Bond Worries and Stress Tests

Matt Levine is a Bloomberg View columnist. He was an editor of Dealbreaker, an investment banker at Goldman Sachs, a mergers and acquisitions lawyer at Wachtell, Lipton, Rosen & Katz and a clerk for the U.S. Court of Appeals for the Third Circuit.
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Bond market liquidity claims a victim.

The archetypal bond market liquidity worry was that bonds are illiquid, but bond mutual funds offer daily liquidity, and this mismatch would eventually lead to disaster. If bond prices fell, investors would want to redeem out of bond funds, and those funds would have to dump bonds into an unforgiving and illiquid market. Prices would spiral down, and contagion would spread to other, better bonds and other, better bond funds.

Here's a letter from Third Avenue Management to shareholders of its Focused Credit Fund:

We believe that, with time, FCF would have been able to realize investment returns in the normal course. Investor requests for redemption, however, in addition to the general reduction of liquidity in the fixed income markets, have made it impracticable for FCF going forward to create sufficient cash to pay anticipated redemptions without resorting to sales at prices that would unfairly disadvantage the remaining shareholders.

And so Third Avenue is flipping the fund into a liquidating trust that will sell those bonds when it feels like the time is right, and then return its investors' money, which "may take up to a year or more." ("Third Avenue will not charge any fee for those services.") This makes it "the first mutual-fund to halt redemptions without obtaining an SEC order authorizing the move," which is not exactly fun territory to pioneer. 

So this is a bond market liquidity story, but it is a very specific bond market liquidity story, one about a portfolio made up of mostly "incredibly risky debt," as Bloomberg Gadfly's Lisa Abramowicz puts it. (Three-quarters of its holdings were rated CCC or worse, or unrated, at S&P, according to Bloomberg.) And like most bond market liquidity stories, the plot is mostly that prices went down. It has been a rough few months for high-yield debt in general, and for the specific bonds in Third Avenue FCF's concentrated, distressed portfolio in particular. Some of that may be attributable to liquidity problems, but it is hard to distinguish the part that is about liquidity from the part that is about, just, security selection and changing investor sentiment.

In any case, as a bond market liquidity story, this story is ... fine? Halting redemptions and taking the time to sell off bonds carefully, while not charging management fees, seems like the responsible way to deal with big losses and redemption demands. And the nice thing about FCF is that the weird bonds are most of its portfolio, so it's not like it will be dumping more-liquid bonds to fund redemptions and thereby cause contagion to better bonds. It's also not a huge fund -- $788 million, after $979 million of outflows this year -- so it shouldn't cause contagion by massive sales. Nor does its liquidation seem likely to undermine confidence in the industry more broadly, though I suppose it's a bit early to say that.

But perhaps it will undermine confidence a bit in a useful way. The big worry about mutual-fund liquidity mismatch is about investor psychology: Bond mutual fund investors who think their investments are as good as cash are the ones who pose the biggest run risk. Mutual funds like FCF offer investors the opportunity to own shares in a pile of distressed CCC-rated bonds while still having daily access to their cash. That's a risky mix, but now at least investors are on notice.

Congrats, Bank of America!

Bank of America only sort of passed the Federal Reserve stress tests earlier this year; it had to stay after class and do some extra work to convince the Fed that it should really be allowed to buy back $4 billion of stock. But yesterday its resubmission was approved, leaving Bank of America in the clear until early next year, when it has to take its 2016 stress test. "They’re absolutely relieved they’ve passed," says an analyst.

The problem for Bank of America was not its capital levels, which were fine, but rather its approach to the stress tests, and the reports of the Fed's objections are perhaps illuminating. From Bloomberg:

Bank executives described the changes as shifting from assuming their risk models are accurate unless proven otherwise to the opposite, which requires more rigorous attention to the data underlying models. The firm scoured data from companies it had acquired after the 2014 stress-test stumble was caused by mistakes in information from Merrill Lynch & Co. dating back years, one of the people said.

From the Wall Street Journal:

The Fed had raised concerns about the quality of the bank’s process, including the level of detail in the risk models the bank was using, according to people familiar with the situation. For example, with some loans the bank used the same models to calculate potential risks and losses for both domestic and international loans, according to these people. In other cases, the bank relied too heavily on intuition rather than computer models when making loss predictions, according to some of these people.

The Fed had also raised concerns that the bank’s internal auditors weren’t sufficiently overseeing or reviewing the process, according to these people. Regulators also had concerns about a decentralized stress-test process, with various units in the bank calculating their own potential losses with their own methodology, according to some of these people.

If you run a sufficiently small bank, you can probably do a lot of your risk management by intuition, or by crude models. And if you build a big bank out of a bunch of little banks, they will probably do lot of their risk management by intuition, or by crude models, and in uncoordinated ways. But if you are the Fed, and you supervise big banks, though, you will want them to put a bit more science into their risk management.

Oops IIROC.

"Canadian Regulator Revokes Praise for High-Frequency Trading" is the absolutely unbeatable headline here. On Wednesday, the Investment Industry Regulatory Organization of Canada released a summary of its findings about high-frequency trading, concluding that high-frequency trading firms "generally provide more liquidity," "contribute substantially to price discovery," probably don't "take advantage of slower non-HFTs or front-run non-HFTs," and are generally just gentle creatures of sweetness and light. Given all those positive findings, it is perhaps not surprising that IIROC went ahead and said that the effect of HFTs was "mostly positive." Then it took that back:

“We erred in the press release we issued yesterday,” Lucy Becker, a spokeswoman for IIROC, said in an e-mail Thursday. “The only conclusion that IIROC has made with respect to HFT is that the results of the study did not reveal any concerns that warranted a regulatory response beyond measures already implemented by IIROC. As a regulator, it is not our role to judge whether or not HFT is positive or negative -- it is our role to ensure that markets operate in an orderly manner and with integrity.”

