Liquidity Management is the First Priority of Risk Management

This leson goes way back with me, to my graduate student days, where I was assisting the teaching of Corporate Financial Management.  At UC-Davis, this was the class that attracted the bright and motivated students.  I happened to get it as my first assistant role at UCD, not realizing it was a plum role.

One of the things we taught was that most firms suffer financial distress from a failure to manage cash flow properly.  That is a salient lesson in the current environment.  I learned it again as a young life actuary, because life insurance companies can die from credit risk, run-on-the-company risk, or both.  Consider Mutual Benefit, which wrote fixed-rate GICs [Guaranteed Investment Contracts] putable on a ratings downgrade, or General American and ARM Financial, which wrote floating-rate GICs putable on a ratings downgrade.  The downgrades hit.  They were toast.

Illiquid assets must be funded by equity or long-term noncallable debt, where the term is as long as the asset’s horizon.  (Near asset price tops, longer, near bottoms, long enough for comfort.)  This is the first step in orthodox risk management: assuring that you can hold onto your assets under all conditions.

But in this current crisis, this rule has been violated many times:

  1. Taking on mortgages where the payments can reset upward.
  2. Hedge fund investors thinking that their funds were liquid.
  3. Venture capital investors presuming that they would easily have the money to fund future commitments.
  4. Banks financing illiquid assets with liquid deposits.
  5. Pension plans and endowments going overboard to buy alternative assets.  (More on pensions: one, two, three)
  6. General Growth, and other REITs choking on maturing short-term debt.
  7. US states, especially California, presume on continuing good times, and overspending what would be sustainable in the intermediate-term.
  8. Investment banks and mortgage REITs that relied on short-term repo funding.  Bye-bye, Bear and Lehman.  Mear miss to Merrill, protected by Bank of America.  Many mortgage REITs dead, or nearly so.
  9. Derivative counterparties like AIG do not factor in the need for more collateral during times of credit stress.
  10. ABCP and SIVs presume that easy lending terms will always be available.

This is the advantage of the actuarial model of risk over the financial model of risk.  I have previously called it table stability versus bicycle stability.  A table always stands, whereas a bicycle has to keep moving to stay upright.  What happens if markets stop trading in any reasonable fashion?  WIll you be broke?  I submit that that is not an acceptable risk to take, because markets do fail for moderate amounts of time.

Better to manage such that you can buy-and-hold for moderate lengths of time, with enough financial slack to tide over rough patches in the market.  Analyze your cash flows over pessimistic scenarios, and ask whether you can carry your positions with sufficient certainty.  Sell down your positions to levels where you are comfortable.

When I was the risk manager for two life insurance companies, one of the first things that I did was analyze the illiquidity of my assets and liabilities, making sure I had liquidity adequate to fund illiquid assets.  The second was analyzing cash flow needs and making sure there was always more cash available than cash needed, under all reasonable scenarios.

This is risk management at its most basic level.  Many on Wall Street looked at short-term asset/liability correlations, and missed whether they could adequately finance their businesses under stressed conditions.

With that, I ask you:

  • Do you have an adequate liquidity buffer against negative events?
  • Are you only risking money that you can afford to lose in entire?
  • Are the companies that you own subject to financing risks?

Asset allocation is paramount in investing.  Bonds and cash get sneered at, but they play an important role in risk reduction for both individuals and institutions.  As my boss at Provident Mutual taught me, “Never risk the franchise.”  That motto guided me, and I avoided crises that other companies suffered.

Will it be the same for you and your assets?  Analyze your survivability in personal finance, and that of your assets, and make adjustments where needed.