©2008 Pacific Investment Management Company LLC. Reprinted with permission. All rights reserved. MARCH 2008 ! 1

The Liquidity ConundrumPaul A. McCulleyManaging DirectorPacific Investment Management Company LLCNewport Beach, California

n this presentation, I will talk about the nature ofliquidity and put it in the context of what is going

on in the current marketplace. My simple thesis isthat liquidity is a state of mind. In the current marketand talk of a liquidity crunch, investors are asking,where did the liquidity go? This question reflects theconcept taught in basic economics that the moneystock is the liquidity in the market, which creates theconcept of liquidity as a pool of money. It is a verybank-centric concept of liquidity; the U.S. FederalReserve (Fed) injects and withdraws liquidity, andthe banks transform liquidity into deposits andloans. Thus, investors think of liquidity as a pool ofmoney, and during a downturn, they wonder wherethe liquidity went.

My answer is that liquidity is not a fixed pool ofmoney but, rather, a state of mind and, in particular,a state of mind regarding risk. Liquidity is the resultof the appetite of investors to underwrite risk andthe appetite of savers to provide leverage to inves-tors who want to underwrite risk. The greater therisk appetite, the greater the liquidity, and vice versa.Put another way, liquidity is the joining or separat-ing of two states of mind—a leveraged investor whowants to underwrite risk and an unleveraged saverwho does not want to take risk and who is the sourceof liquidity to the levered investor. The alignment ormisalignment of the two investors determines theabundance or shortage of liquidity.

Liquidity and NonbanksThe current market reflects the differences betweenbanks and nonbanks, or what I have named the“shadow banking system.” The shadow bankingsystem includes hedge funds, conduits, structuredinvestments, REITs, collateralized loan obligations(CLOs), collateralized debt obligations (CDOs), andso on. Each item is a levered investment vehicle. Inthat sense, they are similar to banks. But traditionalbanks are also very different.

The primary difference is that banks are regu-lated. The regulators implement capital require-ments that limit the amount of leverage a bank canhave on its balance sheet. In return for acceptingregulation, banks get two major benefits—depositinsurance and access to the Fed’s discount window,which translates into always having liquidity.Depositors generally do not care what banks aredoing with their money because, in their minds, theyare not giving their money to the bank but to theFederal Deposit Insurance Corporation (FDIC).They have no incentive to pull their liquidity becausethey are not really lending to the banker but to athird-party insurer—the U.S. taxpayer. If depositorsdecide to withdraw their liquidity, regulated bankscan take the assets that they were holding on lever-age down to the Fed, rediscount them, and maintainliquidity. That is the old-fashioned banking system.

But traditional banks have not been the marginalsource of liquidity growth in the last several years.Marginal liquidity growth has come from theshadow banking system—the group of levered inter-mediaries who take a lot of risk and are not regulated.As a levered intermediary without a regulator, they

For many years, economists believed that liquidity was a phenomenon that could beexplained by a consideration of the monetary aggregates. But if the problems of thesubprime mortgage market teach us anything, it should be that liquidity (or lack thereof)has much more to do with the appetite for risk on the part of borrowers and lenders.

This presentation comes from the New Frontiers in InstitutionalAsset Management conference held in Sacramento, California, on18 October 2007.

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do not have a defined capital requirement; they canhave as little capital as the open market will tolerate,and they can leverage more of their capital. But theydo not have the two benefits of traditional banks—deposit insurance and access to the Fed’s discountwindow. Therefore, nonbanks are more susceptibleto changes in the risk appetite of their deposit base,or funding sources that provide the leverage. Thetwo primary funding sources for the shadow bank-ing system are reverse repo and asset-backed com-mercial paper.

When the market’s risk appetite is strong, theliabilities of the shadow banking system look stable.Brokers mark to market investors’ collateral at facevalue, require reasonable margins, and never hasslethe nonbanks for more collateral, and the asset-backed commercial paper is picking up 2–3 bpsversus conventional commercial paper. Everythinglooks fine. Every 45–90 days, brokers roll over theasset-backed commercial paper, and effectively, theshadow banks have the same stability in their liabil-ities as the traditional banking system.

The only quasi-regulators that the shadowbanking system has are such ratings agencies asMoody’s Investors Service, Standard & Poor’s, andFitch Ratings. Before February 2007, the shadowbanking system had high ratings from these ratingsagencies and was easily funding itself with excessiveleverage ratios. Nonbanks were able to hold an assetat a tighter spread than the regular banking systembecause leverage allows a nonbank to own an assetat a tighter spread relative to its funding cost andstill generate an acceptable return on equity. Forexample, if one broker has levered 12 times andanother has levered 50 times and they have the samereturn on equity objective, then the broker who islevered 50 times will buy all the assets.

