To all - a WSJ thing on dislocations in financial markets still persisting, despite this week's huge drop in prices in the U.S. bond market (incorrectly implying : all (or, much of "all") is already okay again with capital markets).
November 6, 1998
Liquidity Problems Send
Ripples Beyond the Markets
By GREGORY ZUCKERMAN and GREG IP
Staff Reporters of THE WALL STREET JOURNAL
When Jack Ablin got into money management in 1982, he knew he could
make, and lose, a lot of money trading bonds. But he figured at least he could
always trade.
Over the summer, for instance, Mr. Ablin bought $1 million of bonds issued
by Merrill Lynch & Co., betting that interest rates would fall and bond prices
would rise. For the manager of $100 million at Colonial Asset Management in
Jacksonville, Fla., this was a relatively safe, highly rated security that he
assumed he could sell with ease.
Then, the drought set in.
Investors Take Flight
Russia dropped a bomb on international markets in August with its financial
crisis. Investors began fleeing from securities with any risk. Professionals
wouldn't touch anything but U.S. Treasury bonds, the world's safest
investment. When Mr. Ablin tried to sell his Merrill bonds at the end of
September, he found bidders scarce. In a market where ordinarily about $80
million of Merrill bonds trade on an average day, Mr. Ablin found that the few
buyers willing to make an offer would pay only $98 per $100 face value, much
lower than the $104 he thought the bonds were worth.
"Dealers were either slow to get back
to us or would pass on buying the
bonds, and those that would bid gave
us lousy bids," Mr. Ablin says,
shaking his head as he recalls the
frustration. "We made the right move"
in buying the bonds, he argues, but he
hadn't reckoned on the possibility that
usually liquid markets for almost
everything would turn bone-dry.
Liquidity in the highest-quality
securities, whether stocks or bonds --
including those of Merrill Lynch -- has
improved markedly in recent weeks.
'Signs of Some Reversals'
Thursday, U.S. Federal Reserve Chairman Alan Greenspan, in a speech before
the Securities Industry Association, said, "We are already seeing some
significant signs of some reversals" in liquidity problems.
But liquidity remains a problem for many
second-tier issuers and in many new and
growing markets, and it is weighing on the
economy in the process. Some fast-growing
companies are finding that their bond issues are
too small to attract investors, and are slashing
growth projections as a result. Industrial
companies are seeing their borrowing costs rise.
Other companies that had hoped to issue new stock for the first time are
finding the market for initial public offerings closed to all but the strongest.
Real estate is feeling the pinch from plunging demand for commercial
mortgage-backed securities.
The turmoil of recent months has stripped U.S. capital markets of much of the
critical lubricant on which they depend to function normally. Liquidity has
ebbed to an extent few professionals imagined possible. Though painful for all
markets, the loss of liquidity has been toughest on the markets in many
relatively new and exciting securities.
Like Drinking Water
In a liquid market, a buyer or seller of a sizable amount of any security can be
found quickly -- in hours, if not minutes -- and the bid-offer spread is
reasonably narrow. That spread is the difference between the prices at which
the security can be bought or sold. Markets can't function without liquidity.
But like drinking water, people take it for granted until they can't find it.
Seldom has liquidity been as important to the economy as now. In the past
decade, companies large and small have funded much of their growth not
through banks, but by issuing securities in the open market to investors, such
as pension funds and mutual funds. Investors bought the securities assuming
they could sell them easily. But the liquidity crunch has shaken those
assumptions.
"One of the lessons we should learn from this is that good times breed the
illusion of boundless financial liquidity," says economist Henry Kaufman,
president of his own investment-consulting firm.
To be sure, the U.S. still boasts the world's most liquid markets. The bid-offer
spread is usually about three cents per $100 face value for the most popular
Treasury bond, about six cents on a $90 share of General Electric, according
to traders and investors. And the Federal Reserve's surprise interest-rate cut
Oct. 15, in which the liquidity problem was a key factor, has improved
liquidity in many markets.
But it's a different story in newer markets, where it will be a long time before
liquidity returns to healthy levels. In the interim, borrowers and investors will
pay the penalties.
Nowhere is this more apparent than in the once-sizzling market for bonds from
emerging-market governments and companies. In 1989, those borrowers
raised $7 billion in global capital markets. By this year, they were raising $9
billion a month, according to Securities Data Co.
