How the Liquidity “Delusion” Leads to a Crash

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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 – the ability to sell quickly without a significant drop in price – just evaporates when you need it the most. 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.

So is the ECB losing control? Read… Dollar Hits Air Pocket, Euro in Epic Short Squeeze

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  8 comments for “How the Liquidity “Delusion” Leads to a Crash

  1. NotSoSure
    May 8, 2015 at 1:44 am

    Hard to see why there won’t always be some liquidity unless someone like Snowden literally comes out with some proof that the Fed through some lackeys has been buying futures or/and stocks. Until then, forget any analysis.

    • Gil Obrero
      May 8, 2015 at 5:53 am

      Hard to see where any liquidity at all can from from when tens of trillions of what are basically assets with a false price tag attached are chucked at the market.
      What would you pay for them.
      Are you going to risk real cash as opposed to the fake stuff that will not be available anymore, to buy this toxic mush.

      There is not enough real assets in terms of liquidity about to keep any floor under what is virtually worthless tat, only bearing a price tag that is put there by the fed and has no bearing on reality.

      Would you sell your house or raise a mortgage from equity to buy this junk.
      And any new bout of hyper printing to try to jack this junk to higher levels will have just one effect, to crash the currency

      • NotSoSure
        May 8, 2015 at 6:33 am

        @Gil,

        But it’s not you or I or “investors” who’s raising mortgages to buy this market. My point’s more that the Fed and their cronies can probably do this for a quite a while till one or a couple of these cronies were to turn around and start pointing fingers at the Fed thus removing the later’s credibility. And please, hyperinflation can’t occur until those reserves find their way to the general population or the Fed loses credibility (another way is perhaps through an audit).

    • May 8, 2015 at 8:05 am

      NotSoSure, there will be liquidity for many securities, but at a much lower price. How much will the price have to drop before cash flows into the market? Currently, all it takes is a smallish dip. But when the music stops, that cash won’t flow into the market unless securities are beaten down enough – in the opinion of each individual buyer. That’s the cost of having to sell when liquidity dried up.

      Liquidity is the ability to sell quickly without a significant cost (lower price).

  2. Yancey Ward
    May 8, 2015 at 10:30 am

    I think the Rubicon has been crossed. When the time comes, the CBs will end up having to, and will, buy it all- stocks, bonds, derivative positions, etc.

    • Vin
      May 10, 2015 at 1:06 pm

      I think that Yancey’s correct. However, i don’t believe that CB’s will “end up” buying everything, I believe that’s the plan.

      Once the skum have made as much as they desire the CB’s will let them out of their trades simply by taking the other side at whatever price is set. Then the taxpayer will “own” everything and it will be our risk.

      Then, when there’s no bid anywhere to be found, the CB’s will resell the crap with HUGE haircuts back to the skum leaving taxpayers poorer than when we started.

  3. robert h siddell jr
    May 8, 2015 at 12:51 pm

    Has everyone forgotten the Flash Crash of 6May2010 when the DOW lost 999 points in a couple minutes? Wall Street is game of Musical Chairs played in a House of Cards run by Fourflusher Mountebanks.

  4. Julian the Apostate
    May 8, 2015 at 7:44 pm

    No tickee, no washee.

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