There is a reason why the Focused Credit Fund, a mutual fund that specialized in junk bonds, imploded on December 11 – the first fund to do so since the Financial Crisis. It experienced a run by its beaten-up investors and had to dump assets to cover the redemptions. This “forced selling” drove down prices even further. Finally, the fund blocked withdrawals. It would liquidate its assets gradually and pay the remaining investors the leftover subway tokens at some later time.
It was a classic liquidity mismatch, where a mutual fund held “illiquid” junk bonds, while investors were entitled to daily redemptions. This was exacerbated by the “first-mover” advantage in these kinds of open-end funds: the first investors out the door where made whole; those left behind ended up holding the bag [read… It Starts: Junk-Bond Fund Implodes, Investors Stuck].
The culprit? “Liquidity,” or rather the lack thereof, in junk bonds. The only way to sell junk bonds if you have to sell them is at much lower prices – at which there suddenly is liquidity. And why was there no liquidity at the higher prices? Because there was no “dumb bid.”
That’s the theory penned with impeccable timing ten days before this implosion by junk-bond guru Marty Fridson, Chief Investment Officer of Lehmann Livian Fridson Advisors, in a commentary on S&P Capital IQ LCD, titled beautifully, “Can liquidity exist without a dumb bid?”
His answer is no. There are two divergent “camps” among junk-bond market observers, according to Fridson:
One group bemoans the loss of liquidity, which is causing bonds to fall more sharply on bad news than in the past. The other contends that little has been lost because the high-yield market actually never had genuine liquidity.
Liquidity in the junk bond market, now that selling pressures are rising, is in terrible shape. Actually, it has been in terrible shape since the Financial Crisis; only no one complained because low liquidity when buying pressures were strong caused bond prices to soar. The Fed, bond-fund managers, and investors loved that. Financial advisors loved it. Everyone loved it. But now the direction has changed, and suddenly they’re all scared.
A portfolio manager who turns negative on a name and decides to liquidate a large position must be resigned to disrupting the market more violently than would have been the case prior to the Global Financial Crisis. Commentators in the bemoaning-lost-liquidity camp attribute this change to reduced dealer inventories, in turn resulting from tightened banking regulations, imposition of the Volcker Rule, and the transparency created by the introduction of the TRACE system’s essentially real-time trade reporting.
Those who deny liquidity ever existed argue that dealers never really used their own capital to act as shock absorbers, even if they made more of a pretense than they now do of maintaining continuous markets. I come down more on the side of the latter than the former.
A point that repeatedly emerges from discussions of the current state of liquidity is the importance of the dumb bid (“dumb” is not used in this context in its literal sense of “mute” but in the slang sense of “stupid”). The only reason market-makers were sometimes able to make semi-respectable bids on deteriorating credits is that they had an outlet in the form of uninformed buyers.
This “dumb bid” that bids on anything without paying attention isn’t directly the retail investor but fund managers whose products, decorated with appealing and conservative sounding names, were sold to retail investors.
And that “dumb bid,” which is now sorely missing, disappeared during the Financial Crisis when, as Fridson put it, “calamitous trading losses have eliminated those dumping-ground investment organizations from the scene.”
While this elimination process has been going on for decades, “new dumb bidders” would crop up to replace some of those that collapsed. But the Financial Crisis was “a more thoroughgoing exterminator than past downturns, a sort of financial Black Death that wiped out nearly every dumb bidder.”
After the Financial Crisis, only those with “a well-honed understanding of corporate credit were left standing.” But they’re not willing to pick up damaged junk at inflated prices that a bond fund under duress has to sell.
Without this dumb bid, liquidity disappears until the price is low enough. Then liquidity reappears. This price may be very low for bonds that are heading for default, restructuring, or bankruptcy, as many of the junk bonds have already done this year.
And this is what happened to the Focused Credit Fund, which was created after the “dumb bidders” had been washed out:
Its assets under management soared from its inception in 2009 to over $1.2 billion by mid-2011. During the bond swoon triggered by the euro debt crisis, assets dropped and then flattened out at just under $1 billion. But when the Fed kicked off QE3, new money plowed into the fund, which more than tripled to about $3.5 billion by mid-2014. The fact that the fund, like other bond funds, was gobbling up junk bonds in an illiquid market pushed up prices to record levels. But then QE petered out while the price of oil began to collapse. As defaults and bankruptcies were appearing on the scene, investors started worrying about risks that they’d blissfully ignored before, and they yanked their money out.
What was sorely missing was the “dumb bid” that would have bought these damaged credits at inflated prices. It would have created “liquidity” and spread the losses to others. But without the dumb bid, the junk-bond market was declared illiquid, to the point that the SEC is now proposing new regulations for open-end funds – so that they don’t implode so quickly.
