But if I knew how to manage my portfolio safer and smarter than most hedge fund managers, I could realistically grow my wealth.
Even if borrowers make their payments, jitters in the mortgage backed security market can hit liquidity, making it difficult (if not impossible) for REITs to reduce leverage. REITs are also at the mercy of their bankers, who can pull lines of credit (or simply refuse to renew them).
During the financial crisis, many firms had their borrowing lines of credit pulled and were unable to finance their balance sheet. Unfortunately, they had nowhere to go with their securities. There was literally no one to sell to. Individual investors take for granted the fact that if they try and sell a stock, there is almost always someone willing to buy your stock. The problem with bonds is that there is no exchange to speak of – it is a dealer-driven “upstairs” market. Market makers are under no obligation to purchase bonds if they don’t want to.
The lack of liquidity created enormous problems for regulators and bankers alike. If you buy a mez piece of a sub-prime deal for par and liquidity dries up, where do you mark your position? You know that bond is not worth par. But if it doesn’t trade, you don’t have any price to mark it to. Thus, a “mark-to-model” (aka “mark-to-myth”) was used as a way to come up with some price to put on a particular bond.
Liquidity risk was part of what sunk Orange County back in the early 1990s. Orange County had invested heavily in mortgage backed securities as a way to get excess return from “risk-free” assets. Orange County generally bought agency securities. When Alan Greenspan starting raising interest rates precipitously in 1994, mortgage backed securities were clobbered. Because so many hedge funds that owned mortgage backed securities were getting redeemed, there was a lot of selling pressure on these securities, and dealers were fading their prices in order to prevent themselves from accumulating more and more inventory. Falling prices led to falling prices and eventually Orange County became insolvent. While interest rate risk was enough to sink Orange County, the lack of liquidity was a big contributing factor.
© 2013 Market Realist, Inc.