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Saturday, September 5, 2009

Liquidity is a State of Mind (Update)

(UPDATE) Good discussion in comments. My overall point is that humans determine liquidity. Some claim I have cause and effect mixed up. That liquidity causes humans to take increased risk. To me that's backwards. Humans make the choices. Humans create liquidity. And humans are subject to the forces of social mood. Hence liquidity is subject to the forces of social mood, hence = "state of mind". A "credit crisis" is a human-created crisis. I think that's obvious at least it is to me.

(UPDATE) There are lots of ways to use the term "liquidity". I am not trying to say that the way people use the term are wrong. But "liquidity" doesn't drive the markets per se. Humans do. Financial markets are very much a social endeavour. We push the buttons. We create the liquidity that allows the markets to move. See my point? So saying its "all about liquidity" is really saying "its all about social mood". That's the connection. And if you disagree then that's fine. We won't beat a dead horse.

(UPDATE) (As per discussion of how the term liquidity has been used most lately (injections by the FED), most of the excess liquidity that the FED created is just sitting as huge piles of reserves doing nothing but backstopping broken balance sheets. And most of that will be eaten away as losses over time.)

I sometimes get in discussions in the comments section about the term "liquidity". You here it all the time now, its become a buzzword. Now the "G20" is talking about "planning to plan" to remove their stimulus "liquidity". (of course no actual action is taking place just a lot of talk of planning to plan things)

People and media in general like to use the term liquidity. You here things like "its all about liquidity and liquidity moves the markets" or some such dictum. Or "High Frequency Trading" provides liquidity. Or the choking of liquidity is a therefore a "credit crisis". You here media stories talking about it all the time as if "liquidity" is a living thing in and of itself!

But what does it really mean?

What is liquidity? Breaking it down to its most basic definition I googled the term several times and came up with this: "Market liquidity refers to an asset's ability to be easily converted through an act of buying or selling without causing a significant movement in the price and with minimum loss of value. Money, or cash on hand, is the most liquid asset. "

Sounds ok and something CNBC would approve of (the minimal loss of value part). But is that a truthful or useful definition? Is liquidity a natural occurring substance that can be harnessed or controlled for the good of mankind? Can we drill for liquidity in deep reservoirs under the ocean and provide economic benefit for all? Of course not!

(Ok Dan just get to the point!) I came up with my own set of definitions for liquidity:

1) Liquidity is the easy flow of assets, fiat money and credit from one entity (person) to another.
2) Liquidity in the 21st century is mostly the result of the creation and flow of credit.
3) Liquidity is a state of mind.

Notice I dropped the "minimal loss of value" part. Something that has a market is liquid. Even the fraudulent MBS portfolios were liquid. The fact that they only fetched .06 - .10 cents on the dollar is not a loss of liquidity. It just means that people wised up to the fact that it was all a tulip bubble! Why would we think of fraudulent, overpriced assets as "illiquid" as if the some abstract entity was responsible for the dropping in value of these assets? Liquidity was not a problem. People coming to their senses was the problem!

I really only needed to state part 3) of the definition, "Liquidity is a state of mind". Simply put, liquidity is a byproduct of social mood. When we are in an socio-economic upswing, liquidity is more ample. (We pay and offer more!) When we are in a downswing, liquidity is tighter (We pay and offer less!) . Its that simple.

Based on that logic, you can see that liquidity is not some abstract energy that can be harnessed, dispensed at will or is something that can be separated from the greed and fear of mankind. Liquidity cannot be "forced" into the marketplace. The FED doesn't "control" liquidity.

So yes, liquidity does "drive the markets" but it is mankind's social mood that determines the state of liquidity.

So that is what bonkers me sometimes when I hear that term "liquidity" and how it is used. The term has become a placeholder for social mood. An excuse. Saying things like "The market crashed because liquidity dried up in a credit crisis is akin to saying, "The dog ate my homework".

Instead how about the more accurate "The market crashed because humans were fearful" (and rightfully so!). And when you think of it like that you realise liquidity really is not the cause. The market was certainly liquid in providing selling prices of assets in the"crash" of 2008. There was no liquidity problem as far as my definition 1) easy flow of assets from one entity to another. That certainly happened. People wanted to sell and they found buyers! The markets actually functioned pretty good when you think about it. Just because prices dropped drastically and were to the chagrin of the "Fast Money" people doesn't mean there was a lack of liquidity.

How about my definition number 2) Liquidity in the 21st century is mostly the result of the creation and flow of credit? Ah well there we have the crux of the problem! That is why the world is in a mess in a nutshell! Credit is, in its basic essence, borrowing from your future earnings. And boy, we have ramped up borrowing to an extreme state. The world has "doubled down" on its credit. Doubled down on liquidity. It can only end badly.

Which brings me back to the story of the G20 and the quote I found in the story: "Officials are instead focused on discussing the framework for a coordinated reversal of emergency measures once the economy has stabilized."

Just what does that mean?

In a nutshell they are going to stop the flow of credit (liquidity)! They know it has to happen. They know the madness (borrowing at an exponential rate) cannot continue or else they risk upsetting the "status quo" or social mood to the point of worldwide revolution when it all comes crashing down. (Yet it will anyway). They realize that it is madness but they won't say so. The finance ministers of the world quietly must know, "we cannot cheat nature in the long run." They must know it in their hearts. They are growing fearful along with general worldwide social mood.

However even with all the words they spew, they cannot act. They will not act. They are the herd. Government can only react, and react late. They are always the last to a trade. It is one axiom you can count on: Government (the herd) will only exasperate things. The herd is never the answer. Politicians are not savants, particularly 21st century politicians. They are subservient to ineptitude. You can actually make money on that fact. It is one of the reasons why I am calling for the ultimate bear market low of under 1000 DOW. The government's predictable bearish actions will ensure it! Toward the end of the bear market they will pass laws to prevent the market from crashing after the fact! (Count on it!)

And in the end, Governments will act on that growing fear somewhere along the line. They will pull the line of credit when it is needed most. One nation will "break ranks" and others will follow. They will inflame the situation at hand. You can count on it.

And 21st century "liquidity" will be revealed for what it is: A great Ponzi of worldwide proportions. An act of faith. And when faith monetary systems fail. Look it up in the history books.

Nature cannot be cheated forever in the end. She demands payment. Liquid payments.

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