As remarkable as it seems now, this was realityat the beginning of 2007. Those who questioned thereasonableness of the spreads were told that it wasall a result of an enormous pool of liquidity. In fact,that pool of liquidity was a union of risk-seekingstates of mind between the nonbanks and their pro-viders of liquidity. Supported by the ratings agen-cies, the reverse repo brokers and, even moreimportantly, the asset-backed commercial papermarket were willing to take the offerings of morelevered, less transparent, and more conflicted non-bank levered intermediaries. It should have beentaken as a sign that the game was coming to an endwhen structured investments began to issue extend-able asset-backed commercial paper, which gives theissuer the option to extend the maturity for a fixedtime period. This effectively makes the buyer of thatpaper a lender of last resort, all for a mere 2 bps.

In February 2007, it was revealed that some ofthe assets that the shadow banks owned in the mort-gage sector were not without problems. The market-place did not pay particular attention to thissituation until spring, when a Bear Stearns hedgefund revealed that its reverse repo lenders hadasked for more collateral to ensure that they wouldnot lose money on their investment. When BearStearns conceded that it did not have more collat-eral, the lenders decided to sell off the collateral thatthey did have. This was the wake-up call that initi-ated a run on the shadow banking system and thedisappearance of liquidity.

Solving the Liquidity ConundrumAll investment professionals have learned aboutbank runs and have concluded that traditional bankscould not experience runs because deposit insuranceeffectively makes the government the lender of lastresort. Shadow banks, however, did experience themodern day version of a bank run in 2007. Thecombination of not having the protections of theFDIC, being under pressure from reverse repo bro-kers to put up more collateral, and facing an asset-backed commercial paper market that refused torefinance took the market from seemingly unlimitedliquidity to a liquidity crunch. The nonbanks couldnot sell assets fast enough to satisfy the increased riskaversion of their lenders. The liquidity dissipatedand volatility returned to the market because inves-tors’ state of mind changed their risk appetite.

The issue of the liquidity conundrum is, there-fore, resolved. My opinion is that there is no conun-drum. A conundrum is something that cannot befigured out, whereas explaining the current state ofliquidity is simple. Thirty years ago, people thoughtthat explaining liquidity was simply a matter offiguring out where some component of the M2money stock went. Today, determining the state ofliquidity means looking at the state of the risk appe-tite of the levered-up nonbanks and the leveragedproviders of liquidity to the levered-up nonbanks.The state of risk appetite is the critical pressure pointin the market, and it hit that critical point late in 2007.

In my opinion, the appetite for risk in the sys-tem can affect the decision-making process of theFed because it influences the neutral real fed fundsrate. The neutral real fed funds rate is not a staticconcept but, rather, a dynamic one based on the riskappetite in the shadow banking system. When therisk appetite is rising, the neutral level for the fedfunds rate should also rise. More risk appetitemeans a higher neutrality, and less risk appetitemeans a lower neutrality.

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The Liquidity Conundrum

The Minsky FrameworkIt is important to understand the phenomenon thatI have been discussing in the context of the work ofHyman Minsky. Minsky, who passed away in 1996,was the leader of what is known as the “post-Keynesian school of economic thought.” He spentmost of his career at Washington University in St.Louis, but the last 10 years of his career were spentwith a think tank in New York. His key contributionto economic thought was a critique of capitalism’sinherent boom/bust proclivities. He was a post-Keynesian who was more willing than Keynes totake the logic of market-based capitalism in thefinancial markets to its logical conclusion.

Minsky’s core thesis is known as the “financialinstability hypothesis.” Translated very simply, thehypothesis states that stability is inherently destabi-lizing because stability leads to the extrapolation ofstability into infinity, which encourages more risk-seeking financial structures, particularly with debt.Therefore, the more stability a market has and thelonger it lasts, the more unstable the foundation ofthe stability becomes. Stability is destabilizingbecause it begets more unstable debt structures.

Minsky broke down the process of stabilityproducing instability into three steps that are char-acterized by three types of debt units—hedge units,speculative units, and Ponzi units. In a financialcycle, a long period of stability leads to more mar-ginal units of debt creation, and the economy shiftsfrom hedge units to speculative units to Ponzi units.Once the economy reaches Ponzi units, it slows,and it is set up for a reverse Minsky journey. As Idefine the three units in the following, the processthat led to the mortgage market crisis in 2007 willbecome clear.

