Sunday, September 21, 2008

Illiquidity and Uncertainty

My next post is going to go in a very different direction from my earlier ones, but for now I want to make a point about liquidity. People are telling me that the liquidity issue is bullshit, but they’re wrong, and here’s why.

Mortgage securities have ratings. A couple of years ago, investors thought that those ratings meant something. Given that belief, they were able to outsource most of their research to Moody’s, Standard & Poor’s, and Fitch. That was (or would have been, if it had actually been working) very efficient, because it avoided a lot of duplication of effort in the analysis of difficult, complex securities. Based on the ratings, investors were able to ascertain with a reasonable degree of precision how much they were willing to pay for the securities. Consequently, there were a lot of investors willing to buy and sell the securities, and the market could produce narrow bid-ask spreads.

But sometime in 2007, investors suddenly realized that the ratings were complete crap. Moody’s, Standard & Poor’s, and Fitch were not doing a good job with their research, or at least they weren’t doing the job investors had thought they were doing. Now that ratings were no longer considered useful, the pricing of these securities required a tremendous amount of research by each investor considering buying or selling one of them.

So an investor contemplating buying one of these securities has 3 options: she can forget about it; she can put in a lowball bid just as a shot in the dark, on the off chance that it gets picked up by some desperate seller; or she can devote a lot of resources to figuring out how much the security is really worth to her, and then put in a bid that might have a decent chance of being accepted. Considering all the other possible uses she has for her resources, she is unlikely to choose what's behind door number 3.

Similarly, if an institution owns one of these securities, it has 3 choices: it can hold on to the security; it can take the best bid available, in which case it will almost certainly be selling the security for less than it is worth (if indeed it can sell it at all); or it can devote a lot of resources to figuring out how much the security is really worth to it, and then offer it at a reasonable price which has almost no chance of being accepted, since potential buyers were not willing to do that research and therefore don’t know what the reasonable price is and won’t be willing to pay it. Essentially, except under forced liquidation, options 2 and 3 make no sense. The only reasonable thing to do is hold on to the security. That is illiquidity.

One of the potential advantages of government involvement is that the government should be able to do the necessary research with reasonable efficiency. As a huge, huge potential buyer, the government isn’t wasting its resources by doing a large amount of research just to value one little security. If it intends to buy up an entire tranche, it can afford to expend the resources necessary to figure out how much that tranche is worth.

Unfortuantely, the more I read and think about The 700 Billion Dollar Plan, the less I think that is what the government actually intends to do. More later.

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