Wednesday, 3 December 2014

Liquidity meltdown? So what's the problem?

Before we get onto liquidity just a couple of other thoughts-

Russia - Must be one of the only countries where oil prices are rising in local currency at the moment. But the lower oil goes the more likely it is that Putin will have to step in to ’save’ the large local oil companies by taking them into State ownership. Depowering the oligarchs. No wonder he doesn’t want to cut oil production. Meantime the Ruble is making imports more and more costly helping domestic suppliers. Default on Russian bonds? Well if you know you aren't going to get refunding from the West then why not indeed default on any non-Ruble issued bond. As for Ruble issued? Well you can always print more Rubles to repay them. I am still worried that the more the West squeezes the stronger Putin gets, like one of those Star-trek alien beings that feeds on negative energy. Stop firing your phasers at it, it just grows stronger.

Osborne's Autumn Statement - If any member of the banking profession were to leak such financially sensitive information (as new building and infrastructure plans most certainly are) they would be in court. Why is this stuff allowed to be leaked?

Oil - There will come a point when there is so much to lose in correlated leverage plays that it would be cheaper for those facing such losses to buy oil itself to get the price up. I remember talk of a famous fund buying gold when they wanted to offload a massive gold mine holding as they could move gold prices with ease due to gold's low liquidity relative to the liquidity in the mining stock.

Protectionism - Opec is allowed to manipulate prices on Oil, De Beers are in a similar position with regards to diamonds (by the way have you ever tried to get a bid on a second hand diamond?) and yet financial markets can’t be seen to be moving a price a pip.

Ok now on to Liquidity - There is a lot of concern, correctly, that liquidity in some markets is so dire it could lead to some serious meltdowns. Eyes are on High Yield via the energy sector. But should we be concerned about a meltdown caused by low liquidity? The normal response is "Yes of course! Prices will collapse and there will be high volatility and and and" but am I allowed to ask “So what? Does that matter?"

If there is a meltdown in something it's triggered by an adjustment in perceived value. When there is no liquidity then prices pass through where people think fair price sits (otherwise they wouldn’t be moaning of no liquidity) to prices which they feel are unfair or downright silly and don't reflect actual probabilities of default or yield outcome. So why are they selling at values that they think are absurd and moaning that it's due to lack of liquidity?

Most likely it can all be boiled down to money management rules creating large gaps between actual outcome probabilities and priced probabilities. this is particularly true in systems that use price as an input of probability in the first place, as we saw with CDS prices being quoted, wrongly, as actual probabilities during the EU crisis. So we could argue that any huge swings in pricing because of lack of liquidity will punish those who have to employ short term money management rules over those that can take a sanguine long term view. So rather than all being bad, it creates opportunity and acts as a feedback hopefully moving fund management away from the, sometimes cretinous, short term consultants tight risk rules back towards a more balanced macro big picture world.

But what about the losses? Well if the true price that reflects future outcomes has indeed moved then tough. That is nothing to do with liquidity. For those that are being forced to sell below what they see as the  real price, due to no liquidity,  their loss must be someone else’s gain as those selling must be selling to someone else who is picking up a bargain. So the negatives due to bad liquidity are offset by someone else’s positives.

So if there is to be a High Yield meltdown  due to poor liquidity I look forward to buying some at stupid levels caused by some VAR calculation deep in a fund saying  'spew at any cost'. Thank you.

Of course the wealth destruction argument is different. If leverage is involved, which of course it is, then book values will tank and no doubt the value of that book has been used to borrow to fund some other asset, which then has to be sold. Now THAT is the transmission risk to other asset classes.

It's not liquidity that is the problem, it's once again leverage.


abee crombie said...

Interesting thoughts on Russia. with putins recent move on Sistema who knows how much more control he wants of the big oil companies but I do think that in general ppl have overstated his negativity to 'business' and corporations. I think he realizes that international capital markets exist and that they are essential to helping build up Russia, as evidence by Putins openness to investor meetings over the past 2 years, but then who knows what is really in his head.

The problem with buying HY when it is on sale, is that you really need a good broker. Finding most of the smaller issues that look like steals is very hard. Why Bonds dont all trade on an exchange is beyond me.

Polemic said...

Thanks Abee, Yes getting hold of them is hard but someone must have bought them if they've been sold. Perhaps that exchange you are looking for will. if they really become distressed. be Ebay!