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Tuesday, 17 October 2017

The Not-Axed Man cometh

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  • Peters 475px June 2014

Risks previously created by excess leverage have been replaced by chronic illiquidity risks.

I GOT CHEESED off this week. Sure, I get cheesed off most weeks at some point but from time to time there are little episodes that bring me to the point where cheesed off starts to turn into outright despair. This was one of those and I wasn’t even directly involved.

One of my colleagues – it was the senior partner of SwissInvest – asked a major US bank for a bid in nothing more than a couple of million dollars of a relatively recent and otherwise completely innocent piece of plain vanilla paper issued by Boeing. Back came that bane of credit market investors and brokers: “Sorry, not axed …”

This took place just as I had returned to my desk, having attended the quarterly asset allocation committee meeting of a London-based investment management firm for which I am an external adviser on matters macro and fixed income.

Having done all the bits about the Fed, the BoE, the ECB, the BoJ, the PBoC and so on and having discussed risks in the corporate bond markets, I ended up reiterating my point that there is still no meaningful liquidity in the credit markets and my fear that the resulting liquidity risk hasn’t been priced in.

MY THINKING HAD been influenced by a conversation that I had recently with a friend in the market who told me that larger credit funds have been busily stress-testing their portfolios for a sell-off and the commensurate redemptions by investors (or the other way round if you prefer). I won’t go into the issue of the liquidity mismatch again but my chum and I were wondering what assumptions could possibly have been fed into the stress tests.

To be sure, there is significantly less leverage in the bond market than there was going into the Global Financial Crisis but there has also been a notable shift of borrowing away from banks’ balance sheets and into the hands of institutional investors and other non-bank lenders whose investment intentions can easily be derailed by external factors such as the aforementioned redemptions or, as in one case I have been involved in, a change of management. (In this case, the new crew decided to sell an investment that the previous management acquired in the knowledge that they would be holding it for life. I cannot tell you what a messy business this became, but that is a story for another day.)

There has also been a notable shift of borrowing away from banks’ balance sheets and into the hands of institutional investors

BUT BACK TO my Boeing bonds. If one of the world’s largest banks refuses to place a bid on $2,000,000.00 of a simple piece of 6-1/2 year A2/A rated paper in the midst of a bull market, what chance for a major player to find one for $30,000,000.00 or $40,000,000.00 of BBB rated telco or industrial in a bear market? I refuse to accept the argument that the bid was absent because we are just a horrible, smelly little broker. A trader’s job is, with proprietary trading in effect outlawed, to buy paper at a price at which he can resell it at a profit and to live off the spread. Other than being limit-long the credit – highly unlikely, given the paucity of available paper in the name – it seems to me that more than a little something in the market is broken.

Put two people who work in the credit markets together in a meeting room, on the phone or at the bar and it will not take long before the subject arises of the missing liquidity and of the risks this brings with it. This is now more than just the elephant in the room; it has become the room in the elephant.

But there is something that troubles me more than those ubiquitous conversations – and that is the roaring silence on the part of the regulatory authorities. They have clearly created a massive transformation of the risks present in markets. Risk, I have often argued, is like energy. It can be converted but it cannot be destroyed. Credit risk has been squeezed off banks’ balance sheets and into investors’ portfolios and the risks previously created by excess leverage have been replaced by the risks generated by chronic illiquidity.

AGAINST THIS BACKGROUND, recent news concerning Deutsche Bank and its review of trading activities should have regulators running scared that in their rush to protect themselves from reputational risk, they’ve created a monster that could, if the circumstances align as they did in 2008, bring not only the investment banks and the commercial banks to their knees but the insurance and fund managements sectors too. Losing Lehman could suddenly look like a minor upset.

So what does “I’m not axed” truly mean, other than “won’t buy, won’t sell, don’t have to, don’t want to, don’t know where to get ’em, don’t know where to go with ’em.” What? Not even for $2,000,000.00 of a Boeing 6-1/2 year bond? If things are that bad when things are good, what happens when things really are bad?

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