Why is revaluing the degree of liquidity so tough?

by on March 12, 2008 at 8:01 am in Economics | Permalink

Take a simple model of liquidity.  I can sell at a good price only if I think you — you in the broad aggregate and collective sense — won’t.  (Remember: "Liquidity is only there when you don’t need it")  In other words, my motive in selling has to be idiosyncratic.

Now say some common knowledge comes to this market.  No one can sell in response to this common knowledge.  Everyone has it, by definition, so it’s not idiosyncratic.  Transparency, by the way, is simply more common knowledge and that is, with respect to liquidity, the problem in the first place.

Let’s say the new common knowledge is "this asset class isn’t as liquid as we used to think."  Ideally price should fall but how much?  If selling is only scattered the market never learns the shape or exact location of the new demand curve.  Furthermore the selling you observe only tells you "how good is the market at responding to this knowledge shock" and not "what was the initial liquidity downgrading in the first place."  Convergence, today, appears to be problematic.

Does herd behavior, combined with agency problems, make things worse?

Is it the standard story that everyone is afraid of the other trader’s knowledge?  Or can liquidity crises become more acute in a hyper-informed world?  We like to think: "market — trade — liquidity — good, etc.", forgetting the Glosten-Milgrom point that liquidity often rests upon the presence of fools.  Informing the fools eliminates one business cycle problem but creates another.

Addendum: Felix Salmon adds excellent commentary.

oops March 12, 2008 at 8:20 am

well who wants to buy if every major bank in the world want to sell? who’s gonna be first?

JasonL March 12, 2008 at 10:58 am

Misplaced,

I have to say, your comment clarified a few things for me, the non professional. I couldn’t quite get a handle on why these securities seemed to be carrying a stink disproportionate to the actual quality of the risk and return calculation. It makes perfect sense that the context has changed not only in terms of how we look at risk premiums, but also that you need to figure the quality of this type of investment over a totally different sort of timeframe. Very helpful.

DanC March 12, 2008 at 12:53 pm

The housing market can be dominated, it appears, by a relatively small group of people. What percentage of homes go up for sale in a two year period? And did relatively few buyers have the ability to push prices on the margin, especially in some markets, into reckless levels? And did lenders without strong local community ties have the ability to pull some people into that marketplace who could not afford to play the game.

Three groups are having trouble. The sub-prime borrowers who had iffy credit yet through the creation of questionable financial instruments were able to borrow. Many of these people may, at an increasing rate, be unable to repay. How many will default remains uncertain but the financial incentives for these people to default and walk away are very strong. If so what happens when the market is flooded with these homes? Their lenders can not be sure what is going to happen over the next two years. Worst case, what is the risk of catching a falling knife? If fear is pushing the value of the underlying assets too low, then Fed action to remove some of the temporary risks will, at a low cost. create a stable market. It is a risk the Fed should take.

The second group is people who took out home equity loans based on inflated valuations. They now may be trapped in their homes unable to sell without a loss. They are suffering on paper but they, for the most part, will ride out the storm. Will they adjust to the new reality in a few months, or will they drastically reduce spending because of the wealth effect? Locking in low interest rates may help many of these people, if the banks will restructure the debt.

The third group are the people who bought at the peak or were trapped while speculating. I remember people frequently commenting that a home down the street sold for X and they would not be able to buy their home if they were trying to buy, based on income, today. Basic standards for lending were lost. Some buyers were riding a pyramid scheme, selling homes at inflated values, to buy homes at inflated values. Many were payment buyers who bought as much home as they could based on a monthly payment, without much margin for error. Some were playing the game of greater fool.

I remember a person in Phoenix telling me stories about people stretching to buy expensive houses while using rented furniture or leaving half the house without furniture. But outside of a dozen cities how much of a problem was this type of speculation? Nothing the Fed does will save the Miami condo market. Nothing the Fed does will correct the problems in Detroit or Cleveland.

Still the S&L crisis did not destroy the economy and if the Fed can step in and allow housings stocks to be liquidated in an orderly fashion (forgetting about a few extreme markets) we might be able to weather this storm.

HedgeFundGuy March 12, 2008 at 2:20 pm

There are currently problems of both liquidity and solvency in the credit markets – liquidity is the more pressing problem, but solvency is the scariest.

We went through an era of unprecedented recklessness in credit creation, and the question now is how much of that debt will turn out to be bad. Nobody knows what the fair price is, and this won’t really change until we see how defaults behave as the economy turns down and unemployment turns up. But surprises are likely to be on the negative side given that we had reckless lending in pretty much every region and in every area. So in this respect we are facing a day of reckoning rather than a crisis of liquidity. Very different from 1998 where it was purely a mark to market event (many fixed income markets traded close to or through pure arbitrage boundaries).

(Many banks have recognised losses on subprime and some other categories of mortgage holdings as well as leveraged loans. But there are large inventories of other product – commercial mortgages, credit card debt etc – where likely losses are still to be recognised. Banks have large assets in variable interest entities – VIEs, arms length vehicles similar to SPVs -and also directly held as Level 3 mark to model. The GSEs – Freddie/Fannie – also will likely have to take large credit writedowns).

Near-term there is also a liquidity crisis. Leveraged institutions are finding it difficult and expensive to fund their holdings of credit product. The TSLF eases the near term pressure in this respect and one might expect some stabilisation in credit markets once quarter end is out of the way. But stopping, say, Bear Stearns from experiencing a funding crisis does not make the bigger solvency problem disappear.

josh March 12, 2008 at 9:02 pm

if the shock is common knowledge, then the new demand curve should be common knowledge also. of course, then trading would resume at a new, lower, equilibrium price. there shouldnt be any learning, convergence, etc. under the common knowledge assumption. in fact, at any moment in time every asset holder should be, on the margin, indifferent between holding and not holding every security in his portfolio. this is true even after aggregate shocks. this is only false if there is asymmetric information. that trading would cease to take place (rather than continue in usual volume but at a lower price) after a shock must mean that the shock differentially informed traders (milgrom-stokey). you seem to misunderstand how noise traders provide opportunities for trade in the presence of private information. you also seem to misunderstand what common knowledge means.

jim May 15, 2009 at 10:25 pm

Is it realistic?

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