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May 18, 2007 What is Liquidity?
There are several types of liquidity. In general phrasing, liquidity usually alludes to cash, the money or capital that fuels the wheels of commerce. In the financial world, definitions are more complex. There is market liquidity, the ability to buy and sell securities without greatly affecting the price. And there is funding liquidity, referring to the availability of credit and the ease with which institutions can borrow money. These definitions seem relatively straightforward, but do they really capture the concept of liquidity in the market? A recent article in The Deal entitled "Hooked On A Feeling" alludes to a more conceptual definition.
According to Federal Reserve Board Gov. Kevin Warsh, the generally accepted terms used for liquidity don't really capture what liquidity in the market is. In a March 5 speech given at the Institute of International Bankers annual Washington conference, Warsh noted that those definitions don't capture what people, even market sophisticates, mean when they refer to liquidity in the current market. So what is liquidity? According to Warsh, liquidity is not a quantifiable, concrete thing, but a transient concept. In short, liquidity is essentially a state of mind and in a word confidence. But in an industry constantly attempting to quantify all aspects of the market, can such a simple notion be behind the strength of the market?
One way to effectively determine the impact of the vague concept of liquidity is to consider the leveraged financing markets. Debt has rarely been so easy to obtain as it is today due to the high amounts of liquidity in the market. Private equity firms, flush with cash, (or liquidity), are paying ever-increasing acquisition multiples for target companies. This in turn increases the leverage on their deals. Banks, which are eager to be in the good graces of their private equity clients but don't want to hold the credit risk on their balance sheets, sell the debt to securitize the money and syndicate it to a pool of collateralized debt obligation funds ("CDOs"). These CDOs, which use the money to invest in pools of loans and bonds, are finding it easy to raise capital by exploiting the desire for yield that is forcing institutional investors and hedge funds into debt markets due to the marginal returns seen in the stock markets.
This demand makes it easier for companies to refinance their debt at lower rates, and in turn allows private equity firms to reduce risk and boost returns through dividend recapitalizations. Effectively reinforcing the impression that there is little overall risk in the market, making it even easier for companies to borrow money and accordingly increase the demand for debt. So in a circular sense liquidity creates more liquidity and drives market confidence.
So how important is liquidity in determining the appropriate value of a company? Liquidity risk is not company specific; nor does it have any relation to the realization of some level of income. As such, when determining the present value of future cash flows to a firm, the heart of valuation, how much emphasis should be placed on something as intangible as "confidence?" Considering this, it is very difficult to understand and quantify the theory of liquidity. Therefore, to attempt to use such an unquantifiable metric in valuation seems inappropriate, despite what many analysts refer to as the "irrational exuberance" currently being displayed in the market.
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