We are living during an economic revolution wherein the “middleman” is being eliminated. In most cases this is good news. If you need a cab you now call Uber where both the driver and the passenger benefit. Cab companies no longer have a monopoly on who can drive and, most importantly, who can obtain a license (medallion) to do so. Uber opened the industry to millions of people who wanted to drive a cab and earn some money on the side but for whom obtaining a license was cost prohibitive and oftentimes a political impossibility.
Airbnb is another example of a company that has so benefited. Historically, if you needed a place to stay in a town you were unfamiliar with you had to go through a hotel booking site. No longer. Airbnb opened that market by allowing homeowners to rent out rooms and, in many cases, their whole house.
There are many other such examples but its not always the case.
Within the field of institutional finance it has been a disaster. Investment banks use to act as the middleman when it came to clearing transactions; but, with the advent of Dodd-Frank and the elimination of investment banks, there are no middlemen to clear trades. Nowhere is this more disastrous than in the bond market.
In life, the things we know are dwarfed by the things we don’t. The bond market is boring to most people as they feel it has little consequence in their lives. In fact, the bond market greatly affects all of our lives. In 2008, it was the collapse of bond market that almost precipitated the entire destruction of our financial system. Therefore, its safe to say the bond market is something we should definitely try to understand.
Let’s do a basic primer.
The bond market is really the main determinate of what sets the rate for money. Any time you need to buy a car, a house or apply for a credit card, the rate that applies is determined by current bond market rates. Thus the speed, quality and efficiency of the bond market affects all consumers in a variety of economic activities.
Prior to the bond market collapse of 2007-2008, investment banks would act as an intermediary for all bond transactions. When the market was selling off, bond traders at investment banks would come in and buy the bonds and act as a stabilizing effect on the markets. They did so because the market would reward them for assuming this risk.
However, after the collapse of 2008, investment banks ceased to exist, They were transformed into commercial banks. Under regulatory oversight and applicable law, commercial banks can’t use depositors’ monies for speculative purposes. In addition, the banks were further prohibited from taking speculative positions and could only transact when they had an available buyer and available seller on the other side.
Since these changes have been implemented, very little secondary trading takes place. Mutual funds and pension funds now know that when they buy a bond there is a good chance they will have to hold that instrument until maturity. They know it will be very hard to sell their bond holdings. These investment funds have very little turnover in their portfolios and are assuming greater and greater risk as a result.
Currently, with low volatility and low yields, nobody seems to be worried too much about this problem; but, crisis always hits the financial markets and what’s ahead will be no different. Although there has not been a financial crisis since 2008, during the previous ten years there were four major shocks to the system: dot com bust in 2000; the Russian crisis in 1998; Long Term Capital bust in 1998, and the Asian crisis in 1997. The fact is: booms and busts are part of, and natural to, the credit cycle.
We have already seen a glimpse of what is to come with the collapse of the Third Avenue Focused Credit Fund in 2015. Given the problems the fund endured, it had to unwind. However, it took over two years to get the investors their money back. Why? Because the investors were trapped. There were no ready and willing buyers to buy those distressed assets. The fund was not huge. It had about five billion in assets. Imagine the problems that will come when a much larger funds needs to be liquidated. Now think about those investors who could not get their money out and had to raise liquidity to meet their own obligations in other ways.
What happens when you cut out the middleman out of the bond market is that panic ensues.
Here in the U.S., we have been quick to embrace many of the new technologies that eliminated the need for a middleman. But let’s be clear. Investment banks did very well for years clearing bond trades. Now that mechanism no longer exists. We are entering uncharted territory and this lack of a middleman should worry us all. What happens when a large pension fund is forced to sell off some of its assets and isn’t able to meet its redemption needs? Are we going to tell the retirees to wait two years for their liquidity?
The technocrats point to Uber and Airbnb as companies that have benefited us all by cutting out the middleman. But, uh oh!, very few if any of these companies are making any money. The bet on these companies is that one day they will make money. Even titans like Amazon, Netflix and Tesla have struggled to make money because they have had to spend a fortune on growth. Such companies could only exist in an environment like the current one… where the financial markets are so distorted they can borrow unlimited amounts of money to fuel their growth.
Before the markets become rational again, and they will, there will be blood on the streets. Then, once again, markets will reward companies that make money and punish those that don’t. This is the way it has always been during rational times. We will again see the value of companies based upon the merits of their ideas and the profits those ideas generate. We will even see the error of government regulators in taking away the role of investment banks to naturally provide liquidity in the financial markets. Until then, buckle up.
Steve