Liquidity – “it's all that matters"

"Liquidity rarely matters, but when it does, it's all that matters."

Those are the words of Bank of America Merrill Lynch’s equity and quant strategist Savita Subramanian.  Remember them.

Much has been written about the enormous risk before us in liquidity.  It is a two fold phenomenon presenting right now on the Repo markets and also the equities markets.  We explained each here and here.  The latter is a longer read but one at the time and still now is a must read.

BofAML is not alone in becoming vocal about the concern around liquidity.  Since the Fed announced it will (NotQE) pump $60b per month into these Repo markets, they have continually been oversubscribed as the Repo market continues to show very real signs of stress.  Indeed financial giant State Street’s president and CEO said before the IIF “you’ll see more moments like this going forward,” and prompting JP Morgan to say “Given the benefits of our newfound perspective, we recommend viewing these moves as highlighting the limitations of the Fed’s chosen solution to their operational issues…..With year-end coming up, this is all likely to get much worse, in our view, before it gets better.”

Another area this is presenting issues is via the shadow banking or lending sector.  These are firms not regulated like banks but lending enormous amounts to things like car loans and home mortgages.  As the CEO of Scotiabank notes:

"Regulators have been very successful in distributing risk….It’s now been very much deconcentrated. But it hasn’t gone away; it’s been moved."

Indeed such debt instruments might remind you of something else.  The IIF CEO spells that out in a typically understated way…

"We used to make the same case on securitization of mortgages [subprime CDO’s] — that we could slice them and dice them and we distribute risk globally and it was a safer system because it was distributed….We found out that wasn’t necessarily the case." How’s that for an understatement!

Doug Kass talks about this in the sense of disclosure and ‘information’ to the investor. He notes that 80% of loan issuers have no public securities, which serves to limit financial disclosure.  So in the context of these shadow lenders and the host of passive ETF’s and the like that both own them and all matter of other blind investment:

“Never before in history have traders and investors been so uninformed. Indeed, some might (with some justification) say that never before in history have traders and investors been so stupid!

But, the conditions of fear and greed have not been repealed — and will contribute to bouts of liquidity changes that range from, and alternate between, where ‘anything goes’ and ‘nothing is believed.’

Arguably, stock and bond prices have veered from the real economy as the cocktail of easing central banks and passive investing strategies produce a constant bid for financial assets, suppresses volatility and, in the fullness of time, will likely cause a liquidity ‘event.’ 

While the absence of financial knowledge, disclosure and the general lack of scepticism are accepted in a bull market, sadly in a bear market (when everyone is “on the same side of the boat,”) it is a defining feature of a liquidity crisis.”