Hedge Unit. In Minsky’s framework, the hedgeunit describes a borrower who obtains a loan to buyan asset, and the asset plus other income generatessufficient income to pay the interest and amortize theprincipal on the loan. The debt is self-liquidating,and it is hedged because the income stream can paythe interest and amortize the principal. It is a verystable unit, and in the mortgage market, a hedge unitwould be a conventional 30-year fixed amortizingmortgage. In the past, debt was perceived as a badthing, and therefore, trying to pay off one’s mortgageas quickly as possible was part of the culture. If themarginal debt creation in the economy is a hedgeunit as described by Minsky, it is a stabilizing factor.

Speculative Unit. A speculative unit is a stepfarther out on the risk spectrum. It is characterizedby a borrower who buys an asset, and the income

generated by the asset plus other income is suffi-cient to pay the interest on the note but not toamortize the principal. In the mortgage market, aspeculative unit would be an interest-only loan witha balloon payment—at the set maturity date, a bal-loon payment is due that is equal to the amountoriginally borrowed. The speculative type of debtunit is less stabilizing than a hedge unit because theborrower is speculating on at least three things: Theinterest rate is not going to rise, the terms and con-ditions will not change, and the value of the collat-eral will not decline.

If the marginal unit of debt creation is specula-tive, then the system is becoming less stable. But theparadox is that the longer an economy is stable, themore likely borrowers are to engage in such specu-lation. Doing so produces the immediately favor-able effect of lowering the monthly paymentbecause the principal is not being amortized.

Ponzi Unit. Minsky’s third step is called the“Ponzi unit,” which is typified by a borrower whobuys an asset, but the income generated by the assetplus other income is insufficient for amortizing theprincipal or even paying all the interest. In the mort-gage market, a Ponzi unit would be a negative amor-tization loan—at the maturity date, the borrowerhas a balloon payment, but it is bigger than theoriginal amount borrowed because of the unpaidinterest. Like the speculative unit, the Ponzi unit isalso speculating on the interest rate as well as theterms and conditions of the loan not changing. Butit is taking a fundamentally different position withrespect to the value of the collateral. In a Ponzi unit,the borrower is betting that the value of the collat-eral will go up. Borrowers who take on a Ponzi debtunit are betting that if they buy an overvalued asset,when the balloon payment comes due, another bor-rower will pay a higher overvalued price for thecollateral. The collateral cannot just hold its value;it has to go up in value.

Minsky and the U.S. Property Market.Minsky’s three steps precisely describe whatunfolded in the U.S. property market over the lastseven years. By 2006, the preponderance of debtcreation at the margin was Ponzi unit finance. Aclassic example is the 2/28 subprime adjustable-ratemortgage in which borrowers put no money down,get a teaser rate for two years, and can opt to payless than the full amount of interest. The borrowerschoose how much interest to pay, and the rest is puttoward principal. After two years, though, the inter-est rate goes up by about 500 bps. The majority ofthe marginal borrowers for the years 2004 through2006 made use of this mortgage structure.

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Minsky’s hypothesis explains why the down-turn occurred. Property prices had been rising at asteady and stable pace for a long period, so borrow-ers walked the path from hedge units to speculativeunits and, finally, to Ponzi units. In the midst of theexuberance, the rising prices were a self-fulfillingprophecy. As more people walked down the Min-sky path, they drove up the value of the collateral.Very few defaults were occurring because borrow-ers do not default when they are making money.One should realize that what was happening, ineffect, was that by 2006, the mortgage industry wasgranting to marginal borrowers a free at-the-moneycall option on the value of their property. As theproperty market continued to go up, the default rateon the mortgages was low because borrowers’ freeat-the-money call options were going in the money.If they defaulted on their mortgage, they gave upthe in-the-money portion. So, the default rate isinitially low in the last stage of the Minsky journeyfrom speculative to Ponzi.

The rating agencies assumed that this defaultexperience would continue. But by the first quarterof 2007, the subprime mortgages issued in 2006 hada surge of early payment defaults. The percentage

of borrowers not making the first payment on theirmortgages rose quickly, which signaled that theproperty market had reached the Ponzi stage. Forborrowers, the rationale behind not making the firstmortgage payment can be explained by the calloption effect. If the value of the property goes down,then borrowers’ call options are worth nothing, sowhy should the borrower continue to pay for it?Once affordability is stretched beyond any rationalsense relative to rent values, borrowers stop seekingloans. The Minsky journey is over, and the economystarts heading in the other direction.

ConclusionThe forward Minsky journey lifted the neutral realfed funds rate as the risk appetite of investorsincreased. But a reverse Minsky journey will lowerthe neutral fed funds rate and ultimately be stabiliz-ing as Ponzi units are removed, speculative debtunits are restrained, and hedge debt units return.The destination of a reverse Minsky journey is amore stable economy, but the journey itself will bea deflationary one.

This article qualifies for 0.5 CE credits.

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