As late-cycle concerns grow, spreads widen and outflows from junk and loan funds (for instance) accelerate, it’s worth noting that while a lot has changed since the crisis, the global hunt for yield (encouraged, facilitated and underwritten by nearly a decade of accommodation from developed market central banks), has led invariably to maturity and liquidity transformation.
Some will argue that the current setup is considerably less dangerous than that which existed prior to the crisis and the point of this post isn’t to get into a debate about the efficiency of the various transmission channels.
Rather, what we wanted to point out here is that old habits die hard and while the intervening vehicles and dynamics have changed, the result is generally the same: underappreciated risks that have proliferated and otherwise multiplied thanks to financialization.
We’re going to recycle some passages from a post we published in October on the private debt bubble, so if some of this sounds familiar, that’s why.
More than two years ago, on November 16, 2017, Goldman outlined their “top ten themes” for the coming year (so, for 2018). Number 10 on that list was “Illiquidity Is the New Leverage”. The bank’s point was simple: Having learned a lesson from the crisis, market participants have eschewed levered exposure to compressed risk premia in favor of “leaning harder into liquidity premium”. There is, Goldman warned, voracious demand for “anything without a Cusip”.
Smart people can argue about whether investors have indeed avoided employing leverage in order to squeeze out yield in a world where there is no conceptual difference between trades. It’s all one trade (or at least it was until the easy carry regime died and short vol. blew up), and each option is distinguished only by the amount of carry on offer. What isn’t debatable, though, is that the QE-inspired global hunt for yield has forced investors into less liquid assets.
This isn’t confined to the “smart” money. Retail investors have been similarly herded into corners of the market where they might not otherwise have ventured thanks to, for instance, high yield and emerging market debt ETFs. Those vehicles mask an underlying liquidity mismatch.
This is the backdrop against which Deutsche Bank’s Masao Muraki details the evolution of maturity and liquidity transformation in the post-crisis world, with an eye towards identifying where the risks lie if the cycle is indeed turning.
“Banks, investment banks and insurers experienced a liquidity crisis in 2008-09 [and] asset fire sales to secure needed funds and deal with runs increased the magnitude”, he writes, before reminding everyone that “the main culprit was maturity and liquidity transformation.”
Muraki goes on to warn that maturity and liquidity transformation is now underway in the following areas: “US credit investment trusts; insurance companies and banks (dollar funding for dollar-denominated investment) in Asia (e.g. Japan, Taiwan) and Europe; and banks and companies in emerging markets.”
Some of that is obviously tied to the frantic hunt for yield and the proliferation of products that allow easy access to previously esoteric corners of the market in some cases with the promise of intraday liquidity despite the philosophical impossibility of a representative asset (e.g., an ETF) being more liquid than the underlying.
Consider the following “then” versus “now” chart that appears in Muraki’s note:
If you’re inclined to believe that the current setup is less prone to disaster than that which persisted pre-crisis, you might consider that there’s no way to know how retail investors will react in the event a fire sale scenario exposes the liquidity mismatch.
“We believe the level of maturity and liquidity transformation in advanced economies is lower than before the global financial crisis, however, it is difficult to create a model for dynamic surrenders by individual investors who have purchased credit investment trusts, leaving an unknown risk”, Deutsche writes, before adding the following additional color vis-a-vis the other risks mentioned above:
Some of the long-term investment in dollar-denominated assets by Asian and European insurers and banks is covered by short-term dollar funding, though the degree of matching differs widely among financial institutions. For financial institutions with mismatches, the capacity and economic rationale for holding CLO and such to maturity will depend on their ability to secure dollars in the future and the related costs.
There’s some irony here. The democratization of markets (as manifested in the proliferation of vehicles that allow easy access to everything from junk to emerging market debt to loans) may end up being a point of failure during the next downturn. And the inability to forecast how individual investors would react once the reality of maturity and liquidity transformation finally dawns on them muddies the waters further at a time when the post-crisis regulatory regime leaves the Street hamstrung in its ability to cushion the blow by lending its balance sheet.
Muraki couches things in terms of geological shifts. “During economic recoveries, pensions and life insurers (who face high assumed rates of return) and retail investors take on more risk (tectonic plate movement) while a sustained economic recovery with few defaults causes a build-up of energy (tectonic plates deform)”, his note reads.
The longer the expansion goes on, the more pent-up energy accumulates and when it suddenly releases, it “causes default rates to spike”, Muraki continues, characterizing that spike as “plates bouncing off each other.”
Deutsche goes on to say that if you look at put open interest in HYG, it looks like some folks have been buying “earthquake insurance.”
You can take all of the above for what it’s worth, but one thing is for sure: it’s a discussion that is more relevant now than it was just six months ago.
We’ll leave you with another handy visual from DB’s note.