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Detached bonds

21 April 2015 By Neil Unmack, Daniel Indiviglio

Thinning markets for bonds have led even JPMorgan Chief Executive Jamie Dimon to fret over what happens if something shocks investors. The 2008 crisis, after all, started with U.S. mortgage-backed securities. Much has changed. Bank exposure has fallen, while funds and exchange-traded funds have grown rapidly. Overall, lower leverage in the system should mean even a big market surprise won’t trigger another meltdown.

What happened in 2008, again?

The crisis was born as the folly of subprime mortgages was laid bare, starting around 2007. Banks had lent too much money to home buyers who couldn’t pay it back, and then sold the loans to financial repackaging firms on Wall Street and elsewhere, which turned them into bonds. These instruments were structured in ways that added further leverage – and, using derivatives, more overall exposure and opacity – and garnered credit ratings that, in hindsight, were too high.

As the risk in these bonds was belatedly recognized, investors started to sell them. As the potential for huge losses emerged, more and more holders tried to offload them, but it soon became hard to do. The banks and brokers that created the bonds and bought and sold them for both clients and their own accounts collectively ended up stuck with hundreds of billions of dollars of exposure to them, often without initially realizing it. With leverage of, say, 30-to-one, even relatively modest losses started taking bites out of banks’ capital cushions.

Add a mismatch between short-term funding and long-term assets, and those dealing with big lenders started worrying they would not only face damaging paper losses but also run out of liquid funds to meet daily cash needs for the rest of their business. That’s when trust broke down and financial markets of all kinds started seizing up, with the eventual much broader consequences collectively known as the global financial crisis.

What’s different now?

Well, Dimon and others worry that various regulations brought in since the crisis have made bond markets less liquid, This, they argue, could make the next big selloff even worse. In his recent annual letter to JPMorgan shareholders, Dimon says that even Treasuries, traditionally the most easily traded securities of any kind, are harder to buy and sell. Investment firm Loomis Sayles backs him up. Experts there reckon overall U.S. government bond market depth is just 60 percent to 70 percent of what it was, and that at longer maturities it has dried up even more than that.

The same trend also applies to the already much thinner markets for corporate bonds and other kinds of debt securities. In any kind of panic, investors will be trying to sell those while buying safe Treasuries – $2 trillion of them last time around, according to Dimon.

JPMorgan’s boss is right about that. He’s also, though, correct to note that banks are far less vulnerable to the kind of spiral that took hold in 2008. Goldman Sachs provides an example. In its annual shareholder communications, the Wall Street firm showed its leverage ratio has fallen from 26-to-one in 2007 to just 10-to-one last year. That has been one area of focus from financial watchdogs. Bank liquidity has been another, the goal being to diminish cash flow concerns and reduce the scope for knock-on damage across the financial sector.

So we can all rest easier?

From a banking perspective, yes. There will still be pain in a crisis, but it should be far more manageable. But the market structure has changed. Dimon’s skepticism may owe something to the fact that he runs a bank whose business has been crimped by regulators, but he’s justified in saying this will mean that markets behave differently next time there’s a significant jolt.

One big change is that as banks have whittled down their balance sheets, mutual funds and exchange-traded funds have moved more heavily into bonds. They now hold about $1 trillion in credit, according to Citigroup, against roughly $426 billion in 2008. Though leverage is typically far lower in these vehicles than at banks, even today, they are vulnerable to potentially volatile retail investor sentiment. If Joe Public wants out, these funds have to sell. ETFs allow investors to trade throughout the day and rely on banks and brokers being willing to buy their assets, which may be illiquid.

But banks have even less capacity to make markets in a crisis than they used to – even then, many would often simply offer prices so ludicrous anyway that little would trade. In a future crash, bids may come mostly from hedge funds looking for a steal, potentially making price declines steeper than they might have been in the past. Mutual funds and ETFs could even decide to penalize or prevent withdrawals, which would surely amplify any sense of panic.

I see. The problem has just moved from banks to investment funds

Not exactly. Leverage in the system is far lower, and the risk of losses from funds is spread widely among the investing community as a whole. That’s painful for everyone involved, but it doesn’t carry the same danger of highly concentrated losses like those that sank Lehman Brothers, for instance, and required Citigroup and Bank of America to require government bailouts. And the mismatch of short-term borrowing and long-term investing that bedeviled banks last time around shouldn’t cause the same kind of trauma with mutual funds, though some ETF structures may prove more vulnerable to market gyrations.

The IMF’s Global Stability Report, released on April 8, outlined potential risks due to assets moving from being concentrated in banks to asset managers. It said those companies do not necessarily pose as much systemic risk as banks, but that particular types of investment funds could cause system-wide ripples. The report recommends stress-testing fund managers to help keep tabs on this risk. Another solution would be to reduce the number of funds that offer daily liquidity, for example by encouraging investors to switch into vehicles with longer redemption periods or closed-end funds in which trades by holders don’t affect the underlying assets.

OK. Sounds like we can stop worrying

That’s never a good idea – at least not entirely. Dimon and others have also raised the question of how central clearinghouses, entities mostly created since the crisis to reduce the extent to which financial market participants rely on banks as trading counterparties, will hold up in a stress scenario. Policymakers and watchdogs have tackled bank leverage and illiquidity, both culprits in the last crisis. The next one will test the system in other ways.


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