So where’s my free lunch? Read… I was asked: Whatever Happened to Inflation after all this Money-Printing?
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Sure sounds like a dumb bid is just another semantic variance on ponzi finance or the speculative momentum of a bubble. :)
Who could have guessed 2 years ago that oil prices would collapse ? Was the oil price collapse managed by the Fed by first providing liquidity to oil industry to create an over supply of oil and then ending the QE’s which at the same time took away liquidity from the market also took away money from the consumers to burn oil ? And how do one make a “dumb bid” today when one doesn’t even have money to make a bid ? Do one make a visit to Mario Draghi ? Well… I’m not an economist or an investor… I just think that this is interesting.
the marginal buyer makes the market. when there is no market, there is no marginal buyer.
money plowed into low quality credits, and now there is a lack of desire to put money into low quality credit. it’s “the freeze.”
therefore the marginal buyer is exposed, in the cold.
it’s such a dizzying array of credit quality, stacks and preferences, no one knows what’s in them. on to run-off.
Over 50% of loans in the oil and gas sectors are now trading at less than 70% of par. Most if not all of these loans that are under distress, have been securitized and bundled into derivatives. On which funds have gorged themselves! Portfolios held under professional money management now hold an historic high of +35% in corporate bonds.
Unfortunately, these weapons of mass financial destruction have found their way into mutual funds, pension funds, insurance funds, etc. etc.
Days of you??? Visions 2008 only on steroids this time.
Couldn’t agree more. Your assessment makes sense.
I keep asking myself: what kind of rabbit will the Fed pull out of its hat this time?
Or alternatively: will this be a 20-year recession or a Financial Nuclear Blast?
Again, as someone with no understanding of this, it sounds like a description of a malfunctioning market. In a good market, both purchaser and seller should be able to benefit. In a poor market, where there are serious asymmetries, the seller can often take serious advantage of the purchaser (e.g. health care). In a way, it sounds as if the junk bond market is designed as a market for a product that shouldn’t exist in its current form. Is this an example of the mechanisms that lead countries that expand their financial sector too greatly to experience diminished growth?
Credit has to expand to keep the system alive. It is akin to oxygen for carbon based life. Carbon based life expands exponentially (i.e. as a portion of its current size at any moment). O2 has to be sufficient to sustain the current.
In a natural environment, where there are resources for real growth, this is fine; O2 is in surplus or at lease available. But once resources start to strain, become limited, that is where we are these days; O2 is in short supply or increasingly not available. In the really big, longer time line, macro kind of sense.
All CBs have done is ensure, at all costs, is more O2. CBs have prevented the natural selection process that removes low quality O2 consumers from the equation. They just pick winners and make losers, regardless of other qualities. So, now the O2 is running out and we have a lot of organisms that are not well suited to survive regardless.
The petri dish is getting rather small these days. This will be a massive deflationary mess. Thus my call for oil demand shock.
When it rolls over? Who knows. But it will happen. It can’t not happen.
Get out of debt. Stay mobile.
We breath in oxygen and release carbon dioxide, the plants absorb this carbon dioxide and release oxygen for us to breath.
The CB release oxygen to the banks, who then transfers it to the economy, which breaths it in and then returns it to the banks, who recycles it into the economy, but the economy seems to accumulate carbon dioxide (debt) every time it breaths in the oxygen. Today the economy seems to be suffocating from the accumulated carbon dioxide and the lack of fresh oxygen.
In your parallel of CB’s to oxygen generators- in nature oxygen isn’t free and limitless, it is created at a cost in energy (the sun) and usually via carbon dioxide eaters.
In our Alice-in-Wonderland world, Central Banks create money out of thin air. Setting aside the mechanics of CB’s creating new money/credit (credit always becomes purchasing power of some sort) in exchange for old or new assets (government debt), there is a belief that CB’s are some sort or financial god.
In fact, their existence depends entirely on the government
that created them, and the economies in which they operate. To the extent that they can assist in growth in incomes, they will survive the long run. But Central Banking is like driving a car in deep snow. Pedal to the metal means the stucker you will get.
Hi Cooter, would you please expand on the “Get out of debt. Stay mobile.” point? Thanks!
First and foremost is there is absolutely no accountability, or prison sentence for theft since Holder and Obama,and the too big to prosecute. I read where dead banker club is now 72.Falling from high rise,staple gun,suicide note hanging………Who knows if they tried to leave and it is like the roach motel.You can go in but….