Hahaha they front-ran themselves. I have to say, I write about high-frequency trading sometimes, and in my experience nothing in financial markets -- not mortgage fraud or insider trading or hedge-fund fees or even bond market liquidity -- causes anything near the level of emotional frenzy that you get when you say the slightest positive thing about high-frequency trading. I bet IIROC's phones were ringing off the hook.

Davis Polk on the Litvak decision.

We talked the other day about the Litvak decision, in which the U.S. Court of Appeals for the Second Circuit decided that lying to customers about bond prices either is or is not a crime, and left it up to a jury to decide which. That was a victory for Jesse Litvak, the former bond trader convicted of lying to his customers, since he now gets a new trial where he can make some better arguments. But it was also probably a victory for prosecutors, because juries tend to err on the side of finding financial maybe-crimes to be crimes, so you should expect to see more of these cases. Here's a Davis Polk & Wardwell memo agreeing with that assessment, but with a caveat:

Nevertheless, the Second Circuit’s extensive discussion about the relevance of Mr. Litvak’s experts to the ultimate question of materiality signals that defendants may have compelling arguments that similar misrepresentations made in the course of RMBS transactions are not crimes. Although juries may disagree, the Second Circuit appears sympathetic to the argument that these misrepresentations are not necessarily material considering that RMBS valuation is subjective and complex; the counterparties are sophisticated; transactions are conducted at arm’s length; and puffery is common. 

I think I agree? Expect to see more of these cases, and more jury convictions, but then also more hard-fought appeals and skeptical courts.

People are worried about unicorns.

Here's Tom Braithwaite on "Why the titans of the ‘sharing economy’ are shunning IPOs":

For all the affected nonchalance, any rational early investors in Uber or any large “unicorn”, private companies valued at over $1bn, are biting their nails, worrying that the private valuations are vulnerable to a tougher economic or market climate. There is no reason to believe demand is going to get better and every reason to think it could get worse.

This is of course equally true for rational investors in, I don't know, Yahoo or Ford or Pfizer. Public valuations are "vulnerable to a tougher economic or market climate"; that's why stocks trade every day. In the olden days, the initial public offering was a big binary event; people who invested before the IPO might lose everything, but if there was an IPO, they'd make multiples of their money because of course public valuations were much higher than private ones. Now private markets are the new public markets, and Uber's $62.5 billion valuation reflects not venture capitalists hoping for a 10x return but rather market investors who think that's a fair valuation. And a fair valuation is one that could go up or down with economic and market conditions.

Elsewhere, here is a delightful story about India's religious startups, which are, you know, disrupting religion:

OnlinePrasad’s founder Goonjan Mall also has a consulting background, and left Bain & Co. to bootstrap the startup in 2012, out of a frustration with the often crowded and mismanaged temple experience that persists through most of India. Mall told a reporter for CNBC that the idea “came in a flash”: “Religion must be simplified and technology was the perfect tool” to do so in India.  

People are worried about stock buybacks.

Here's part 2 of a big Reuters investigation into stock buybacks, this one focused on how buybacks increase earnings per share, total shareholder return and other measures that serve as executive-compensation benchmarks. That, I sort of argued yesterday, is the idea. 

People are worried about bond market liquidity.

I mean, obviously, with the Third Avenue news. On the other hand, the Financial Industry Regulatory Authority put out a press release and research note yesterday finding "Corporate Bond Liquidity Healthy by Most Measures," though the timing was awkward.

Me yesterday.

I wrote about stock options and buybacks and stuff.

Things happen.

DuPont, Dow Chemical to Combine in Merger of Equals. Merger of Dow, DuPont Likely to Get Close Antitrust ScrutinyBarclays CEO Staley Said to Freeze Hiring 'for a Long Time.' Fosun Group’s Chairman Is Said to Be Missing in China. Hedge Fund Copycats Draw Record Money as Clients Hunt for Safety. SEC Suspends Public Accountants for Bad Auditing. Morgan Stanley to Pay $225 Million Settlement Over Mortgage Securities. Treasury Auction Investor Lawsuits Consolidated Before New York Judge. Who's Profiting From $1.2 Trillion of Federal Student Loans? Joseph Cotterill has fired up the Pari Passu Saga again. James Stewart on the JPMorgan whistleblower who had fake customer complaints filed against him. Aesthetic Integration, which works on formal verification of financial algorithms, won the UBS Future of Finance ChallengeSplunk n' Dash Sdn. claimed those three abandoned 747s in Kuala Lumpur. Nearly Half of Youth Say 'American Dream' Is Dead: Harvard Poll. Counterpoint: "Don’t stress about your debt. Go ahead and go broke in your 20s." In vitro puppies. Wu-Tang Clan Won’t Actually Steal Their Album Back in a Heist With Bill Murray.

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

To contact the author of this story:
Matt Levine at mlevine51@bloomberg.net

To contact the editor responsible for this story:
Zara Kessler at zkessler@bloomberg.net