Strategies for a liquidity crisis.

THE ESSENCE OF A LIQUIDITY crisis is a flight from riskier assets to cash. The recent seize-up in commercial paper issuance illustrates this flight-to-cash feature as some money market funds strayed from their mandates (e.g., by buying subprime-related securities to stretch yields). Now there is

a rush to replace expiring short-term corporate IOUs with Treasury paper as managers fear not being able to meet client withdrawals without sustaining losses. In addition, the inability to roll over commercial paper forces even good money market managers to buy bills to replace maturing assets as the outstanding supply of commercial paper plummets. As a result, three-month bill rates have fluctuated in "Black Swan" fashion by more than four standard deviations, according to a Bloomberg analysis. One has to go back to the 1987 stock market crash to find anything close to comparable drops in bill yields. There are simply not enough T-bills to go around.

The longer-term danger from a liquidity crisis is a prolonged deleveraging or debt-deflation process such as the U.S. experienced in the 1929-1933 Depression, or that Japan experienced for more than a decade from 1990. Federal Reserve Board Chairman Ben Bernanke has studied these episodes as much as anyone on the planet and regards them as the result of monetary policy failures.

In a debt-deflation process, investors have to sell assets to meet debt payments or margin calls, creating a self-defeating cycle of falling asset values, declining net worth, and rising debt burdens. If this becomes a systemic crisis, the process lasts long enough to cause a macroeconomic breakdown as investment losses and falling profits force layoffs, diminish investment spending, and squeeze consumers, which in turn causes more layoffs in a self-reinforcing down spiral.

The housing recession already under way before the latest credit crisis began was creating a mild version of this.

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The current crisis has been a wake-up call to the Fed. By raising rates for borrowers and reducing the availability of credit, the crisis has sharply raised the risk of recession, prompting the Fed to ease aggressively over the past few months. The more pressing issue has been to stop the seizing-up in credit markets.

Deleveraging's impact

Debt deflation means trying to deleverage--"trying" because everybody cannot sell their positions at the same time without causing asset values to fall faster than borrowings, which implies imploding net worth and thus higher leverage ratios. It is analogous to the famous "paradox of the thrift" where everyone tries to save more but the deficiency of aggregate demand that results causes a drop in income and savings despite the higher savings rate. That's what happened to Japan.

Looking asset class by asset class shows what works and what does not in this environment.

SOVEREIGN DEBT AND CURRENCIES.

The winners are sovereign debt and the currencies that have been shorted, or borrowed to finance leveraged positions--mainly, the yen and the dollar. Massive dollar short positions have been taken because huge foreign purchases of U.S. fixed income assets have been the primary financing source for the U.S. current account deficit. Because of universal sentiment that the dollar was on a one-way street downhill, many of these dollar bond purchases were hedged for the currency risk. These short dollar positions had to be covered when, for example, European investment funds holding U.S. subprime debt liquidated their positions to meet client redemptions.

Another boost to the dollar has come as U.S. investors liquidated some of their foreign asset investments. Roughly 90% of U.S. mutual fund flows since 2005 have been going into foreign currency assets. Flight-to-quality is causing some repatriation, which means selling other currencies and buying dollars as, for example, U.S. investors liquidate Brazilian stocks.

Similarly, many Japanese investors are repatriating funds to their home country, boosting the yen.

GOLD AND OTHER COMMODITIES.

Many players expect gold to rise in a crisis. Time after time, they are disappointed. There are many investors who rely on historical patterns without understanding the underlying dynamics causing the pattern. That gold does well in a bank-run scenario is a historical artifact of the days when gold was the monetary base. For example, during the debt deflation of 1929-1933, there were not many, if any, investments that did better than gold. In essence, gold was cash. Like T-bills today, this caused a massive bid and shortage that eventually prompted President Roosevelt to outlaw gold as an investment.

Today, deleveraging still means "cash is king" in a debt-deflation process, but gold is no longer cash. It's just another commodity, and commodities tend to deflate with everything else when "cash is king." Gold outperformed in the early 1930s, while other commodity prices plunged. If gold had not been "money," it would have plunged like all the other commodities.

STOCKS. Deleveraging means reallocating to less "beta" and more quality, essentially to earnings streams that are more predictable and less volatile. Large-cap growth stocks tend to meet this criterion as they have income streams that are roughly half as volatile as small-cap value stocks. The latter tend to have lower p/e's that reflect their more volatile and cyclical earnings streams.

This means one must also account for whether this earnings volatility difference has already been overvalued or undervalued by the market. Ever since the tech bubble burst, small-cap value stocks have outperformed, largely eliminating their undervaluation and making large-cap growth stocks more attractive. One reason for the long outperformance of small-cap value was the unusual liquidity and easy credit environment that prevailed until recently. Large-cap growth stocks tend to outperform in tighter liquidity environments because of their relative ease in obtaining financing compared to smaller players with more volatile cash flows.

From an international perspective, these same principles apply in each country and between countries. Higher beta emerging markets tend to under-perform in a liquidity crisis, because rich country investors "come home."

BONDS. Quality rules, and no quality is higher than sovereign quality. In addition, credit crises are often the inflection points for shifts toward aggressive rate-cutting cycles, which also favor non-callable government bonds over callable, lower-quality credits that see defaults rise in the economic slowdown that usually accompanies aggressive rate cutting.

HEDGE FUNDS. Obviously, the increased volatility associated with credit crises creates enormous trading opportunities for those who are well positioned and who understand the dynamics in play. The poorly positioned are among the worst losers, as recent hedge fund blowups illustrate. Strategies that rely on small return differences that are aggressively leveraged also tend to blow up in a liquidity crisis because they implicitly assume ease of entry and exit without much price impact. This hurts many quantitative strategies.

While a liquidity crisis is under way, the things that work are often the opposite of what worked before because what worked before is what's liquidated. If what worked before is a good, long-term idea, then the liquidity crisis may be a prime opportunity to buy good investments cheap.

ROBERT T. MCGEE Director of Macro Strategy & Research, U.S. Trust, and former chairman of the ABA Economic Advisory Committee