The issue is not a malfunctioning market, but rather that bonds and other financial assets are not suitable for markets. A bond is issued by a debtor and held by a creditor. Sure, the creditor can transfer the bond – and its intrinsic relationship with the debtor – to someone else, but they are ultimately only redeemable by the issuer. These are unlike real goods (cotton, soybeans, etc.) that can always be redeemed – used or eaten – by the owner.
” these weapons of mass financial destruction have found their way into mutual funds, pension funds, insurance funds, etc. etc”
The market (so-called assets) bag is bursting at the seams with junk.
Now, its like trying to stuff 20 pounds of flour into a 10 pound sack!
Sooner, rather than later she’s gonna blow.
Likewise no dumb bids for commodity producers trying to dump assets?
If you watch TV or listen to the radio, you would think that the US is doing well and we are recovering nicely. I even saw a local news report on the Holiday shopping and it was almost giddy in how well the local retailers had done.. Even Mastercard came out with a report that said holiday spending was up 7.9%? THEN I read people like Wolf, Stockman, ZH and others and it looks like the economy is crumbling. Or at best, getting ready to crumble. More likely to fall off the proverbial cliff…
So again, Main Street and Wall Street are on totally different cycles which affect each other but are not really correlated directly. I was listening to a pod cast last night about how even the homeless population, in the opinion of those who try and keep statistic on such, is shrinking again. According to them, due to government intervention and housing support.
Everything seems so out of balance and disconnected from each other. Many of us have been like Fred Sanford (Sanford and Son’s TV show) that was always saying “This is the big one!” while clutching his heart.. Only to find out it was just indigestion again..
Logic and markets do not seen to have much to do with each other but I am still fascinated watching and reading. No novelist could write a story that was any more interesting or intriguing that what is going on in the US right now..
Thank you all for sharing… I hope all of you have a Peaceful and Prosperous New Year.. And I really wish/hope that the worst case scenario doesn’t finally happen.
George Orwell could not have envisioned this….
The three foundational things I’ve learned about America over the years (or as my freshmen students say, ‘muhrika’) can be summed up by –
– The Great Hostile takeover – we exterminated the native Meso-Indian cultures, “from sea to shining sea” (the great open plains empty because intentionally spread diseases had already done their job) who once numbered over 250 million. All military actions were cruel mop-up operations.
– Founding Fathers as “pirates” – If you look at the richest families from Maine to Florida, their fortunes were made stealing from the Spanish galleons. Many continued plundering whatever ship went by because they were financed by the original boyz of Wall Street.
– The Next Dumb Sucker – Most businesses are filthy scams, and since “the bid’ness of America is bid’ness”, they are passed on to the subsequent investor, who discovers he or she has been suckered. Perhaps that is the only thing that has changed since colonial, and that’s how we could become a world dominating power, because we overthrew, and made completely opaque, the concept of caveat emptor.
See, in the days of our fore-pirates, a failing business could not be passed on to another party, because when it went under, the debt rebounded to the originator. George Washington learned this the hard way, several times over, and basically died bankrupt because of the first great scam of the American colonial times – The Great Dismal Swamp.
Read “George Washington and the Dismal Swamp”: it should be the seminal history book on the making of America. Whether GW was a sucker, or a figurehead, he and a group of rich Virginia investors bought most of North Carolina and South Virginia, a vast swamp, and tried to drain it. They spent millions of dollars, and the lives of thousands of slaves, and the endeavor failed multiple times over a thirty year period.
Each time Georgie sold his part, it failed again, and came back to haunt him; the last one was right at the end of his life, after his Presidency. Only from a quickly cooked up pension from Congress did our first fraudster-in-chief not die in the poor house.
I now take two things away from George Washington’s life – America has been one great real estate play (that is finally collapsing under its last desperate creaky exurban expansion) The second lesson, which plays out in the bid’ness realm, is that the sucker must now eat his bet.
Without the rubber band rule, business can be conducted in the most ruthless, damn the future kind of way, and lead us from Dismal Swamp scams to completely opaque business practices, like MBS’s and CDO’s, where the scams can be chopped up and dumped on the next sucker, without their ability to know the true value of their investment.
Since all the suckers have too much debt already, there is no buy, no liquidity….. The Great Freeze-Up is coming again soon.
Will the Colombian Drug banks bail us out again with their $30 billion cash injection?
Will it even work this time?
Anybody with gold, is holding something they think, is worth 10 to 15 times more, than it really is.
Scrap steel (usefull stuff) is worth .5C an Oz roughly, so how is gold possibly worth $1000.00 + Oz.
Buying gold is like buying a new house, or new car, it has massive Forced Realization Deprecation, built into it.
When you have to realize it, in desperate times, it is worth maybe 10% of what YOU, paid for it.