How the Liquidity “Delusion” Leads to a Crash

by Wolf Richter, Wolf Street

They were just about all there at the Las Vegas SkyBridge Alternatives Conference, or SALT: Daniel Loeb, T. Boone Pickens, and of course George Papandreou, who in March 2011 as Greek prime minister had produced one of the funniest official Eurozone lies ever when he reassured those that were being shanghaied into bailing out Greece: “We will pay back every penny.”

A couple of thousand others were there, including John Paulson, who made billions after betting against bonds backed by subprime mortgages using credit default swaps. “Hedge fund stars,” the New York Times called them. One of these “stars” was Ben Bernanke who, in his function as Fed Chairman, has done more for these hedge funds stars than anyone else, ever, period.

They all have one thing in common: They’re going to ride this Fed-gravy-train all the way to the end. They’re going to max out this rally in stocks and bonds and real estate and what not, though the oil-price crash has knocked a serious dent into their shiny veneer. And they’re going to add to their gains to the very last minute, fully leveraged, fully aware that this won’t last, totally cognizant that this is artificial and that its end is drawing closer. Then, at the first rate increase or whatever other sign they might see that the gravy train starts derailing, they’ll jump off.

That’s the plan. In this overleveraged market, their twitchy fingers are going to hit the sell button all at once, assuming that there will still be buyers out there, that there will be enough liquidity in the markets to where they can get out without having to pay an extraordinary price, and before everyone else is trying to get out.

But market liquidity, when you need it the most, just evaporates. It’s “one of the most under-appreciated risk factors facing most investors today,” Mohamed El-Erian, chief economic advisor at Allianz, told Business Insider. He went on:

Aided and abetted by ultra-loose central bank policies, investors have collectively embraced a liquidity illusion – or, to be more precise, stumbled into a liquidity delusion.

As a group, they believe that, should conditions cause them to change their collective mind, there will be enough liquidity in markets to reposition their portfolios with relative ease and at a relatively low cost. But this belief runs counter to both structural conditions on the ground and recent market signals.

Part of this “delusion” of liquidity is due to the “pronounced decline in the risk absorption appetite of broker-dealers,” he said.

When desperate overleveraged sellers, hounded by margin calls, are forced to sell en masse, the big broker-dealers, facing tighter regulations and nervous shareholders, will no longer provide liquidity by buying assets with plunging prices to park them on their balance sheets in the hope of making a buck later.

They not only reduced their ability and willingness to intermediate during a big selloff “in absolute terms but also relative to the enormous growth in the end-user investor base,” El-Erian said.

Among that investor base: hedge fund stars with their huge funds and a twitchy finger on the sell button.

We have already seen the results, he said, namely “a series of sudden out-sized price moves in quite a range of markets, from sovereign bonds to foreign exchange, emerging markets, and high-yield corporates.” So far, these episodes didn’t last long, “due to the stance of central banks.” Which are there to bail out the stars.

So this is how the dynamics of a crash play out:

First, a sudden change in the investment paradigm – such as that that triggered the May-June 2013 Taper Tantrum or this January’s Swiss National Bank decision to alter its currency policy – creates widespread investor demand for portfolio adjustments.

Second, broker-dealers either attempt to step back from the marketplace altogether or only agree to transact at very wide bid-offer spreads and only in small size.

Third, losses associated with the resulting outsized price movements force over-levered investors and weaker hands to try to de-lever in a rather disorderly manner.

Fourth, further price overshoots are accompanied by rather shaky market functioning that attracts regulatory concern and places central banks in yet a deeper operational dilemma.

This is economist-speak for an all-encompassing rout where there are no buyers and the market itself threatens to seize. And the “operational dilemma” for central banks would be which hedge fund stars to bail out. That’s how it went last time. That’s what they’ll think about next time.

He has some advice: When liquidity dries up and valuations for select securities crash to such low levels that they’re clearly a buy, investors who’re hounded by margin calls cannot buy. Instead, they’re forced to sell into this market. They lock in losses and miss the opportunity because they don’t have the liquidity. So he says, reign in your risk and keep some “dry powder” handy. Ah, the most despised asset of them all: cash!

But that trigger to step in and buy some select securities isn’t that 4% dip, but when “prices have fallen well beyond what is warranted by fundamentals.” Alas, “fundamentals” have been obviated by events years ago, and those select securities would have to fall very far.

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