What is Liquidity (V)

I am sure that I will write more on this topic, should I live so long.  My contentions are:

  • Securitization does not create liquidity, it only redirects it.
  • The Fed does not create liquidity, it only redirects it.
  • The Treasury does not create liquidity, it only redirects it.

When I wrote this, one reader asked me to expand on this.  Let’s start with the simple one, securitization.  Take a bunch of loans.  How easy is it to trade them?  Not that easy.  The buyer will want to re-underwrite the whole thing.  It will take time, and time is the opposite of liquidity.

But when you securitize, the last loss pieces are very liquid.  After all, they are AAA/Aaa.  But that comes at a cost.  The lower-rated pieces are less liquid for two reasons.  1) the tranches are small. 2) in a bad situation, the principal could be wiped out in entire.

Securitization does not improve liquidity in aggregate, but it shifts liquidity to the AAA securities.

But what of the Fed and the Treasury?

They don’t create liquidity, as much as steal liquidity from savers.  The Fed creates liquidity through low interest rates, redirecting economic value from savers to debtors.  it is even more transparent in liquidity facilities they create and in quantitative easing, where they put the solvency of the central bank at risk.

Practically, the Treasury and Fed are a unit — think of the Fed as the commercial paper issuing arm of the treasury, though their commercial paper bears no interest, and is redeemable instantly.  We call them dollar bills.

The Fed and Treasury can redirect liquidity to their favorites, but it leaves the rest of the market starved.  The market will heal over time, but it is no credit to the Fed or Treasury.  The market finds ways to heal in spite of the actions of governments.