Friday, November 7, 2008

Liquidity Is Noncontagious

(Felix Salmon) This is why Treasury's original TARP plan, to buy up illiquid assets, was doomed from the start, and why it's good news we've moved on from there:

J.P. Morgan Chase & Co. said Friday that its Level-3 assets increased $1.3 billion in the third quarter...
The New York financial-services firm said the increase was largely the result of $15.2 billion of transfers of assets into Level 3, principally AAA-rated collateralized loan obligations backed by corporate loans for which liquidity decreased and market activity was limited...
J.P. Morgan said the increases were largely offset by decreases in Level-3 assets due to $12.3 billion of sales and markdowns of residential mortgage exposure and $3.5 billion of sales and markdowns of leveraged loans and transfers of similar leveraged loans to Level 2 due to the increased price transparency of such assets.

This kind of stuff isn't easy to read, but the point is that over the course of the third quarter, CLOs became so illiquid that there was no market for them at all any more, and they had to be classified as Level-3 assets. At the same time, however, the leveraged loans which make up those CLOs managed to see "increased price transparency", with the result that they got promoted to Level 2 from Level 3.

The idea behind the TARP was that liquidity and price transparency could trickle upwards from simple to more complex instruments. If you know the price of a bunch of bonds, then you can work out the price of the CDO that they're packaged into. And if you know the price of a bunch of CDOs, then you can work out the price of CDO-squareds. And so on.

But as JP Morgan shows today, it doesn't really work like that: it's entirely possible for loans to become more liquid even as CLOs become less liquid.

There's actually a good reason for that. In crunchy times like this, there's a finite amount of liquidity to go round, and when it arrives in one neck of the financial woods, that's often because it's left another. For instance, CDS are popular because they're more transparent and liquid than bonds. But the rise of CDS has seen liquidity move from the bond market to the CDS market, which means that bonds have become increasingly illiquid as the CDS market has grown. Far from making it easier to price bonds, the CDS market has actually, in some ways, made it harder.

And so Treasury's plan for some kind of trickle-up TARP liquidity was always overoptimistic. You might be able to make one market liquid and transparent, but that doesn't mean that related markets will be any easier to price.

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