Recent economic data suggests that the worst of the recession is behind us. The stock market has been moving higher in anticipation of a recovery in the business community. While the economic future is still uncertain, we will
likely see increased economic activity over the coming months.
Of all the lessons that have come out of the past many months, one of the most useful ones for investors is the value of price transparency and liquidity.
Facing the Music
This recession was characterized by a dramatic loss in value across the entire range of asset classes. But while all owners of assets were negatively impacted, some asset owners suffered worse than others. Owners of stocks, bonds and mutual funds felt the pain first because stocks and mutual funds trade daily on an exchange, and similarly bonds trade daily over-the-counter and are valued daily by pricing services. The benefit of having exchange-traded or highly liquid over-the-counter traded assets is that there is always a market for them, meaning that those assets can be converted to cash when necessary and desirable.
Prices for exchange-traded and daily-valued over-the-counter assets are transparent and readily available. Owners of such assets thus are aware of the assets’ values each and every day. During the market declines of the past year and a half, owners of these liquid assets were fully and regularly (and yes, painfully) informed of the hits to their net worth. Because of the price transparency of daily-valued exchange traded and over-the-counter assets, those whose balance sheets were largely populated by such assets readily faced and adapted to the reality of price depreciation.
The same can not be said for non-exchange traded assets or non-daily-valued assets, where each transaction must be separately negotiated. There is no daily pricing or exchange-like trading mechanism for assets such as real estate, closely held businesses, partnerships, and complex financial instruments such as asset-backed securities. Valuation is generally based on a historical record of comparable sales or infrequent appraisals. When sales activity of that class of assets slows, there is even less basis to determine realistic values.
The consequence of an inaccurate perception of value is that owners of non-exchange traded or non-daily valued assets don’t recognize value impairment in a timely manner, and are not as quick to adapt their financial decisions to the new reality. These owners often end up holding these types of assets for a period beyond which they can make a reasonable return on their investment. Worse yet, owners of non-daily valued assets can make risky decisions about incurring further liability, erroneously thinking they are worth more than in reality they are. In this sense, illiquid, non-daily valued assets can “contaminate” a balance sheet, leading both borrowers and lenders to make bad
The Nature of Leverage
There are two ways to purchase assets—cash or credit. Most investors pay cash for their investments (note that we do not view one’s primary residence as an investment). However, some investors use leverage to increase their returns. Investors using this strategy, called margin, take on debt in order to have the capital to buy more assets. This strategy works well during periods of rising asset values, as the investor is using the lender’s capital to expand his net worth. But when asset values decline, the magnitude of exposure can wipe out the investor’s equity in the asset, leaving the investor potentially owing more than the asset is worth.
Consider the difference in lending practices based on liquid versus illiquid collateral. Lenders loan money based on the value of the collateral that secures the loan. When the collateral is accurately and continually priced, lenders make “real-time” appropriate lending decisions. In the case of margin lending based on daily valued exchange-traded assets such as stocks, lenders make an immediate call to add or sell assets if the value of the assets falls below a certain level.
Compare this to lending based on illiquid non-exchange traded assets such as real estate or private securities. The lack of accurate, daily valuation leads lenders to make mistakes in the pricing of the credit they provide to borrowers. One of the striking lessons of the past few years is that lenders (both consumer and commercial) offered too much credit on the basis of the perceived (not real) value of the loan collateral. Lenders also charged too low an interest rate for the deflationary risk associated with those assets.
In the years leading up to the recession, we experienced a robust real estate market with continually increasing sale prices. Other assets including stocks and bonds also rose in value. With the increase in asset values, households and businesses incurred a massive build-up of debt. From Main Street to Wall Street, a pervasive attitude developed that asset values will continually rise, safely supporting additional debt. Businesses and households became more and more laden with debt based on “contaminated” balance sheets.
Balance Sheet Contamination
Once asset values started to decline, credit as a source of capital dried up. And because borrowers often had taken out loans with short durations, the loans came due just as the value of collateral was sinking. At that point, households and businesses realized that they had assumed more debt than their cash flow could support. Lenders now had securitized interests in assets that were dropping in value below the loan amounts and, worse, there was no quick and easy method to convert those assets to cash.
The mistake of so many investors, households, and businesses was to incur excessive debt which could only be rationalized if the value of the collateral supporting that debt continued to increase. Because the owners of illiquid, non-daily valued assets could not rely on an exchange or daily over-the-counter market for accurate valuations and continual liquidity, owners of these assets ended up misjudging the severity of their asset impairment.
Though the owners of daily valued, exchange traded assets were the first to “feel the pain” of declining net worth in real time, those same investors now are enjoying rising prices on the exchanges.
The cumulative effect of contaminated balance sheets across the board, from households to banks and businesses, caused the recession. The main lesson: investors holding assets with clear and transparent values and daily liquidity have a tremendous advantage during times of high market volatility, particularly when markets freeze up as they did last year. Liquidity and transparency go hand in hand, and are critical components of sustainable wealth.