Illiquid assets

GLOBAL INVESTOR 1.15 — 05
Investors and firms share a common problem:
liquidity risk premiums are hard to gauge, both
across different types of assets and over time.
Liquidity does not manifest itself in standard
measures of risk, such as price volatility. In
fact, in normal times, illiquid investments are
not necessarily more volatile than liquid ones.
Of course, price volatility may simply be hidden
because illiquid investments are priced
at lower intervals – turnover is itself a definition
of liquidity. However, even in equity markets,
as we learn from Yale’s Roger
Ibbotson (see page 10), lower turnover
stocks actually proved more resilient
(and less volatile) during the financial
crisis in 2008 than their highly liquid peers.
Bringing it all together
not really refer to
the availability of cash
in the economy, but rather
to the smooth functioning of financial markets
and thus the economy as a whole. To a financial
firm, liquidity refers to the ability to meet
its debt obligations without becoming insolvent.
While cash holdings (a liquid balance
sheet) provide a buffer against losses, the
ability to convert assets into cash to meet
current and future cash flows – its funding
liquidity – can prove critical for survival in the
event of stress. Therefore, funding liquidity is
now a key regulatory imperative. Nevertheless,
central banks ultimately will always need
to act as a backstop to commercial banks; as
the role of commercial banks is typically to
invest clients’ liquidity (deposits) in less liquid
assets, they would structurally not have sufficient
liquidity to withstand a bank run.
On premiums and risk
While the different concepts of liquidity are
often treated in isolation, it is essential to try
to understand how they interact. We know
that liquidity black holes wiped out entire
markets, such as the junk bond market in
the mid-1990s, and the subprime mortgage
market more recently. We understand that the
deterioration of balance sheets forced banks
to cease lending, resulting in a vicious liquidity
squeeze that required significant policy
intervention to restore confidence so that the
financial system could fulfill its most basic
purpose. The most challenging part of the
liquidity discussion is that it depends heavily
on circumstances. The financial crisis was
such a profound event that it still has a significant
impact on investors’ attitudes toward
illiquid investments. Consequently, entire asset
classes are being shunned, sometimes
unjustifiably, and genuine opportunities will
be exited prematurely or missed altogether.
In other cases, investors may actually end up
paying too much for liquidity. If history has
taught us one thing about liquidity, it is that it
is often self-fulfilling, and at times a mirage.