Here are some simple propositions on liquidity:

  1. Liquidity is positively influenced by the quality of an asset
  2. Liquidity is positively influenced by the simplicity of an asset
  3. Liquidity is negatively influenced by the price momentum of an asset
  4. Liquidity is negatively influenced by the level of fear (or overall market price volatility)
  5. Liquidity is negatively influenced by the length of an asset’s cash flow stream
  6. Liquidity is negatively influenced by concentration of the holders of an asset
  7. Liquidity is negatively influenced by the length of the time horizon of the holders of an asset
  8. Liquidity is positively influenced by the amount of information available about an asset, but negatively affected by changes in the information about an asset
  9. Liquidity is negatively influenced by the level of indebtedness of owners and potential buyers of an asset
  10. Liquidity is negatively influenced by similarity of trading strategies of owners and potential buyers of an asset

Presently, we have a lot of commentary about how the bond market is supposedly illiquid.  One particular example is the so-called flash crash in the Treasury market that took place on October 15th, 2014.  Question: does a moment of illiquidity imply that the US Treasury market is somehow illiquid?  My answer is no.  Treasuries are high quality assets that are simple.  So why did the market become illiquid for a few minutes?

One reason is that the base of holders and buyers is more concentrated.  Part of this is the Fed holding large amounts of virtually every issue of US Treasury debt from their QE strategy.  Another part is increasing concentration on the buyside.  Concentration among banks, asset managers, and insurance companies has risen over the last decade.  Exchange-traded products have further added to concentration.

Other factors include that ten-year Treasuries are long assets.  The option of holding to maturity means you will have to wait longer than most can wait, and most institutional investors don’t even have an average 10-year holding period.  Also, presumably, at least for a short period of time, investors had similar strategies for trading ten-year Treasuries.

So, when the market had a large influx of buyers, aided by computer algorithms, the prices of the bonds rose rapidly.  When prices do move rapidly, those that make their money off of brokering trades take some quick losses, and back away.  They may still technically be willing to buy or sell, but the transaction sizes drop and the bid/ask spread widens.  This is true regardless of the market that is panicking.  It takes a while for market players to catch up with a fast market.  Who wants to catch a falling (or rising) knife?  Given the interconnectedness of many fixed income markets who could be certain who was driving the move, and when the buyers would be sated?

For the crisis to end, real money sellers had to show up and sell ten-year Treasuries, and sit on cash.  Stuff the buyers full until they can’t bear to buy any more.  The real money sellers had to have a longer time horizon, and say “We know that over the next ten years, we will be easily able to beat a sub-2% return, and we can live with the mark-to-market risk.”  So, though they sold, they were likely expressing a long term view that interest rates have some logical minimum level.

Once the market started moving the other way, it moved back quickly.  If anything, traders learning there was no significant new information were willing to sell all the way to levels near the market opening levels.  Post-crisis, things returned to “normal.”

My Conclusion

I wouldn’t make all that much out of this incident.  Complex markets can occasionally burp.  That is another aspect of a normal market, because it teaches investors not to be complacent.

Don’t leave the computer untended.

Don’t use market orders, particularly on large trades.

Be sure you will be happy getting executed on your limit order, even if the market blows far past that.

Graspy regulators and politicians see incidents like this as an opportunity for more regulations.   That’s not needed.  It wasn’t needed in October 1987, nor in May 2009.  It is not needed now.

Losses from errors are a great teacher.  I’ve suffered my own losses on misplaced market orders and learned from them.  Instability in markets is a good thing, even if a lot of price movement is just due to “noise traders.”

As for the Treasury market — the yield on the securities will always serve as an aid to mean-reversion, and if there is no fundamental change, it will happen quickly.  There was no liquidity problem on October 15th.  There was a problem of a few players mistrading a fast market with no significant news.  By its nature, for a brief amount of time, that will look illiquid.  But it is proper for those conditions, and gave way to a normal market, with normal liquidity rapidly.

That’s market resilience in the face of some foolish market players.  That the foolish players took losses was a good thing.  Fundamentals always take over, and businesslike investors profit then.  What could be better?

One final aside: other articles in this irregular series can be found here.

For those that want the quick hit and don’t care about the underlying ideas, here is the main idea:

A vehicle holding assets may appear more liquid than the assets themselves, but that is only true in bull markets.  When bad times come, the liquidity proves elusive, particularly for large trades.

