Last week I attended the Milken Global Conference in Beverly Hills – a truly amazing experience for learning from and meeting with exceptional individuals from many walks of life. For me the most interesting topic was the discussions around the concepts of liquidity in the financial system, which in my mind has always been one of the most broadly misunderstood concepts in finance. For those of you readers who are not familiar with the jargon of finance, the term “liquidity” refers to the degree to which an investment can be readily sold for cash. Cash, in point of fact, is the most liquid of all investments. The desire for liquidity should rightly stem from investors’ needs to acquire the necessities of their lives, such as shelter, food, education, etc, each of which must be acquired for cash. In my career it seems that the desire for liquidity on the part of investors has far outstripped their actual needs for it, and has led to certain very interesting phenomena.
When considering liquidity there are a number of things to focus upon. First, as suggested above, is the question as to how much liquidity investors actually need. There is a cost associated with liquidity, with the prime example being the holding of cash, which has no return or yield. It should be considered optimal for an investor to not pay for liquidity that is not required, and yet the large majority of pension fund investments reside in securities that are considered to be liquid despite the fact that pension funds’ need for cash to meet their retirement obligations is for the most part quite far into the future. Given this, it is worth wondering why this is so. Why are pension funds and other investors sacrificing yield, or paying up for liquidity that they don’t actually need?
The second consideration is the issue of whether there truly is liquidity in the market. In other words: Do investors who are paying for liquidity get anything for their money? The notion of liquidity is predicated upon the belief that if holders of “liquid” securities desire to sell these for cash that there would always be a bid at a reasonable price, one that approximated true and fundamental value. In a panel discussion led by Milken himself, Steve Tananbaum of Goldentree shared a slide revealing that high yield debt issuance has climbed some $446B since 2007 while during that same time dealer inventories have shrunk by $239B, or 90%. The point he was making is that the consolidation in the financial industry combined with the impact of the regulatory changes that have been imposed upon the surviving institutions has severely reduced the ability of the intermediary community to deliver liquidity. That Milken panel underscored the point that during the past few decades the balance sheets of market-making intermediaries, whose job is to provide liquidity to investors, has shrunk dramatically while the holdings of securities by the largest fund managers has swelled, thus calling into question the market’s ability to deliver upon the promise of liquidity.
In another session at Milken, Mohammed El Erian explained that most investors today are on the same side of “the Central Bank trade“ – long the market and counting on a continuation of the very easy monetary policy of global central banks that would continue to lift financial asset values. El Erian expressed concern that if sentiment were to change from bullish to bearish and investors wished to reposition accordingly by shortening their duration and selling securities, there is simply not enough liquidity in the system to facilitate this move. Extraordinary price declines could occur as people, increasingly desperate to find liquidity, chase the few bids that might be available lower and lower. This is pretty much what we saw in the financial markets in 2009.
As a young mortgage-backed securities trader at Drexel Burnham Lambert in 1986 I had the good fortune to hear Michael Milken address the Drexel fixed income team. He said a number of things that day that stuck with me forever, but perhaps the most important one was that “Liquidity is an illusion. It is always there when you don’t need it and never when you do.” As investors considers this reality it would be appropriate to ask the important question of “How much liquidity does one need, and what is the best way to insure that the liquidity need is met?” In my mind, cash and treasury bills are liquid, and most else is not. It seems to me that the significant price that investors pay for the illusion of liquidity, that is represented by the yield differential between assets like stocks or bonds that are considered to be liquid and real estate which is considered to be illiquid, is not worth paying. Given how illiquid the “liquid” securities market became in 2008/9, and in most other crisis moments in the preceding decades, it is fascinating that the majority of investors’ capital continues to target securities that offer lower yields and the illusion of liquidity.