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A ‘Big Short’ Lesson About Bond Liquidity

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Angry Investor: “So, Mike Burry, a guy who gets his hair cut at Supercuts and doesn’t wear shoes, knows more than Alan Greenspan and Hank Paulson?!”

Burry: “Yeah. Doctor Mike Burry. Yes. He does.”

Any choice you make, someone else smarter and more experienced than you has come to the opposite conclusion and is on the other side of the trade. It doesn’t matter whether you pick your own stocks, buy focused mutual funds, or hold indexed ETFs. It requires a generous amount of chutzpah to conclude that what you’re doing makes perfect sense while holding that the chairman of the Federal Reserve and the secretary of the Treasury don’t know as much as we think they do — the brilliant point of that exchange from “The Big Short.”

When asked what qualities give someone an edge in investing, Warren Buffett didn’t say intelligence or experience. He didn’t say connections or access to research. And he didn’t say knowledge of complicated algorithms using massive data processing power. He said: “The ones that have the edge are the ones who really have the temperament to look at a business, look at an industry and not care what the person next to them thinks about it, not care what they read about it in the newspaper, not care what they hear about it on the television, not listen to people who say, ‘This is going to happen,’ or, ‘That’s going to happen.’”

Doctor Michael Burry had done his research. He knew that the AAA mortgage securities flooding the market were stuffed with mortgages of homeowners who had little to no financial capacity to pay them. Not only that, he had identified the catalyst that would begin the ultimate cascade of defaults: the sub-prime mortgages in these pools came with abnormally low “teaser” rates that would expire in less than two years, after which the monthly mortgage payments would double or even triple.

Burry didn’t care what his clients thought. He didn’t care what Alan Greenspan or Hank Paulson thought. In fact, he didn’t care what anyone else in the world thought. He cared only about whether the data and his research were accurate and reliable. If they were, Burry had eliminated the “if” and he knew the “when.”

Risk Catalysts

There is plenty of risk in the investment world. However, unless a catalyst comes along, observable risk can exist almost indefinitely without actualizing. When a catalyst is identified, the risk turns into a threat. And when the trigger to a catalyst is identified, the threat becomes a call to action. That is what motivated Burry.

As I was watching the movie, it was hard to comprehend how so many otherwise intelligent and informed investors could be so blind. Yet in the real world, even if you have hard data — even if you have the catalyst and the trigger — the social need for validation and the historical fact that the crowd (i.e. the market) is mostly reliable, is enough for most of us to feel confidence in going with the flow.

Further, the way we experience present day reality is qualitatively different from the way we consider the past. In looking back we feel none of the social pressure, none of the potential for alternative outcomes and none of the negative financial consequences or self-doubt that affects thinking and decision-making in real time.

History doesn’t repeat itself in the sense that events don’t align themselves in exactly the same way; but it does repeat itself, almost perfectly, if we observe the history of investor behavior. That is why a more careful consideration of how we are perceiving a risk may be as important, perhaps even more important, than the risk itself.

Within that context let’s see if we can reframe a current risk, one that has been receiving a lot of attention: bond market liquidity.

Bond Conditions

Unlike the environment in “The Big Short,” there is no opaqueness covering up the dangers lurking in the bond market. Thanks to lingering memories of the financial crisis, investors are more attentive to a risk with potentially systemic consequences. In the eyes of many serious and experienced observers, this one falls well within that parameter.

The following observation from the Financial Times blog FT Alphaville neatly summarizes current worries: “This is spooking a lot of people in the finance industry such as Jamie Dimon, Stephen Schwartzman and Nouriel Roubini who have warned that decrepit bond market conditions could exacerbate or even cause a financial crisis.”

Recent events elevated concerns. In early December, the $788 million Third Avenue Focused Credit Fund (a junk bond fund) stopped redemptions and announced it would liquidate. A week later, Stone Lion Capital Parners (a hedge fund) suspended redemptions in all of its bond funds. Three days after that, another hedge fund, Lucidus Capital Partners, liquidated its bond holdings to meet its investors’ requests. Finally at the end of the month, Whitebox Advisors announced that it would liquidate its credit mutual funds amid losses and heavy redemptions.

The online journal Knowledge@Wharton connected the dots back to the financial crisis: “The redemption halts naturally drew comparisons to the collapse of funds packed with subprime mortgages at Bear Stearns and BNP Paribas in 2007, which similarly stopped payouts after the value of their holdings plunged. In both 2007 and 2015, the issue was liquidity.”

This begs the question: Are these recent events the canary in the systemic coal mine or is this just an extreme but otherwise normal condition in high yield/high risk/junk bond funds? There is no shortage of commentary on this issue. Research has come from banks, brokerages, mutual funds, hedge funds, think tanks and the IMF — to list just a few.

In a recent issue of its Global Financial Stability Report, the IMF wrote: “Changes in market structures appear to have increased the fragility of liquidity.”

The Brookings Institution warned: “Illiquidity in financial markets can help trigger or exacerbate a financial crisis by creating actual or paper losses at banks or other financial institutions.” This was the cascade effect that nearly brought down the financial system in 2008.

Knowledge@Wharton took a contrary stance. It noted there is a dramatic distinction between the risks in the financial system today and those that existed before the financial crisis.

In the third quarter of last year, the five largest Wall Street banks held $6.7 billion of corporate debt designated as illiquid and hard to value — less than 1% of their nearly $803 billion of equity. In comparison, in 2007 Lehman Brothers alone had $25.2 billion of illiquid securities in its trading book, versus only $21.4 billion of equity. Liquidity may be fragile, but the banks are not.

While the potential for systemic risk 10 years ago was no secret (lax lending standards, opaque investment structures and hidden counterparty risk), there weren’t enough Mike Burrys around, so investors continued to trust the efficiency of the market and the integrity of the ratings agencies to price the risks. Big mistake.

Today there is no shortage of scrutiny or concern about a potential liquidity crisis. But history teaches us that market crashes and/or systemic crises rarely (if ever) occur when so many market participants are concerned about them.

Should we be concerned about bond market liquidity risk? Of course we should, just like we should be concerned about all kinds of risk. But we should be more concerned that our perception of risk is built on a foundation of verifiable facts, not simply what our friends are saying. History tells us to listen to our friends, but to use that information intelligently. If we are doomed to have predictable investment behavior patterns, they might as well be good ones.


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