ETPs are wonderful things, but there is one thing that ETPs can’t do.  They can’t change the underlying assets that they own.  Merely because you have the ability to buy or sell at will does not change the performance of the assets held.  Like most investment products, the amount of assets invested expands in a bull market and contracts in a bear market.

People follow trends.  As they follow trends, they tend to lose money, because they buy and sell too late.  As such, average investors in ETPs tend to lose money relative to buy and hold investors.

In this sense, liquidity is not your friend.  Just because you can trade, does not mean that you should.  Speculators tend to lose to the longer-term investors, who hold for longer periods of time.  Trading itself is a zero-sum game, but bearing risk is a positive sum game, if done with a margin of safety.

Also, if you are trying to do an institutional-size trade in an ETP, you will find that the market impact costs are significant.  Just because there is an exit door in the theater does not mean that everyone can get out instantly.

Repo Transactions

But here is my favorite bugbear in liquidity: repo transactions.  Repurchase transactions turn a long-term asset financed short into a short term asset.  Now the Fed thinks that it can control the repo market.

Honestly, the easy solution is to disallow the accounting treatment of repos, and force those who do them to display them as a long asset and a short liability.  Why?

Because in crises, the long assets are illiquid, and as such the value shrinks when liquidity is prized.  The liquid liabilities still demand to be paid at par.

The accounting change would be better than what the Fed thinks that it might do.  You can’t make long-dated assets liquid.  The cash flows are distant.  Yes, there may be some interest payments that are near, but ultimate repayment of principal is distant.

Let me suggest a better concept of liquidity: assets are liquid to the degree that you can turn the underlying into cash.  When I say that, I do not mean trading big blocks of stock, but selling companies for cash.  That is liquidity, and as such most risky assets do not have significant liquidity, though many trade every day during bull markets.

Liquidity is a scaredy cat, it disappears when it is most needed.  That happens because people think they can sell at par when they can’t.

All for now, but remember this — liquidity is a bull market phenomenon.  People are far more likely to trade when they have unrealized gains rather than losses.


Here are the predecessor posts in this series:

This series has been very irregular.  But it does include the first real post at this blog.  It is something that I think about frequently, and my best summary for what liquidity means is:

What does it cost to enter or exit fixed commitments?

Tonight I want to take a slightly different approach, and talk about two aspects of liquidity: assets and liabilities.

On the liability side, we can look at publicly traded assets and say that they are liquid, though many may only be fungible.  When I was a bond manager there were some trades that took days or weeks to set up.  Some were public bonds coming to market that were complex, others were asset- and mortgage-backed bonds that took some time to research.  Some were pure privates where you were trading the whole chunk or nothing — it was not far distant from being a bank.

With many investments, there is a liability structure.  Yearly, quarterly, monthly, daily liquidity.  Funds are locked up for three or five years.  Funds are locked up until assets are liquidated, and you might be paid in kind, not cash.

The ability to get cash is an important aspect of liquidity.  But so is the ability to preserve value, and that is the asset side of the question.  After all, liquidity means that you have assets that preserve value, such that you can liquidate and spend it.

From an asset standpoint, stocks are liquid as far as trading goes, but not liquid in terms of preserving value in the short-to-intermediate run.  Equity is illiquid, whether public or private.  It offers no protection of value.  Think of it this way: if you were going to buy a house in a few months, would you invest your down payment in stocks?  It would not be wise to do that.

There are various ways of owning equities, and other investments.  It is more important to understand the riskiness of the assets, than the shell in which the assets are held.  The shell may offer liquidity at intervals, but that has no effect on the underlying value of the assets.

Thus I will say it it is far more important to focus on the value of the assets, than on when cash will be released to you.  As one of my bosses said to me:

Liquidity follows quality.  The better the asset is, the more liquid it becomes.

As a result, those wanting to do best in investment management should keep a supply of short-to-intermediate high-quality debt as the performance of risk assets may vary considerably, which will affect the ability to achieve fixed commitments.

Liquidity is the ability to preserve value for near-term spending.  Thus both asset and liability aspects of investments have to be considered when considering liquidity — it is not only ability to liquidate, but to receive value back in real terms.

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.

When I was a corporate bond manager, I often dealt in less liquid bonds.  Why?  They had more yield, I only bought those that my credit analysts liked, and I had a balance sheet that could hold them.  I had the option of holding those bonds, but not the obligation of holding those bonds.  As credit conditions improved in early 2003, to leave my successor with a simpler portfolio, I decided to lighten my holdings of bonds issued by a private bank.  I held 35% of the issue, and bought most of it near the height of the panic.