A Benchmark Suffers
But in October, that vast financing machine slowed down sharply. Traders and
investors report that bid-offer spreads have at least tripled since July for most
emerging-market bonds, and volume is almost nonexistent in many issues.
Daily trading volume even for Brazilian Capitalization bonds, the sector's
benchmark, has plummeted to about $80 million in recent days, down from
$315 million earlier this year. Most corporate bonds still trade "by appointment
only," meaning it could take days, not minutes, to complete a trade.
Jan Friedli, an international-bond-fund manager for Nicholas-Applegate Capital
Management, ran head-on into the largely illiquid market when he went looking
for $250,000 of a 29-year Venezuelan bond in September. Before August, it
would have taken a few minutes on the phone with a dealer quoting a 25-cent
bid-offer spread. This time, calls to three dealers produced bids of $44 and
offers of $48 per $100 face value. A $4 spread on a $44 bond represents an
instant 9% hit to a buyer. J.P. Morgan Securities finally found someone to sell
Mr. Friedli the bonds at a price of $46 after a three-day search.
The liquidity problems have been compounded by the reluctance of Wall Street
dealers and banks to use their own balance sheets to act as intermediaries
between buyers and sellers. In normal bond and currency markets, dealers act
as principals, standing ready to use their own capital to buy securities from
customers. They then turn around and try to find another buyer to take the
securities off their hands, incurring a risk that prices might fall while they hold
the securities.
But dealers have been so hammered by losses from Russia's turmoil,
hedge-fund mishaps such as those at Long-Term Capital Management and
their own falling stock prices that they have stepped back from taking even
small risks. Now, many firms act only as agents, trying to match buyers
directly to sellers. The process is much more difficult for investors, but
dealers limit their risk of being caught with too many bonds on their books
should another crisis send prices reeling.
Nomura Cuts Trades
Nomura Securities, a leading trader in the struggling commercial
mortgage-backed securities market, has cut its principal trades in that market
by as much as half in the past two months, executives say. Chase Manhattan
Corp.'s debt and equity trading assets fell to $23.6 billion at the end of
September from $39 billion a year earlier as the bank sought to reduce its risk
exposure and to better deploy its capital. Bear Stearns Cos. has slashed its
inventory in securities backed by income-generating assets, a market in which
it is a major player.
"In a time like this, it's good to have discipline," says Jeffrey Mayer, the head
of mortgage- and asset-backed securities at Bear Stearns.
The knowledge that securities firms are retreating from risk does little to foster
confidence among investors who might consider buying the securities such
dealers underwrite. Investors who buy bonds underwritten by investment
banks usually expect the bank to be there, through good times and bad, to buy
or sell the bonds. They're angry when it turns tail.
"At least they're trying to find parties on the other side of a trade to help you
out," says Janet Braggs, who manages $4.5 billion in bonds at Scudder
Kemper Investments in Boston. "But it feels like someone has snatched the
chair out from under us and we've hit the ground hard."
Stock markets haven't been hit as hard by illiquidity as bond markets, but even
there, investors complain of increased difficulty trading blocks of stock
without big swings in prices. In part, that's because stock-trading desks, like
their bond counterparts, are also limiting their exposure to risk.
One Firm's Experience
Friedman Billings Ramsey Group Inc., a securities dealer based in Arlington,
Va., reported a big third-quarter loss, owing primarily to losses sustained in
stocks it bought from customers during the summer, when the small stocks in
which it specializes took a beating. The firm, which itself went public only last
year, slashed its brokerage unit's securities-trading inventory to $15 million at
the end of the third quarter from $138 million at the beginning of the third
quarter.
Russell Ramsey, president of the firm, says its inventory grew with the
business and with the bull market itself. In those happier days, dealers were
willing to hold more inventory "because you feel comfortable there's not a lot
of risk, and you're trying to do a good job for the customer," he explains. "But
then you realize there's more risk, and in some cases, the customer doesn't
even demand it."
The consequences of low liquidity are rippling through the economy. Epoch
Networks Inc., an Irvine, Calif., Internet-service provider, was unable to sell
$75 million in junk bonds in August, and has been told by its bankers that the
market won't be hospitable to it until next year, at the earliest.
As a result, the company has been forced to slash 90 jobs, rein in acquisitions
and slow the rollout of what it regards as a cutting-edge alternative Internet
service.
