Liquidity Death Spiral Traps Credit Suisse

Traders are getting increasingly punished for trying to sell unpopular debt at the wrong time.
At Closing, June 20th
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Credit Suisse just got caught up in the same liquidity death spiral that has claimed a growing number of debt funds.

Some of the bank's traders increased holdings of distressed and other infrequently traded assets in recent months without telling some senior leaders, Credit Suisse CEO Tidjane Thiam said on Wednesday in a Bloomberg Television interview. This is bad on several levels. For one, it highlights some pretty poor risk management on the part of senior officers at the Swiss bank.

But perhaps more important from a market standpoint, it exposes a trap in the current credit market: Traders are getting increasingly punished for trying to sell unpopular debt at the wrong time. The result has been a growing number of hedge-fund failures, increasing risk aversion by Wall Street traders and further cutbacks at big banks.

This all simply reinforces the lack of trading in less-common bonds and loans. At best, this spiral is inconvenient, especially for mutual funds and exchange-traded funds that rely on being able to sell assets to meet daily redemptions. At worst, it could set the stage for another credit seizure given the right catalyst -- perhaps a sudden, unexpected corporate default or two, or the implosion of a relatively big mutual fund.

To give a feeling for just how inactive parts of the market have become, consider this: About 40 percent of the bonds in the $1.4 trillion U.S. junk-debt market didn't trade at all in the first two months of this year, according to data compiled from Finra's Trace and Bloomberg. While corporate-debt trading has generally increased by volume this year, more of the activity is concentrated in a fewer number of bonds.

Popularity Contest

Trading has been increasingly concentrated in the most-active high-yield bonds

Source: Finra's Trace

This has made it even harder for big banks to justify buying riskier bonds to make markets for their clients, the way they used to, because they could get stuck holding the bag. That's what happened with Credit Suisse, apparently. The bank suffered $258 million of writedowns this year through March 11, and $495 million of losses in the fourth quarter, because of its holdings of distressed debt, leveraged loans and securitized products, including collateralized loan obligations, according to a Bloomberg News article by Donal Griffin and Richard Partington.

Credit Suisse is in a tough spot because it is trying to get out of its hard-to-trade assets at a bad time. It's re-evaluating its business model under new leadership, higher capital requirements and the shadow of poor earnings.

But it's certainly not alone in feeling the pain from a brutal and unforgiving period in debt markets. JPMorgan Chase, Bank of America and Goldman Sachs are expected to report disappointing trading revenues in the first three months of the year, and Jefferies already reported its train wreck of a quarter.

This difficulty on Wall Street may eventually trickle down to mutual-fund investors, along with anyone else who buys riskier corporate debt. Here's why: It has become progressively more difficult to execute a trade in the past six months, especially because banks are much less willing to complete a transaction without lining up a buyer. That can take time, and, done poorly, can move the market away from the buyer or seller before the trade is finished.

Turbulent Trades

High-yield bond values have had bigger swings as it gets more difficult to execute trades

Source: Bloomberg

"The biggest issue that the market faces is that you have an increasing amount of participants that require daily liquidity in an asset class that really doesn't offer daily liquidity any more," said Michael Pohly, the portfolio manager at hedge fund Kingdon Credit.

That's a little scary. The good news so far is that these trading woes haven't yet triggered another credit crisis. The bad news is it's only getting harder to transact in riskier debt, making the market increasingly fragile and prone to seizures going forward.

This column does not necessarily reflect the opinion of Bloomberg LP and its owners.

    To contact the author of this story:
    Lisa Abramowicz in New York at

    To contact the editor responsible for this story:
    Daniel Niemi at

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