I told my secretary, “The phone will start ringing off the hook in 30 seconds.”  She gave me that usual sweet smile and said, “Okay, David.”  I offered a chunk of the bonds 0.2% below the last trade in spread terms, without guaranteeing the level.  To my surprise, I got a lot of bids rapidly, to the point where I said “whoa! there are too many that want these bonds.”  I recalibrated my levels and offered a “supply curve” of bonds, where I offered more the higher the price went.  I ended up selling 2/3rds of my holdings, and made significant gains for my client.  The final trade was 1/2% tighter than my initial proposed trade.

Having traded small and microcap stocks, and traded illiquid bonds, I am less afraid of illiquidity than many are.  Illiquidity is something that one can absorb, if he has a strong balance sheet and a patient disposition.

The great Peter Lynch would buy small cap stocks for Magellan, with strict orders on price.  Then he would let them sit, while they gained in value on average.  Marty Whitman buys in “safe and cheap” small cap stocks that are illiquid and holds them until their value is recognized.

If you have a strong balance sheet or patient investors, take advantage of it, and buy investments that are less liquid, where value may take a while to obtain.

But liquidity is not natural to all assets.  Most things in an average person’s life will not be liquid.  Your house and car are not liquid.  It will take a lot of effort to sell them and buy a different house and car.  So why should futures on property values be liquid, or residential mortgage-backed securities?

Well, debts that are very certain will always be liquid.  Debts that are less certain will be liquid during boom-phases, and illiquid during bust-phases.  In general, that is why AAA-rated asset-backed securities, which are usually “last loss” securities are fairly liquid, while lesser-rated securities trade rarely.

My point is that you can’t take illiquid assets and make them liquid.  Assets are liquid because they are short term, where one knows the cash flow to be received soon.

Are public stocks, like Exxon Mobil, liquid?  In one sense, yes.  During the day, when trading is in session, and there is
no news hitting the wire, then yes, quite liquid — one can get in and out of a position easily with little difference between the bid and ask.  But, when news hits, or from the closing price to the next day’s open, the price can move considerably.

Over a long period of time, the shares of two companies in identical businesses, one publicly traded, and one privately held, could deliver the same value over a long period of time.  The public company would have the ability to adjust its capital structure to buy in shares when they are cheap, and sell when they are dear, unlikely as that behavior is.  The public company would adjust its debt levels more frequently, while the private company would likely keep debt high and equity low, to keep taxes low.  The private company could act quietly and think longer term, subject to the constraints of their loan agreements.  The public company would have more bumps to its seeming value from news events, including earnings releases.

For the holder of shares in the public company, though liquidity is available, the value of the shares will vary.  For the public and private companies alike, liquidity for any large amount of the shares would be an event.  And, aside from successful maturity dates, the same would be true of large amounts of debt — there might be a public market available for small amounts of it, but just try to buy or sell a big amount, and pricing conditions are rarely favorable.  My example at the start of the post, where I sold 20% of the total issued amount for a favorable price, only happened because the willingness of investors to take risk increased dramatically since the last trade.  Yield greed had set in.

But that brings up the other definition of liquidity — what does it cost to enter/exit fixed commitments?  Tight credit spreads mean that corporations can (borrow) enter fixed commitments cheaply, and lenders, dearly.  The same applies to Fed policy — a wide Treasury curve means that it is expensive to borrow long, and cheap to borrow short — but borrowers want more security than to have a short maturity leash.

But when lenders are scared, they gravitate to short loans and high quality — cash equivalents lent to the Treasury.  If enough do that, short term yields get really low.  They can even go negative.

I remember arguing with a visiting professor at Wharton back in 1990 that negative interest rates were possible.  He told me I was nuts, people would sit on cash.  I replied, “what if you can’t keep the cash safe?”  Maybe I should have said, “What if it is inconvenient to transfer and guard several billion dollars in cash?  There are costs to that as well.”

In a liquidity trap like we are in, short-term money managers that must have US Treasury collateral must bid for it, no matter what.  They can’t move to cash.  Cash to them is very short-term debts of the most creditworthy entity that they know — their Government, the one that controls the Fed, sorta.

But the volume of lending, particularly to smaller business borrowers is light.  Is there really a lot of liquidity out there?  Or, is it being used primarily by the US Government and its affiliates while the economy is weak?  I think that is the case.