"It costs a lot of money to build networks, so we've had to take our foot off
the accelerator because now we have to depend on our cash on hand," says
Scott Purcell, the company's chief executive officer.
Computer Literacy Test
When Computer Literacy Inc. canceled its initial public stock offering on Oct.
23, liquidity concerns figured prominently. The Sunnyvale, Calif., company,
which sells technical books and training materials on the Internet, first filed its
IPO plans on July 17, the day the Dow Jones Industrial Average closed at a
historical high of 9337.97. CEO Chris MacAskill says the fact that his
company was small and unprofitable didn't at the time cool Wall Street's ardor
for another Internet concept. But as the company hit the road to promote its
offering, the market began crumbling, led by the smallest, least liquid stocks.
"Interest in the company was high: We had 45 one-on-ones, our luncheon in
New York and breakfast in Boston were full," recalls Mr. MacAskill. But
portfolio managers kept fretting that many recent Internet IPOs were below
their offering price -- even though the companies' financial results were
meeting or beating expectations -- and the managers had trouble selling their
illiquid stock. "The feeling was: 'This is a small-capitalization deal-we're
worried about liquidity. Go get bigger and come back to us later.'"
Instead of raising $30 million in its IPO, Computer Literacy is settling for $10
million from venture capitalists and slower growth.
In the past decade, commercial mortgage-backed securities became a major
source of real-estate finance. Issues of these securities shot to $35 billion
through the first nine months of this year from $470 million in all of 1988,
according to Securities Data. But that growth has ground to a halt, and
real-estate deals are unraveling as a result. Dallas-based Amresco Inc. canceled
$400 million in planned loans to developers. The rates charged on the loans
were no longer profitable, and the company likely would have had difficulty
financing the loans because its own lenders couldn't count on being able to
repackage, and then sell, Amresco's loans as commercial mortgage-backed
securities. While the top-rated securities in this group still trade, for much of
the lower-rated, the market "is somewhat of a misnomer, because there aren't
enough transactions there to speak of," says John Levy, a real-estate
investment banker based in Richmond, Va.
Warning: Be More Diligent
Analysts are starting to sound warnings about the impact of the lack of
liquidity. "We expect there to be more downgrades and defaults," says Edward
Emmer, the head of Standard & Poor's corporate-rating department. Mr.
Emmer sent a memo to the rating agency's group of analysts last week,
warning them to "be more diligent" about the growing liquidity crisis and its
impact on U.S. corporate health.
The illiquidity of recent months and the resulting distortions in prices of
securities, especially bonds, have made it increasingly difficult for many
investors to figure out what their portfolios are really worth. That, in turn, has
helped damp liquidity.
"If you can't compare securities, you delay your investment decision," says
Hari Hariharan, at Banco Santander in New York. And so, in a vicious circle,
the information vacuum feeds illiquidity, which feeds the vacuum.
The NFL Fumbles
Investors won't buy what they can't trade. The National Football League was
preparing to set a first for a professional sports league with a $600 million
bond issue, backed by its $18 billion national television contract. At the outset,
there were plenty of cheerleaders. But late last month, the deal was scrapped.
"There's a liquidity crunch," says Jon Prestley, a credit analyst at Hartford
Insurance Co. "And while we were interested, I was worried about the ability
to trade the bonds after we bought them."
And there are products for which a market has simply vanished, such as the
debt used to finance Indonesian power companies, Chinese toll roads and Thai
oil refineries. By some estimates, $30 billion in such project financing was
raised during the past decade, with a significant slice funded through bonds
placed privately with foreign, primarily U.S., insurance companies. While the
bonds never enjoyed an active secondary market, it was a relatively simple
matter two years ago to get a firm bid from the deal's underwriter and sell a
bond within a day, says Joe Draper, head of emerging-markets fixed-income
trading at Salomon Smith Barney in Tokyo.
Not anymore, says Mr. Draper: "Over the summer, the market turned to dust."
What if normal liquidity returns soon to the capital markets? The consequences
for the economy of the recent dry period will be slight. But some fear that
illiquidity in many securities could last into next year, as both Wall Street
dealers and investors try to keep their year-end books in the best possible
shape. Should liquidity worsen, it could again raise the specter of a credit
crunch as investors, unable to sell in one market, "are obliged to liquidate in
other markets, creating a contagion effect," argues Neal Soss, chief economist
at Credit Suisse First Boston in New York.
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