliged to supply them with plenty of fish.

OK an example. “The RMBS based CDO market became very illiquid in 2008.” This sounds like a safe claim. The fact is that the volume of trading of RMBS CDOs collapsed so the market became thin. A market can be thin if everyone agrees on the fundamental value of assets and is pleased with their current portfolio. This was not the case in 2008. Many firms were very eager to get the CDOs off their books and no one had a clue what they were worth. A market can be thin as it is perceived to be very risky so everyone likes to hold zero of the asset. This was not the case in 2008. Net holdings of RMBS base CDOs were not zero. Many firms and individuals owned them and felt that they were bearing risk. They would have liked to reduce their holdings.

I think it is clear why the market was thin. The market clearing price was much lower than it had recently been. Very few wanted to buy at any price higher than this market clearing price, but the owners of the CDOs weren’t willing to sell at the market price, because then they would have had to book the losses. The market seized up, because it was necessary for it to seize up to neutralize mark to market accounting. Here as in the case of the allegedly illiquid firm the problem isn’t that the assets were illiquid, the problem was that their market price was so low that firms couldn’t cover their liabilities by selling the assets.

Having no respect at all for the efficient markets hypothesis, I am perfectly prepared to believe that this was an irrational panic and that many firms could profitably be saved by an emergency loan. It is not very bold to type that now, but at the time, I thought that the cost of a well designed TARP to the Treasury would be huge and negative – that the US Treasury had a huge gigantic profit opportunity.

This opportunity was largely wasted. My understanding is that the Treasury now guesses that it plus the Fed will make money saving banks (I count making good AIG fp obligations part of saving the banks). Not enough to cover the losses from saving GM Chrystler, Fannie Mae and Freddie Mac but quite enough to make it impossible for any semi-sane person to take the EMH seriously (of course I think no semi-sane person ever took the EMH seriously and I strongly suspect that Eugene Fama is semi-sane).

Well here we are finally at the end of an overlong post. My conclusion is that the debate on financial reform is seriously endangered because of a gross equivocation. It is insinuated that so long as trading volume is high, all firms will have an excellent cash flow. It is almost stated that extremely high trading volume is useful to savers and small investors. It is assumed that the problem in 2008 was that markets stopped working in a way pleasing to active traders who think that they can beat the market.

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