One Bank’s Warning As Credit Cracks: ‘The Black Swan Is A Liquidity Crisis’

“[We have] reviewed [our] pandemic planning procedures and are prepared to respond appropriately if and when the situation progresses”, the Cboe said Friday, adding that, if necessary, it will close the Chicago pits and operate the options exchange in “electronic only trading mode”.

Cboe is prepared to facilitate the normal operation of all trading platforms by staff working from remote locations, including from home, if warranted”, a statement reads.

It was the latest sign that financial services provision – an increasingly electronic business anyway – could be affected by containment measures tied to the coronavirus outbreak.

This week, JPMorgan, Morgan Stanley, Bank of America and Danske all made moves to divide workers and split operations, utilizing back-up locations in order to reduce the risk that entire lines of business will be jeopardized by one infected employee.

“Dividing our workforce into different locations improves our ability to serve clients continuously while reducing the health risks associated with physical contact should a case arise”, JPMorgan said, in a memo to workers Thursday.

Morgan Stanley moved half of its traders from Manhattan to Westchester, while Bank of America will shuffle at least 100 employees in equities and FICC to a site in Connecticut next week as a precaution.

One question worth asking as carbon-based lifeforms play hide and seek with the invisible biological threat that’s chasing humanity around the globe, is whether and to what extent this will increase the chances of already illiquid markets becoming even less reliable at a time when cracks are beginning to show.

“We would highlight the risk of ‘people'”, Deutsche Bank’s George Saravelos wrote, in a note dated Friday. After citing the same contingency plans mentioned above and observing that “work from home arrangements are being encouraged”, Saravelos asks if “market functioning and liquidity operate as smoothly when the world’s major financial centers are in partial shut down?”

The answer, of course, is probably not. “Worry about liquidity, not funding”, he goes on to say.

Of course, funding pressures are building, as highlighted in a predawn note published in these pages (see: “Defcon 1“). But Saravelos reminds you that “the black swan is a liquidity crisis”.

As regular readers are acutely aware, one of the topics near and dear to my heart is the inherent liquidity mismatch built into many popular credit ETFs, which promise intraday liquidity against an underlying pool of assets which is more or less liquid depending on market conditions.

Right now, market conditions are challenged.

“At times of stress the question always arises as to where is the vulnerability in the financial system [and] in our view, it is not a funding crisis like 2008 but a liquidity crisis we should be worried about”, Deutsche’s Saravelos went on to write, adding that “banks’ capacity to hold inventory has been severely curtailed by regulators”.

He’s referring to the onerous post-crisis regulatory regime which makes the street less willing to lend its balance sheet in a pinch. That regime along with the explosion of corporate issuance has created a dramatic mismatch between the market itself and dealer inventories. Have a look:

(Deutsche Bank)

“Investor assets have been funneled into a very narrow set of ETF vehicles”, Saravelos cautions.

Although credit ETFs have survived stress test after stress test, worries persist, as do skeptics, who have for years cautioned that some left-tail event will eventually come calling and expose the underlying liquidity mismatch.

Friday marked one of the worst days for credit markets in years, as corporate bonds tied to travel names and energy companies came under pressure amid warnings from airlines and the worst single-day collapse in crude prices since 2008.

Market participants are clearly trying to find liquidity where it’s available, which in credit means turning to CDX and ETFs. The spread on CDX.IG blew out by the most since 2011 on Friday.


According to Lipper data out Thursday evening, investors yanked $4.7 billion from IG funds in the week through Wednesday.

That’s the most since May of last year.

As one PM told Bloomberg, “this is what the start of a recession after a long bull market feels like”.

“This is the first day of seeing some panic in the market”, he added.

Read more:

Retail Investors Will Be ‘Shocked’ To Discover The Truth About Corporate Debt Bubble, Street’s Most Famous Bear Says

A (Dove’s) Wing And A Prayer.

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5 thoughts on “One Bank’s Warning As Credit Cracks: ‘The Black Swan Is A Liquidity Crisis’

  1. During the Rosh Hashannah week, it is said that on Rosh Hashanna (new year) the fate of the next year is written, by Yom Kippur it is sealed. The flattening yield curve was the new year- widening credit spreads wtih an exogenous shock to the economy (virus) seal your fate. As sure as day follows night we are in for an economic slowdown. If not properly dealt with it will be a major long lasting one. I am not reassured so far by either the Trump Administration or the FOMC.

    For a very long time I have watched and waited for bank loan mutual funds and ETFs to blow up. I thought it was almost a given. Why? My understanding is that bank loans are a bit illiquid and take 2-4 weeks to settle once traded. That is in a regular normally functioning market. I was stunned when I saw Jeff Gundlach recommend them on a Barron’s panel a year or two ago. The only way I would touch this asset in a pooled vehicle that would either be in a closed end fund or interval fund structure- where there was a decent liquidity match for the asset. I am actually not as concerned about high yield ETFs because the ETF structure by definition forces the ETF to buy the bigger deals which have more liquidity- in fact the structure forces the manager to be more cautious and conservative; and the ETF structure also allows a couple of routes to tap liquidity. I would avoid mutual funds for high yield on the other hand- Third Avenue fund was a prima facie case and it has already happened. Liquidity if not addressed often migrates to solvency or credit issues. Although I am cautious about municipal bond high yield ETFs, if you drill down and look at them, they have a sleeve of investment grade investments. I do not think their risk of a blow up is excessive. And for the same reason as taxable high yield ETFs their structure forces the manager to focus on the larger issues which is a plus. Not so sure about high yield municipal bond mutual funds.

    I am a professional investor with long years in the bond market and have studied these issues for some time. I could be wrong of course but I have a solid basis for making these comments. Caveat Emptor.

    1. Appreciate the thoughtful comment. What you’re describing is analogous (to my ears) to CDOs (or CDOs squared) where the risk of the underling asset is mitigated by bundling it into a larger structure of similarly risky assets, Genius.

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