Liquidity is not magic; it can’t be created or destroyed — it just travels where it is needed.  During booms, liquidity appears abundant because of loose monetary policy and high willingness to take credit risk.  It seemingly disappears in the bust, as the marginal fixed income investor attempts to eliminate credit risk — liquidity then flows to the highest quality assets.

Liquidity is always around; it is only a question of where the marginal credit buyer has migrated.  In the current environment, it is short high-quality obligations that are still king, and lower-quality longer obligations that trail, though not as badly as last winter.

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.

Liquidity is a function of human action.  We all have to work and trade to survive.  Liquidity is where people are transacting at any given moment toward that end.  Structural changes in the economy, whether by the government or through private channels will shift where liquidity goes, but it will not change the amount of liquidity, unless the changes are so severe that the economy itself becomes much less productive.

I have had a number of posts on liquidity over the past few years, in an attempt to explain an ill-understood phenomenon.  Here is a sampling:

Because of high frequency trading, I want to take another stab at what liquidity is.  Limit orders offer liquidity; an investor or market maker offers to buy or sell at a fixed price.  Market orders consume liquidity — they lift or hit limit orders, often forcing the bid-ask spread wider.

But not all limit orders are the same.  They vary because:

  • Some limit orders narrow the bid-ask spread, which aids liquidity.
  • Some limit orders bid/offer more shares, which increases liquidity.
  • Some limit orders hang out there for a long time, which also boosts liquidity.

Liquidity means being able to make a choice, and if possible to do it in size, at a price that you like.  Also, for many of us, it means that we have some amount of time to think about the price.  That is liquidity — the ability to buy or sell in size without having to “bust a gut” to do so.

High frequency traders claim to add liquidity, but their bids and asks are ephemeral.  They add little liquidity, because the average investor can’t act on them.  They are like market orders, because they are gone in a flash, consuming longer-dated liquidity.

I am not saying that high frequency trading should be illegal, but that investors and market makers should carefully consider the rules where they trade.  For investors: are you trading in a market where you have a disadvantage?  For market makers: you should be the heavy hitter here; don’t let anyone more powerful/fast in.  Operate your market for the best interests of all, and ignore those that want an advantage.  In some cases this may mean executing trades once every five seconds, or any such similar interval.

Level playing fields promote broad markets.  Let clever market makers so structure their businesses, that level playing fields dominate investing.

Liquidity is like water. Is water a solid, a liquid, or a gas? Depending on the situation, water can be any or all of the three. When I started my blog, my first serious post was “What is Liquidity?” Given what was about to happen in Shanghai seven days later, and what that would do to liquidity, the post was ahead of its time.

Yesterday I saw two posts on liquidity:

Both had a number of good points, though I like my piece better.  Let me borrow from Peter Bernstein, where he said something to the effect of “Liquidity is the ability to have a do-over.”  In other words, if you make an investment mistake, how much does it cost you to reverse it?

The three aspects of liquidity:

  • What sort of premium does it take to get someone to lock into a long-term commitment?
  • Slack assets available for deployment into new investments, and
  • Bid-ask spreads

are correlated.  When there are few slack assets relative to investment needs, large premiums have to be offered to get investors to lock into a long-term investment, and bid-ask spreads tend to be wide as well.

But let’s consider the flip side of liquidity.  Liquidity is akin to holding a long option.  Rising volatility is the friend of one who has liquidity or a long option.  But, being long an option means someone else is short an option.  Having liquidity means that someone else has to provide cash should you choose to buy something.  If you liquidate shares in a money market fund, cash must come either from new investors in the fund who take your spot, or the fund has to raise liquidity internally, handing you some of the proceeds from not entering into an overnight loan.

Or, consider the bid-ask spread in stocks, or other securities.  When the bid-ask spread is tight, it means that the market maker (or specialist), is comfortable that short-term volatility is low enough, that he will be able to profit from the tight spread on average.  When there is severe uncertainty, as there often is in esoteric fixed income instruments during a panic period, the bid-ask spread disappears, and one is reduced to “price discovery, using a broker who is discreet about your intentions regarding buying or selling.  (My, but I got good at that during 2001-2003.   Ouch.)

I like my definition of liquidity, which is the willingness (price) to enter into or exit fixed commitments.  It covers all three aspects of liquidity, and helps explain why they are usually different manifestations of the same phenomenon.

