Understanding and Monitoring the  Liquidity Crisis Cycle Richard Bookstaber

In the aftermath of the Long-Term Capital Management debacle, it is clear that a large hedge fund can have a systemic impact on the market. The high leverage, forced liquidations, declining liquidity, and cascade of widening spreads turned the Greenwich, Connecticut, hedge fund’s losses into a global event. Without an infusion of capital to stem the need to liquidate to meet margin calls from its creditors, LTCM’s demise – and the collateral loss to its creditors – appears to have been inevitable. The natural questions to ask are: What was the cause of the crisis? How can this type of crisis be prevented in the future?

liquidity

Recent regulatory investigation into LTCM started with an ill-defined target, the community of “highly levered institutions.” There are problems, however, with pointing to high leverage as the critical characteristic in the LTCM crisis and, for that matter, in the general description of hedge funds. The most immediate problem is defining what leverage means. After all, using conventional measures of leverage, the leverage of many hedge funds pales beside the 20+ times leverage of the broker/dealer community. Another problem is understanding why leverage should matter. A hedge fund that holds one-year U.S. T-bills with 10:1 leverage would not be considered in the same league as a fund that is levered 2:1 in riskier and less-liquid Russian Ministry of Finance bonds.

Finally, not all hedge funds are highly levered by any definition. At any time, we can usually find some of the largest hedge funds with unencumbered cash – that is, not only with positions that are unlevered but also with free cash to spare.

The characteristics of hedge funds and other financial institutions that lead to potential crises do not rest entirely with their ability to take on leverage or with their ability to take large risks or to invest in illiquid markets. If a fund is highly levered but in instruments that have low risk and are highly liquid, the fund not only poses little risk to the market; it poses little risk to its investors. If it is in very risky instruments but unlevered, so that no creditors are involved and it has no risk of forced liquidation that could cascade into a problem for the markets, a fund’s failure may be unfortunate for the investors but it does not have systemic implications.

If it is in very illiquid instruments but not levered and has the stability of capital to allow a long holding period, a fund is no more of a concern than an insurance company that holds real estate in its portfolio.

What matters is the cycle that begins with the confluence of risk, leverage, and illiquidity—risk of loss coupled with leveraged positions, resulting in a need to liquidate into a market that cascades downward in price because of the rise in liquidation orders and the reduction in liquidity providers.

The liquidity crisis cycle

The liquidity crisis cycle consists of three stages. The first is a loss that acts as the triggering event. The second is a need by the fund to liquidate positions to meet the creditors’ margin requirements – or have the positions liquidated for it. The third stage is a further drop in the fund’s asset value as the market reacts to the fund’s attempts to sell in too great a quantity or too quickly for market liquidity to bear. The drop in prices caused by the need to liquidate precipitates an additional decline in the fund’s mark-to-market value, which leads, in turn, to yet more liquidations for margin or redemption purposes.

In principle, these stages can be modeled and the ultimate severity of the crisis can be measured. The likelihood of a triggering market shock can be determined by the distribution of the changes in market prices for the assets. For a fund that has a binding margin requirement, the amount it must liquidate because of the market shock will be related to the inverse of its leverage.

 

See full article on Understanding and Monitoring the Liquidity Crisis Cycle in PDF format here.

Via bookstaber.com