My colleague Joe Calhoun noted that the Wall Street Journal has documented further anecdotes about the credit market illiquidity this week.
Corporate-bond investors have struggled this week to find trading partners for some large orders, causing unusual price drops and raising concerns that trading could freeze in future market turmoil.
“Buyers just disappeared” early Thursday for many low-grade bonds and even some higher-grade ones, said Jason Graybill, senior managing director at Carret Asset Management LLC, which oversees $2 billion.
That would seem to confirm my hypothesis about the state of credit markets independent of the most visible measures. I relayed that sentiment yesterday as it related to the leveraged loan market, but it applies equally to other areas of credit not usually very liquid, including junk debt:
Market values in leveraged loans (at least if the index is a fair proxy, and it is very likely that less liquid leveraged loan “products” fared with a much higher beta) since the dollar turn have been beaten far worse than during 2013’s major global selloff. So much so, that the prices here in the index are now well below when QE3 even began. [emphasis added today]
Again, that would add evidence to the suspicion that haircuts are being adjusted and collateral calls have been given out – thus explaining well why Wednesday’s treasury market was bid to such an enormous imbalance. While all seems to be calm now, the usual track of disorder is exactly that kind of ebb and flow. It will take some time before we see, as best as possible, the full extent of how this repricing, recalibrating and reconsidering will wind its way through the system.
Not to be an alarmist, but this was what occurred in the ABX indices in 2007 (and, to make plain, I am not claiming that 2008 is being replayed; only that there are similarities in systemic properties that will in 2014 and likely 2015 find their own expressions). A lot of then related to hedging, as the ABX’s represented the most liquid parts of MBS and structured finance trading. Thus it was typical to hedge an illiquid position of some mezzanine or even more junior tranche with a short on one or more of the ABX. It was seemingly a sound position given the expectation that if the mortgage market overall ran into problems a decline in the ABX would provide that risk outlet.
I wrote back on August 1, 2007, how that was actually an unsound position contrary to all expectations:
As the subprime mortgage mess became big news in February , valuations of CDO’s backed by them fell. The market value of them in the BSHGSCS [one of the Bear Stearns funds that collapsed] fell 14.4%. Just as the hedge was designed, the ABS index value also dropped and the funds saw 13.5% gain – not a full hedge but effective enough to limit losses. The BSHGSCSELH [the other Bear hedge fund] saw a 4.4% decline in market value but earned 5.3% on its hedging.
Then the wheels fell off exactly where the models cannot predict. Despite the falling valuation of subprime CDO’s the ABX index stabilized. It seemed that the subprime loans made before the middle of 2006 were performing within constraints – it was the loans made in the third and fourth quarters that were trouble. This distinction was the reason for the “all clear” signal that Wall Street and the Fed sent shortly after the New Century and Countrywide troubles were made public.
In short, there was a disparity not just among the various indices of different “vintages” but also a wide discrepancy between the behavior of illiquid pricing and liquid pricing that nobody anticipated – a fact that I still, to this day, find more than a little astounding that nobody brought common sense to check the regressions.
The seeming asymmetric behavior of the leveraged loan index that I described yesterday with the treasury market trading this week, now adding what Joe found in the Journal today, brings back some of those same gut instincts. There is a good chance that what happened next in 2007 will recur, though hopefully not to the same extent and then ultimately to the same trajectory thereafter. As hedged positions were found totally lacking it unleashed a torrent of trading seeking to lay off more risk in other places. However, the system was set up in such an incestuous manner that the very desire for hedging locked everything into a positive feedback loop of decay. That is the true end of every bubble, whereby the trigger recognition that past assumptions are false cannot be absorbed by the system moving forward.
Hedging simply beget more hedging as counterparties were forced to reprice, recalibrate and reconsider everything that they thought solid to that point; which only worsened prices and even further limited the usefulness of prior hedges (some explanation is found here for anyone interested). Given, again, the trading in treasuries this week I think we can fairly assume the re-adjustment process has begun in that manner. We can only hope that strain is more easily absorbed now than in 2007, which sounds like a preposterous comparison given what has transpired between then and now – but that only applies if you believe central bank measures have done anything positive beyond just the surface gloss of psychology.
Liquidity matters; or, more precisely, liquidity discrepancies matter.