Must-Read: Nouriel Roubini: The Liquidity Time Bomb
Must-Read: I do not think Nouriel’s argument makes complete sense here, but I cannot put my finger on exactly what is wrong with it. Perhaps “liquidity” is being used in different senses? In one sense, the market is “liquid” when there are lots of assets that are not subject to moral hazard factors when you try to sell them–hence you can get a known amount of cash quickly. In another sense, the market is “liquid” when you can quickly change your position in assets that *might but haven’t been subject to moral hazard without taking a large haircut. Is using the same word “liquidity” for both creating confusion?
: The Liquidity Time Bomb: “Before the 2008 crisis, banks were market makers in fixed-income instruments…
But with new regulations punishing such trading (via higher capital charges), banks and other financial institutions have reduced their market-making activity. So, in times of surprise that move bond prices and yields, the banks are not present to act as stabilizers…. As a result, when surprises occur… the re-rating of stocks and especially bonds can be abrupt and dramatic: everyone caught in the same crowded trades needs to get out fast… because many investments are in illiquid funds and the traditional market makers who smoothed volatility are nowhere to be found, the sellers are forced into fire sales. This combination of macro liquidity and market illiquidity is a time bomb…