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Bill Gross: 6 Scenarios That Would Threaten ‘Shadow Banking System’

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Bill Gross begins his monthly investment outlook newsletter by waxing rhapsodic about the view from his home’s shower and joking about his plan to eat fewer water-intensive almonds in response to California’s drought.

He then gets utterly serious, sending some good-natured jabs at former employer PIMCO’s higher liquidity strategy in its funds (see PIMCO Leaders Address Bill Gross Departure, Big Outflows) before warning that there are six different scenarios — all of them currently in play — that could lead investors to start a run on the “shadow banking” system.

What is the shadow banking system, you ask? Gross defines it as comprising mutual funds, hedge funds and ETFs, and their vulnerability is all about liquidity: these modern “banks” are not required to maintain reserves or even emergency levels of cash, he says.

In his analysis, Gross argues that during the financial crisis, “markets experienced not only a Minsky moment but a liquidity implosion, as levered investors were forced to delever. Ultimately the purge threatened even the safest and most liquid of investments.” That led to money market funds breaking the buck, threatening the “$4 trillion overnight repo market – the center core of our current finance-based economy.” Then the Federal Reserve and other central banks became the “buyers of last resort” and the government backstopped the “too big to fail” financial instutitions.

However, in recent federal legislation and court rulings (on AIG, in particular) Gross detects a reluctance of central banks and governments to “exercise similar ‘puts’ in the future to stabilize asset prices” and are instead “pursuing inquiries as to which financial institutions are ‘strategically important’ – code for ‘big enough to threaten asset market stability.’”

Those institutions include insurance companies like Prudential and MetLife but also asset managers like PIMCO and BlackRock. Those companies “have responded as you might expect,” Gross says. “‘No problem’ sums it up — markets are a little less liquid they claim, but recent experience would show that for PIMCO at least, there were no ‘fire sales’ or ‘forced selling’ after my recent departure, as stated by CEO Doug Hodge in a friendly WSJ article. Ah now I’ve caught your interest.”

Then Gross cites CEO Doug Hodge’s admission that PIMCO has adopted “internal proprietary ‘liquidity”’ provisions, adding that it used derivatives for exposures “to support cash buffers and inflows” (sic). “The fact is that derivatives on a systemic basis represent increased leverage and therefore increased risk – presenting possible exit and liquidity problems in future months and years.”

That’s when he argues that mutual funds, hedge funds and even index products like ETFs are part of the “shadow banking system.” Since they “in effect now are the market, a rush for liquidity on the part of the investing public, whether they be individuals in 401(k)s or institutional pension funds and insurance companies, would find the ‘market’ selling to itself with the Federal Reserve severely limited in its ability to provide assistance.”

So what does Gross think might “precipitate” such a “run on the shadow banks”? He lists six possible scenarios: 1)  A central bank mistake leading to lower bond prices and a stronger dollar.

2)  Greece, with “the inevitable aftermath of default/restructuring leading to additional concerns for eurozone peripherals.”

3)  China, which Gross calls the “’mystery meat’ of economic sandwiches — you never know what’s in there.” The “sure warning sign” emanating from China is that credit there has expanded “more rapidly in recent years than any major economy in history.”

4)  Emerging market crisis — dollar-denominated debt/overinvestment/commodity orientation — take your pick of potential culprits.

5)  Geopolitical risks, which Gross says are “too numerous to mention and too sensitive to print.”

6)  Finally, Gross equates the current “levered financial system” with the ‘butterfly effect’ from chaos theory, saying that “small changes can upset the status quo.”

Perhaps Gross has seen the latest Jurassic Park movie. In Michael Crichton’s original novel, his mathematician character Ian Malcolm defines chaos theory this way: “A butterfly flaps its wings in Beijing and weather in New York is different. Chaos is not just random and unpredicative … complex systems like weather have an underlying order,” and the reverse ”that simple systems can produce complex behavior.”

Then what does Gross think investors should do to prepare for such a run? “Hold an appropriate amount of cash so that panic selling for you is off the table.”

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