Penalising Liquidity

Pablo Triana. Professor. IE Business School

31 October 2007

The recent chaos on the markets could change the way the most standard assets are valued.

It is usually assumed that the prices of ´normal´ financial assets, such as high-capitalisation shares, the main currencies, many raw materials and (solvent) government bonds enjoy a liquidity premium. Their relatively high value is partly explained by the fact that they can be bought and sold quickly and easily; in other words, investors can rid themselves of their positions in a convenient and transparent manner. As shown by recent events on the markets, owning assets that are difficult (or impossible) to liquidate can give rise to a great deal of headaches.

However, perhaps paradoxically, the rapid proliferation of highly sophisticated financial structures in today´s markets could have given the liquidity premium a turnaround of 180°. In a world where many players hold complex positions, the benefits of liquidity enjoyed by the more ´boring´ assets, such as shares, can become a penalty. In other words, high liquidity is becoming a reason for less rather than more worth.

Why? Because the deterioration of the more sophisticated markets can lead to dramatic sales on the more liquid markets. When complex products enter a very negative phase, the market value of the corresponding positions falls and can even disappear (i.e. obtaining a bid becomes impossible), forcing the hedge funds and other speculators, who had been filling up on non-standard structures, to obtain cash to satisfy the now unceasing margin calls from their brokers and balancing items and the demands for the return of capital from their increasingly nervous investors.

And what do these players sell in exchange for the much-needed cash? Whatever they can, which inevitably means their more liquid assets. When the market has fallen into a feverish search for liquidity, it is difficult to get rid of non-liquid items.

And what happens with the prices of the liquid items sold en masse by all these players? Of course, they fall and become highly volatile. This process could fuel itself, bringing further momentum to the disaster, through two basic channels: first of all, regular, straightforward investors could panic when faced with the unexplainable chaos and reduce their own positions; secondly, the growing volatility could force additional sales due to the fact that the value-at-risk models used by investment banks and institutional investors would indicate the need to reduce risks. The end result could be a rather unpleasant domino effect. The liquid assets (together with those who innocently invested in them) would essentially be paying the price for being so liquid when non-liquid investments have become an extremely dominant item. From the valuation point of view, liquidity becomes a millstone, not an advantage.

Of course, we have just witnessed such a process. In recent years, many funds have accumulated highly consolidated positions exposed to structures that contained a significant risk component in North American mortgages, especially sub-prime mortgages. The deterioration of the market value of the said investments as a result of a chain of non-payments by homebuyers generated margin calls and made external investors nervous. The inevitable need to obtain cash forced the funds to sell liquid shares. During the hectic days of mid-August, many blue chips on Wall Street gave their worst daily performances in more than four years and the Dow Jones fell to below 13,000 points. All in an environment of healthy economic behaviour and sound corporate results. Unquestionably, it is difficult being so liquid when you are surrounded by so many non-liquid items.

Typically, a variable income professional would explain to his clients that one of the factors that justify the value of the asset is its high liquidity. But this familiar sales pitch could soon stop sounding attractive. After the events of the last few weeks, many clients may begin to demand a substantial discount because on shares that are simply too liquid.

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