Where Do Illiquid Credit Markets Lead?

It’s axiomatic that the real news and analysis that matters most gets buried in the stuff that moves the needle for the radio and TV cable news networks. Case in point today is this extraordinarily good article by Felix Salmon. Let me excerpt a bit of his writing with an explanation to follow.

Liquidity is drying up across the bond markets. Regulations designed to curtail banks’ leverage have had the unintended consequence of also sharply reducing their ability and willingness to make markets in corporate and even government debt. New regulations on the leverage ratio that will reduce banks’ repo funding books threaten to make matters even worse and to spread the drought from credit markets to rates, the underpinning of all financial markets. Secondary markets are close to a breakdown that will soon imperil the primary markets on which companies and sovereigns depend for funding. All that is masking the decay is the extraordinary actions of central banks.

That’s actually taken from a Euromoney article, which is unfortunately available by subscription only, but you get the point. Liquidity is vanishing and that’s one mother of a problem. Felix does a good job of explaining the ramifications of all of this as well as fairly noting that the solution – the buy-side investors making a market – isn’t happening and likely won’t. Perhaps the most interesting part of his analysis is the observation that the natural result is going to be a liquidity premium, or his words an “illiquidity premium” tacked onto the yield. He reckons that major corporate issuers will just deal with an extra 50 basis points but not sovereigns. I’ll get to the issue of sovereigns in a moment but let’s pause for a moment and think about those extra 50 bps or whatever it amounts to might mean for another sector.

What Felix didn’t touch on is the potential effect on consumer rates. Illiquidity doesn’t discriminate in its choice of targets. Credit cards, MBS and auto loans are not immune. A premium can and will have some impact on retail sales, the inability to liquify those receivables would be devastating. Felix is right to suggest that corporate issuers could weather higher borrowing costs, I don’t think the same can be said of the retail side. A liquidity squeeze can behave much like a financial panic. As issuers perceive the problem they rush to pick up the last dollar, the market begins to migrate to the paper with the least risk, buyers vanish and the least desirable paper goes wanting for demand. The consumer receivable market, including real estate, will be the tail no one wants.

Felix makes the point that sovereigns rely on the markets and their historical liquidity to finance and refinance their debts. A dearth of liquidity is, therefore, occurring at a particularly bad time given the need to roll over as well as refinance record amounts of debt. Here are his thoughts.

Sovereigns, however, are another story — they need to borrow in size, and they have historically relied on liquidity issues to ensure that they get the cheapest possible rate. (That’s the main reason why US Treasury bonds have the lowest yields in the world, on a swapped-into-dollars basis: it’s all about the liquidity, not the credit risk.) The great bond liquidity drought is arriving at the worst possible moment for G20 sovereigns which are already struggling with unprecedented levels of bonded debt. It’s always liquidity that kills you, not insolvency: it’s the inability to roll over your debts as they come due. Which means that the next wave of sovereign debt defaults might come even sooner than many analysts currently fear.

Right now the “great bond liquidity drought” is not a problem since central banks around the world are sucking up massive amounts of issuance. Though this drought isn’t front page news, don’t for a second think the Bernankes of the world aren’t aware of it, nor should you assume that they will suddenly withdraw and leave economies to the tender mercies of a dysfunctional bond market. QE may be with us for much longer than anyone suspects. Radical surgery caused the markets to seek life support and there appears to be evidence they aren’t nearly ready to function without a respirator.

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