The Liquidity Game

Hugo Dixon. CEO and founder of Breakingviews.com

3 July 2007

On May 31 Hugo Dixon, CEO and founder of Breakingviews.com, took part in the 2007 World Affairs Seminar of the Master of International Legal Practice with an address on global finance and the liquidity game, a summary of which can be found in IE Focus.

The signs of increased market jitteriness are unmistakeable. Last week, 10-year US government bond yields briefly nudged through 5.25%, as investors woke up to the fact that inflation and interest rates are on the rise across the world. But the liquidity bubble that has been fuelling asset price inflation as well as the global M&A boom probably won´t pop just yet.

This is because liquidity isn´t just a function of interest rates. It is best thought of as a willingness to play the financial game - by lending, borrowing and betting money. That willingness is only partly determined by the cost of money. A bigger part of the story is risk appetites. Interest rates have been rising in much of the world for at least 18 months. But over this period liquidity has been rising too.

Risk appetites are, in turn, determined by the balance between greed and fear. When greed exceeds fear, markets rise - and vice versa. Today, fear seems to be increasing: even before last week´s jitters, most smart operators thought assets were priced above their fundamental values. But greed has been increasing even more rapidly. As a result, what one could call "net greed" is still on an upward trend.

Greed is an infectious disease. As the rich get richer, they don´t stop wanting to get richer. Hedge fund managers, LBO barons, investment bankers and oligarchs look around and see others who are making even more money than they. The globalisation of finance has spawned a global greed pandemic. This, in turn, has been matched by a cornucopia of conspicuous consumption: the super-yachts; the avid collecting of contemporary art; and the explosive demand for private or near-private jets.

Carry on

The smart players are more infected by greed than fear largely because they have downside protection. Hedge funds, LBO houses, even bankers have much more to win by markets going up than they have to lose by markets falling. You are more likely to do a daring high-wire act, if you have a safety net. But it´s only the insiders who have this safety net. The outsiders, the ultimate providers of capital, don´t.

Managers of hedge funds and private equity - the two dominant species in the modern financial jungle - are both rewarded by what´s called carried interest. They typically collect 20% of the profits when things go well. But they don´t share in the losses when things go badly. This one-way bet accentuates greed and blunts fear.

Bankers also have skewed incentives. The bulge bracket banks that sit at the centre of the system don´t provide loans in the same ways as they did, keeping the risk of default in-house. Instead, they only originate loans, collecting fat fees. The loans are syndicated away as soon as possible. As long as bankers can play this game of pass the parcel, they don´t face any risk.

And what about those they syndicate to? Well, in many cases, the suppliers of debt (particularly for LBOs) are collateralised loan obligations (CLOs) and hedge funds that specialise in credit. These too earn fees by cranking out deals. Since they are not principally playing with their own capital, their risk appetites are also skewed.

Breathless accumulation

This cat´s cradle of one-way bets doesn´t just anaesthetise fear. It encourages a breathless accumulation of assets. If the public is willing to let you play "heads I win tails you lose" with $1bn, that´s pretty nice. But how much better to play it with $20bn.

But it´s not good enough just to accumulate bigger and bigger funds. To collect their carry, hedge funds and private equity also need to deploy their funds rapidly and book a profit. This breathless accumulation and deployment of assets will ultimately drive down returns - and, hence, fundamental values. But, in the short run, it has exactly the opposite consequence. Buying assets drives prices up.

Predicting what will pop the bubble is, of course, hard. But one can sketch out possible scenarios. Maybe rising interest rates will eventually do the trick. Maybe there will be a global political crisis such as a big bust-up with Russia. Or there may be a crisis inside the financial system, such as a large LBO running into problems. At some point, even the smart money may conclude (as they did in 2001) that it is easier to collect their carry by shorting assets rather than going long.

But it doesn´t feel like the game is going to come to an end just yet. Not that this is such a comforting thought. When the bubble bursts, it will probably go with a louder pop.

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