Forget Default: Deutsche Reckons Debt Market Risk Lies ElsewhereBy
Focus on liquidity has transformed principles of bond market
Deutsche estimates $2 trillion of duration in mutual funds
What’s in a word? A lot when it comes to the term “liquidity.”
For years, academics, investors and regulators have sparred over the meaning of liquidity, and the degree to which it’s said to have deteriorated in the marketplace. For many, it’s simply the ability to sell an asset without significantly affecting its price. To others it’s the hallmark of a healthy market, or the symptom of a disease brought on by “easy money” provided by central banks in the years since the financial crisis.
To Aleksander Kocic, derivatives strategist at Deutsche Bank AG, it’s something that has turned the world of fixed income on its head -- transmuting an age-old principle of debt and converting the world’s biggest market into something theoretically far more risky.
“Liquidity transforms the risk of default (the ability that the debtor may not be able to pay back his debt) into the risk that the securities representing the debt find no purchasers,” he wrote in research published late last week. “It replaces responsibility with salability.”
For Kocic, today’s era of booming bond sales has an eerie parallel to the subprime crisis of the mid-2000s. Back then, low interest rates spurred an intense search for yield that culminated in investors purchasing risky home loans in the form of securitized and salable bonds. Such securitizations had the benefit of convenience as investors could buy and sell specific exposures comprising hundreds of thousands of individual home loans.
But the steady demand for mortgages helped spur a rise in home prices and inflation, which ultimately forced the Federal Reserve to raise interest rates, thereby bursting the bubble.
“The forced unwind of leverage was responsible for the transformation of conditional insolvency to unconditional illiquidity,” Kocic wrote in the report, dated Sept 15. “Subprime borrowers were considered financeable only because their debts were salable. That went on even when they were no longer solvent and it ended with a liquidity crisis -- at that point, no debt, except for the highest grade, could be transacted.”
Today, Kocic argues, post-crisis regulation has created a far less liquid environment for debt securities, which have been forced off the balance sheets of big broker-banks and onto those of a wide variety of funds who snap them up in the belief that they can capitalize on immediate price gains. At the same time, a cottage industry has cropped up to offer “liquidity transformation” services, including exchange-traded funds and open-ended mutual funds that promise investors the ability to buy and sell illiquid debt instantaneously.
While the parallel may be frightening, Kocic says the prospect of a sell-off remains “infinitesimal” providing that regulators and central banks are aware of the problem, and the situation persists. As long as such rules prevent “the transformation of liquidity into leverage” and subsequent inflation, the risk of a crisis “appears lower.”
“The biggest risk in this context is posed by irresponsible deregulation and inflation or anything that would cause a rapid rise in price level,” he concludes. “This implies predictable monetary policy and a tightly controlled Fed exit.”