As for now, versus mid-February 2007, the willingness to enter into fixed commitments has declined markedly, even though it has improved over the last seven weeks.  That is no guarantee that it will continue to improve linearly.  Bear markets have their rallies, and this current rally has been a good one.  It would be rare to have such a short bear market, or one that ended without clearing away most of the prior excess lending problems.  We still have a lot of wood to chop there.

Many market commentators, myself included, have been talking about the amazing amount of liquidity in the markets. Caroline Baum wrote a piece recently asking what liquidity really was, and she did not draw any real conclusion, in my opinion. For someone as smart as Caroline Baum to not come to a conclusion, means the concept must be pretty tough.

Last week’s copy of The Economist took another stab at it, and here is the critical quotation:

Helpfully, Martin Barnes, of BCA Research, an economic research firm, has laid out three ways of looking at liquidity. The first has to do with overall monetary conditions: money supply, official interest rates and the price of credit. The second is the state of balance sheets—the share of money, or things that can be exchanged for it in a hurry, in the assets of firms, households and financial institutions. The third, financial-market liquidity, is close to the textbook definition: the ability to buy and sell securities without triggering big changes in prices.

Pretty good, but it could be better. These are correlated phenomena. Times of high liquidity exist when parties are willing to take on fixed commitments for seemingly low rewards. Credit spreads are tight. Credit is growing more rapidly than the monetary base. Banks are willing to lend at relatively low spreads over Treasuries. Same for corporate bond investors. And, if you are trying to generate income by selling options, it almost doesn’t matter what market you are trading. Implied volatilities are low, so you realize less premium, while giving up flexibility (or, liquidity).

The demographics of the developed world favor saving over spending, given the given the graying of the Baby Boomers. Given that the excess credit is heading for the financial markets, and not to the goods markets, we are getting asset price inflation, but not goods price inflation. Spreads tighten, implied volatilities drop, and companies get bought out of the public markets, and get levered up in the private markets. The excess of credit also lowers the costs of carrying assets, which in turn leads to more trading, and bid/ask spreads tighten.

In short, what we are faced with is a situation where there is increasing leverage among market intermediaries in order to earn high returns off of assets with low unlevered returns. This cannot persist indefinitely, and when it reverses, the markets will be ugly. This is why you should insist on high quality stocks and bonds in this market environment. When the willingness to take risk diminishes, the low quality stuff will get killed.

These articles appeared between May and July 2011:

Most People are not Better off Buying Common Stocks on their own


Why Amateurs Should Invest in Common Stocks

Yes, I wrote them both, but they complement each other.  Yes, most average people get skinned investing in common stocks, but if you apply yourself assiduously to investing, it will improve your performance in other jobs, by broadening your skill set.

Impossible Dream, Part 2

Impossible Dream Project, Part 1

The latter of (part 1) these was my highest day and month for access of my blog.  I came close to eclipsing the monthly total last month, but missed by 2%.  These pieces take up asset allocation via valuation, and momentum.

Learning Leadership

A story of how Roy and I disobeyed orders a little, and created a lot of growth for the company that we served.  Personally, I think this is a great story… I never created more value than when I worked for Provident Mutual.

On Longevity Derivatives

I like to think that I am an intelligent skeptic on derivatives; in this case credit risk fights any real hedging.

Segmenting to Make Better Decisions

The smaller the range of choices is, the better people do in choosing.  One way to facilitate that is to break down decision making into a series of choices with each having few options.

The Rules, Part XXI

All assets represent future goods.  The prices of assets represent the trade-off between present goods and assets.

The Rules, Part XXII

Rapid money supply growth with no consumer price inflation can only really occur within the confines of an asset price bubble, or else, where does the money go?  Interest rates are low at such a time because of the incredible liquidity, and complacency of lenders that they will get an equal amount of purchasing power back.  Perhaps another possibility is when a country’s currency is being used more and more as a shadow currency, like the US in the Third World.  But even that will come home someday.

Learning to Like Lumpiness

This is probably one of the most important articles I have written, because investment returns are lumpy, and we need to learn to live with it.  For those of us that are smart, we need to take advantage of it.

What is Liquidity (V)

Liquidity cannot be created, but it can be redirected.

Got Cash?

Cash is valuable even when interest rates are low.  Cash is flexibility and optionality.

Enduring Ponzi

Madoff’s Ponzi scheme lasted so long because it raked off so little.

The Costs of Illiquidity

On the tradeoff of liquidity in order to get yield.

Silent as Night

It also taught me a lesson.  When fees are deducted daily, no one notices.

“Is He Economically Rational?”

