Howard Marks wants to talk about liquidity.
Marks does not think liquidity is whether or not you can sell an asset; true liquidity is how easily you can sell an asset — and at what price — when you’re forced to.
In a note to investors on Wednesday, Oaktree Capital’s Howard Marks wrote about the topic, something that is on the mind of investors, particularly those in fixed income who have seen spreads compress as government and investment-grade corporate bond yields have tumbled over the last year.
Marks introduces his memo with a really important discussion about what he sees as the common misconception about the definition of liquidity:
Sometimes people think of liquidity as the quality of something being readily saleable or marketable. For this, the key question is whether it’s registered, publicly listed and legal for sale to the public. “Marketable securities” are liquid in this sense; you can buy or sell them in the public markets. “Non- marketable” securities include things like private placements and interests in private partnerships, whose salability is restricted and can require the qualification of buyers, documentation, and perhaps a time delay.
But the more important definition of liquidity is this one from Investopedia: “The degree to which an asset or security can be bought or sold in the market without affecting the asset’s price.” (Emphasis added) Thus the key criterion isn’t “can you sell it?” It’s “can you sell it at a price equal or close to the last price?” Most liquid assets are registered and/or listed; that can be a necessary but not sufficient condition. For them to be truly liquid in this latter sense, one has to be able to move them promptly and without the imposition of a material discount.
Marks’ note comes on the heels of this report from the Financial Times on Monday, which cited a number of investors in the bond market who are worried about a potential liquidity crunch in markets.
And the small distinctions between what Marks says liquidity is and isn’t are incredibly important.
Liquidity and solvency became the key terms of the financial crisis, and it is worth revisiting this Paul Krugman column from December 2007 distinguishing the two. A lack of solvency is an inability for an entity to meet its obligations. A lack of liquidity is an inability to raise cash on short notice.
Much of the anxiety in markets right now centres on bond prices and whether investors, particularly those that manage bond funds, will be able to meet client redemptions if those redemptions ever come en masse (like they did during the financial crisis, for example). This is something the Fed has acknowledged it is keeping an eye on.
And so what Marks is saying is that it does not matter if your portfolio holds a bunch of, say, ‘AAA’-rated corporate bonds and highly-rated government bonds like US Treasuries, which are, in theory, highly liquid assets.
(If I owned, for example, $US1,000,000 of 10-year Treasury bonds I could very easily sell them at market price right now. If we’re in the middle of a financial crisis, that prospect is less clear.)
And so again, Marks notes that what matters is what price you’ll be able to get for those bonds if you’re forced to sell them quickly.
“Usually, just as a holder’s desire to sell an asset increases (because he has become afraid to hold it), his ability to sell it decreases (because everyone else has also become afraid to hold it). Thus (a) things tend to be liquid when you don’t need liquidity, and (b) just when you need liquidity most, it tends not to be there.”
And this is really the crux of the whole issue.
Liquidity is not a contractual concept. You, as a bondholder, are not obligated to liquidity, but are merely counting on its availability. And when you need it most, the market might run dry.
Marks concludes his letter by citing his colleague Jay Wintrob who joined Oaktree from AIG, the insurance firm that famous required a government bailout during the financial crisis.
Marks wrote than when he told Wintrob that he didn’t think the issue of liquidity was particularly important or profound, Wintrob said:
In September 2008, AIG experienced serious liquidity issues (despite its $US1 trillion balance sheet) when it couldn’t post $US20-25 billion of liquid collateral related to credit default swap contracts written by one of its subsidiaries. The U.S. government stepped in as a result, lending support that eventually reached $US182.3 billion, massively diluting AIG shareholders in the process. When you can’t meet a margin call because you have insufficient liquidity, that’s profound.
And so on days like Wednesday when the stock market sells off, people might be asking about the health of things like the biotech sector. These things are important in their own right, but Marks is writing about something more essential with regard to how the financial system functions, not just what investors and commentators think about certain part element of that system.
For Marks is asking investors a very basic, fundamental, and not-easily-answered question: if you don’t know what you can sell a given asset for, do you really know what it is worth?
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