The key financial message of the COVID-19-induced bond market liquidity crisis is that our debt markets lack the resilience necessary to be a source of strength in a crisis. They cannot withstand the stress that modern financial markets require to adapt the supply of credit to dramatic demand fluctuations.
This weakness contributes again to the second financial crisis of this century. Debt market failure was a key cause of the Financial Crisis of 2008. But the regulatory cure for financial market failures in 2008 only increased debt market dysfunction. Draconian measures including Dodd-Frank legislation have proven counterproductive to the goal of robust debt markets.
Government remedies have strengthened institutions at the expense of the system.
The regulatory initiatives in the wake of the 2008 Financial Crisis made our financial institutions stronger. But the government mistook strong financial institutions for a strong financial system. Indeed Dodd-Frank and other Financial Crisis-inspired regulations have made the banks so conservative that they have become inadequate to address the debt market risks created by the COVID-19 crisis.
The heart of the problem is simple. Billions spent by financial institutions on risk management, at regulators’ behest, are pointless if regulators remove these same institutions from the risk management equation when threats appear. We have ignored the faltering debt markets and encouraged financial institutions to reduce their participation in these markets through Volcker Rule-related regulations. The folly of Post-Financial Crisis regulations was to make the banks safer by removing bank responsibility for credit intermediation. The Fed is considering asking banks to ignore these new rules during this crisis but has yet to do so.
As federal management of the effort to replace LIBOR reveals, improving markets is not part of the skill set of government. To return our debt markets to health, private sector innovation is the key. Strong fixed income markets must be more informative and nimbler, and an appropriate amount of financial capital committed to market participation. Post-Financial Crisis federal regulations have had the opposite effect.
The fallacy: sound financial institutions create stable financial markets
In the Financial Crisis of 2008, our government equated the problems of the debt markets with the problems of the banking system – concluding that a safe banking system was equivalent to a sound financial system.
As the Government wraps its arms around more institutions that normally transmit the needs of borrowers to sources of investment funds, each new government-scrutinized and “stabilized” financial institution or intermediary becomes too risk-averse to respond to crisis-induced changes in the demand for funds – failing to help provide rapid access to credit – a barrier to market normalization, not a conduit.
As a result of the new regs, the banks are now admirably constructed to protect only themselves in a crisis.
Arbitrary Fed credit is a poor substitute for considered bank credit.
The unfortunate tepid reaction of banks executing their role in emergency monetary policy has forced the Fed to bypass the banks in defense of the economy, going directly into the primary and secondary markets for debt.
However, the Fed is ill-suited to managing the very expensive and labor-intensive process of managing the risk of investing in corporate debt instruments and asset-backed securities. We have created banking institutions that spend billions analyzing risk they won’t take anymore, while the Fed spends nothing on risk management only to be the sole bearer of risk.
Says Matt Levine of Bloomberg,
“The banks, after all, are in the everyday business of lending to businesses. They have experience in loan underwriting and pricing and due diligence and document negotiation and all the nuts and bolts of giving unsecured loans to companies; they have deep relationships with the companies and can evaluate how creditworthy they are and can customize covenants and terms for each company. The Fed has never met any of these companies; the Fed just knows the banks. For the Fed to jump into the business of commercial lending overnight is just weird.”
This misallocation of responsibilities has forced the Fed to find a private source of expertise and asset management skills. The Fed has, in desperation, retained a single asset management firm, BlackRock (BLK), to assist it. No matter that the banks devote far greater resources to risk management than does BlackRock. According to the Financial Times,
“BlackRock’s dominance in the ETF market raises questions of a conflict of interest. The fund group’s $566bn in fixed-income ETFs represents about half the global total. The Fed’s buying will probably boost assets across the company’s ETFs, improve their liquidity and could even attract new classes of investor who take comfort that the Fed is there beside them.”
How can debt markets better manage market sentiment?
Risk transfer, the function of efficient markets, is less expensive than risk management. Yet risk transfer has been ineffective in debt markets due to post-Financial Crisis regulations and inadequate debt markets for risk transfer.
While stock markets around the world have proven equal to the task of managing the shift to greater market volatility that COVID-19 created; stock markets succeed where bond markets fail. The fundamental difference is the stock markets’ power to provide investors with instant relevant state-of-the market information and with the ability to act immediately and in enough volume to transfer market risks to those equipped to absorb it.
Stock markets instantly reveal what market participants want to know – the price of current economy-wide risks – then provide all investors access to transactions at these revealed market prices. The bond market fails on both counts.
Stock markets use two market innovations that debt markets have emulated but without comparable success – a market-wide index and a means to change market-wide risk exposure with a single transaction.
Poor debt market structure, the major weakness in our financial system.
In the Financial Crisis of 2008, our debt markets and financial institutions collapsed – forcing the Fed to divert its life-giving liquidity around dysfunctional short-term debt markets such as Treasury repurchase agreements (OTCPK:REPO), term deposits, and money market funds; directly rescuing all three.
The COVID-19 crisis shows the inadequacy of the fundamental assumption at the core of Dodd-Frank and other government remedies for the highly leveraged financial institutions. Regulations stifle action. Without an adequate market response to changing conditions, markets cannot save themselves.
How are debt markets different from stock markets?
Why have stock markets transferred information and risk efficiently during the COVID-19 crisis, where debt markets have failed?
A clue can be gleaned from a comparison of bond index ETFs with stock index ETFs. Elsewhere, I argue that bond ETFs come closer to reflecting market valuations than do the screen prices for corporate bond issues during this crisis. In other words, bond index funds are like stock index funds in the sense that they improve the information available to bond traders.
But LIBOR has lost its credibility as a single summary measure of conditions in credit markets, a dramatic reduction in credit market information. Bond index funds are not as informative as stock index funds, because representative bond index construction is frustrated by the splintered, illiquid nature of the bond markets themselves.
Bond market indexes that represent the market as a whole can only be constructed from more bonds themselves, or more creative collections of bonds, that are as useful in representing bond market conditions as are large corporate stock issues.
To manufacture more informative bond indexes, the demand side of the bond market needs a greater say in the construction of market representative fixed income instruments. The only barrier to better bond ETF construction is a merger of ETF construction with exchange trading, as explained here.
The forced conservatism of big bank traders has turned the fixed income markets into a wasteland. These banking regs also clog the most important channel by which Fed open market purchases, usually repo, reach corporate borrowers – borrowers desperate for cash as their retail operating revenues are crushed by COVID-19.
The collapse of the old channels of monetary policy transmission has forced the Fed into a role for which it is poorly suited – direct investment in corporate debt through every available channel – direct lending, acquisition of market-traded short- and long-term debt.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.