Now after all of this, it’s not so much a question of rationality but ethics.  Who will do the right thing for the one he ultimately serves?  Working for those people is a joy, and is beneficial to those that own. Doing right does well for many.

Downgrade Jitters

On why credit ratings are opinions, and not facts.

Where to Hide?

How to preserve purchasing power, even when it is difficult.

The Costs of Illiquidity — II

Don’t buy REITs that are not publicly traded.


This portion goes from February 2010 to April 2010.

Probably the biggest new thing I did at the blog was start “The Rules” series.  Personally, I think all of them are best articles, because they proceed from deeply held beliefs of mine.  So I start with those:

The Rules, Part I

There is no net hedging in the market.  At the end of the day, the world is 100% net long with itself.  Every asset is owned by someone, regardless of the synthetic exposures that are overlaid on the system.

The Rules, Part II

Unless there is a natural purchaser of an exposure that one is trying to hedge, someone must speculate to a degree to allow you to hedge.  If the speculator is undercapitalized, risks to the financial system rise.

The Rules, Part III

The assumption of normality for asset price changes is wrong in virtually every financial market setting.  The proper distributions are fatter tailed and more negatively skewed.

Normality allows researchers to publish, regardless of the truth.

The Rules, Part IV

Governments that scam the asset markets (and their citizens) take all manner of half measures to defend failed policies before undertaking structural reform.  (This includes defending the currency, some asset sales, anything that avoids true shrinkage of the role of government.)  The five stages of grieving apply here.

The Rules, Part V

Massive debt issuance on a sector-wide basis will usually have a slump following it, due to a capacity glut.

The Rules, Part VI

History has a nasty tendency to not repeat, when everyone is relying on it to repeat.

History has a nasty tendency to repeat, when everyone is relying on it not to repeat.  Thus another Great Depression is possible, if not likely eventually.

When people rely on the idea that a Great Depression cannot occur again, they tend to overbuild capacity, raising the odds of another Great Depression.

The Rules, Part VII

In a long bull market, leverage builds up in hidden ways within corporations, and does not get revealed in any significant way until the bear phase comes.

The Rules, Part VIII

Illiquidity is a function of total transaction costs, which can be considered barriers to entry.

The Rules, Part IX

Attempting to control a system changes it.

The Rules, Part X

The more entities manage for total return, the more unstable the financial system becomes.

The shorter the performance horizon, the more volatile the market becomes, and the more index-like managers become.  This is not a contradiction, because volatile markets initially force out those would bring stability, until things are dramatically out of whack.

The Rules, Part XI

Could an investment bank go to junk status?

The Rules, Part XII

Growth in total factor outputs must equal the growth in payment to inputs.  The equity market cannot forever outgrow the real economy.

And that’s the end of the “rules” posts for now.  They express deeply held beliefs of mine.

My next group of posts dealt with banking reform:

Most of it comes down to getting the risk-based capital formulas right, raising capital levels, and most of all avoiding borrowing short to lend long.  The asset-liability mismatch is the core of why banking crises happen, because the liabilities run when asset levels are depressed.

The next group deals with debts and liabilities of nations and other lesser governments:

Debt-based economic systems are inherently inflexible.  Governments that make long-term promises without pre-funding them scam their taxpayers, and those to whom they make promises.  All solutions are ugly once the willingness of a government to pay on its promises is questioned.

What is Liquidity? (IV)

My point is that you can’t take illiquid assets and make them liquid.

Moat, Float, Growth

Warren Buffett labors to preserve the company he has built, so that it can last far longer than he will.  An impossible task, but what is Buffett if not one that does things far beyond what most of us can do?

In Defense of the Rating Agencies – V (summary, and hopefully final)

I never did go on CNBC for this.  They figured out what I told them: “This wouldn’t make for good television.  It’s too complex.”  But it does come down to my five realities:

  • Somewhere in the financial system there has to be room for parties that offer opinions who don’t have to worry about being sued if their opinions are wrong.
  • Regulators need the ratings agencies, or they would need to create an internal ratings agency themselves, or something similar.  The NAIC SVO is an example of the latter, and proves why the regulators need the ratings agencies.  The NAIC SVO was never very good, and almost anyone that worked with them learned that very quickly.
  • New securities are always being created, and someone has to try to put them on a level playing field for creditworthiness purposes.
  • There is no way to get investors to pay full freight for the sum total of what the ratings agencies do.
  • Ratings can be short-term, or long-term, but not both.  The worst of all worlds is when the ratings agencies shift time horizons.