Re-energizing the moribund bond market

January 15, 2015 05:14 AM

How we got here 

In the months before Lehman Brothers collapse, risk expert David M. Rowe cautioned that second means of valuation had become indispensable. “There is no satisfactory second means of valuation,” Rowe noted. “The non-linear sensitivity of tranche values to poorly understood and volatile co-variability results in significant uncertainty around any model-based price.” 

Essentially, the predictive reliability of risk analytics dried up without liquidity. “In effect, the market standard Gaussian copula model is not a structural model: it is a shorthand mechanism for expressing the market’s consensus in terms of pseudo-structural parameters linked to observed price,” Rowe notes. “The lack of any true explanatory structure is apparent in the internal inconsistency of the necessary parameter values required to match the prices for different tranches. In essence,…the Gaussian copula model is effectively just as a means for traders to communicate differing views on behavior of the underlying portfolio, particularly co-variability. As long as there is an active two-way market, this works fine. Tranches can be bought and sold on this basis and the process produces objective values for mark-to market purposes. The problem is that market liquidity is the only source of objective valuation.”

Basically, markets were opaque and without active two-way trading, value was impossible to gauge. 

By contrast, interactive finance democratizes information with available information technologies to incent and provide contemporaneous, verifiable behavioral data to supplement statistically based valuations. Through its crowd-sourced behavioral innovations, interactive finance provides both a second and more robust means of valuation to clarify real-time and near real-time market and risk values.  

When markets are so opaque that trading occurs only in a small fraction of outstanding issues, transactional and risk clarity must be restored. With best executions, mark ups and risk information clarified and presented in real and near real time with robust interactive finance technologies liquidity will be the norm, volumes will recur and confidence will return. 

Bond market debt

Here’s another way to see the product breakdown in billions as of Q2 2014 (see “Bond market debt,” above): 

Virtually all these markets are seriously illiquid but for Treasuries (where the Federal Reserve has bought back roughly half of what it sold), and Money Markets, which trade with rare but significant risk to potentially “breaking the buck,” like during the Lehman Brothers collapse in 2008. 

While the $7.6 trillion corporate bond market debt may be characterized as an artifact of the asset crisis, Treasury debt of $12 trillion, mortgage related debt of $8.7 trillion express Federal Reserve Bank and Treasury legacies and progeny.

The asset crisis popped when Reserve Primary Fund, a money market mutual fund, broke the buck pricing at 97¢ a share instead of $1.00 net asset valuation to write down losses in connection with Lehman Brothers bankruptcy. A contagion of investor fear wrenched $300 billion from institutional money markets. Beset with redemptions, funds stopped purchasing commercial paper, freezing up short-term credit and making it enormously difficult for corporations to repay maturing and to purchase new short-term debt. With the potential for bankruptcies roiling the economy, Treasury intervened with an insurance program, backed by its Exchange Stabilization Fund, which sustained $1.00 net asset valuation for money market mutual funds enrolled in the program. The Federal Reserve extended liquidity. 

Illiquidity desiccated standard statistical models. “Financial engineers and investment bankers created financial instruments called credit default swaps (CDS) on structured collateralized debt obligations (CDOs) and collateralized loan obligations (CLOs), but, in hindsight, these financial contracts lacked sufficient transparency to easily identify, assess and clear the risks,” observed economist Rawle O. King in a Congressional Research Office report.  “[CDOs] and [CLOs] were developed to repackage credit risk inherent in loans, bonds and other types of debt instruments by creating investment-grade fixed income risk from a pool of speculative grade or mixed credit quality fixed income securities,” noted King on the implosion. 

He went on to point out that credit default swaps function as insurance contracts for bond holders to protect against default by bond issuers. He noted that CDSs are traded OTC without the benefits of exchange clearing and noted at the time that the notional size of the CDS market was estimated to be 10X larger than the U.S. Treasury market, 5X larger than the mortgage market and more than double the size of the U.S. stock market concluding, “The $55 trillion CDS market failed as investor appetite for these securities disappeared.  Thus, the credit market crisis spread to the broader financial markets as counterparties, unable to identify and quantify precisely where losses lay, stopped lending to each other.” 

It was not only the outsized risk of overleveraged positions but the inherent fear of not knowing where risk was hiding that led to the crisis. Investors, institutional and retail, should always know what risk they are holding.

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