By Pam Martens and Russ Martens: September 8, 2014
Last week the Fed announced a plan for the next financial crisis that feels to some observers like a plan to burn down the trading houses on Wall Street – or, alternately, guarantee another massive taxpayer bailout of the biggest banks.
The Federal Reserve Board and its regional banks are overflowing with economists. What the Fed does not seem to have is an honest, informed voice to consult about how trading markets think in a severe financial crisis.
Last Tuesday, the Federal Reserve Board along with other bank regulators announced a new liquidity rule for the largest Wall Street banks – the ones that required the massive bailout in the 2008 to 2010 financial crisis. The goal of the new rule, according to the Fed, would be to force the biggest, most complex banks to hold enough “high quality liquid assets” (HQLA) so that they could be easily liquidated if there was a run on the bank, eliminating the need for another taxpayer bailout. So far, so good.
Then the Fed and its fellow regulators did something that raises serious doubts about their market sophistication. They announced that in addition to U.S. Treasury securities, where a flight to safety always flows in a crisis, the big banks could also hold corporate bonds and corporate common stocks in the Russell 1000 index among their newly defined “high quality liquid assets” earmarked for an emergency.
Just six weeks before the Fed anointed non-exchange traded corporate bonds as liquid assets, all the way down to investment grade, the Financial Times ran this opening paragraph in an article by Tracy Alloway:
“The ease with which investors can trade corporate debt has declined sharply in the five years since the financial crisis according to research that is likely to feed fears over the prospect of an intensified sell-off in the $9.9 trillion US market.”
Then there is this 2010 paper by Jack Bao (Ohio State) Jun Pan and Jiang Wang (both of MIT Sloan School of Management), aptly titled “The Illiquidity of Corporate Bonds.” It starts off like this: “The illiquidity of the US corporate bond market has captured the interest and attention of researchers, practitioners and policy makers alike.” (Apparently, everybody but the researchers at the U.S. central bank.)
Looking at transaction level data for corporate bonds during the last financial crisis, the researchers report:
“In particular, the aggregate illiquidity comoves in an important way with the aggregate market condition, including market risk as captured by the CBOE VIX index and credit risk as proxied by a CDS index. Its movement during the crisis of 2008 is also instructive. The aggregate illiquidity doubled from its pre-crisis average in August 2007, when the credit problem ?rst broke out, and tripled in March 2008, during the collapse of Bear Stearns. By September 2008, during the Lehman default and the bailout of AIG, it was ?ve times its pre-crisis average and over 12 standard deviations away.”
End of story on liquidity aspect of corporate bonds in a serious crisis. Now let’s talk about contagion.
Liquidity is typically viewed — outside of the Fed — as the ability to exit a security quickly without experiencing too much of an air pocket drop in pricing.
In a financial crisis, with plunging stock prices, if the largest balance sheets in the county – the mega Wall Street banks – start dumping their stocks (which they have been blessed to load up on by the Fed), it will quickly add to the downward spiral in stock prices, forcing an instant reappraisal of what the corporate bonds of those same corporate parents are worth.
This is called contagion. It feeds on itself.
There is one reason that U.S. Treasury securities are liquid and corporate bonds are not. Treasuries are so simple and transparent that they do not require a prospectus or even a leaf of paper to trade. They are backed by the full faith and credit of the U.S. government – which actually means the ability to tax its citizens to pay its bills and a very effective means of tax collection – taking it from your paycheck before you receive what’s left.
Corporate bonds are frequently so complex that they are issued with dozens of pages of incomprehensible legal jargon. Check out just a supplement to a prospectus for Verizon debt securities. Among the information Verizon is required to share with you about its corporate debt is this:
“Each series of notes will constitute a new class of securities with no established trading market. The notes will not be listed on any securities exchange or on any automated dealer quotation system. The underwriters have advised us that they currently intend to make a market in the notes. However, they are not obligated to do so and they may discontinue market-making activities with respect to the notes at any time without notice. Accordingly, we cannot assure you as to the liquidity of, or the trading market for, the notes.” (Italics emphasis added.)
There may be far greater contagion correlation in the next financial crisis between corporate debt and corporate stocks. That’s because corporations, since 2006, have been using ever rising proceeds of debt offerings to buy back their own stock.
According to Birinyi Associates, for calendar years 2006 through 2013, corporations authorized $4.14 trillion in buybacks of their own publicly traded stock in the U.S. In 2013 alone, corporations authorized $754.8 billion in stock buybacks while simultaneously borrowing $782.5 billion from credit markets.
Jeffrey Kleintop, the Chief Market Strategist for LPL Financial, issued a report that found that corporations are now the single largest buying source for all U.S. stocks. This trend has continued into 2014 with Standard and Poor’s 500 companies buying back approximately $160 billion in the first quarter.
Since corporate debt has been financing much of this bull market in stocks while the Fed’s low interest rate environment has been the enabler to ever larger amounts of corporate debt offerings sold to yield-hungry investors, this is all destined to end badly when both punchbowls are removed.
For the Fed to now suggest that these two categories of corporate securities will be a boon to liquidity at Wall Street’s big banks in a serious financial crisis is to ask us to suspend all rational common sense.
The Senate Banking Committee needs to enter the debate on this dangerous plan.