Last weekend marked 10 years since the fall of Lehman and their role in the start of the GFC, and it is a good time to reflect on that incredible time in financial markets.
The importance of liquidity
About 15 years ago, when I joined Macquarie Fixed Income, one of my first tasks was to work with Head of Research, Dean Stewart, on a piece called the ‘Importance of Liquidity in Fixed Income’. I didn’t know it at the time but that research would influence and shape our investment beliefs, philosophy and processes. It became the bedrock of our approach to markets and portfolio positioning during the most extreme financial market conditions, and is just as important today as it was back then.
The 2003 research paper was well received by clients and consultants, but it didn’t gain a following (or receive ‘likes’ or ‘retweets’ as it might today). It was five years before anyone would come to appreciate (or be reminded of) the true value and importance of liquidity.
Collateralised Debt Obligations: a lesson in the value of research
Linked to this time was the emergence and then proliferation of Collateralised Debt Obligations, or CDOs. Consistent with our belief that we must truly understand the risks involved before we invest in new markets or instruments, we investigated CDOs and again released a research paper to little fanfare. Okay, so it was complicated … even for fixed income.
The research concluded that CDOs were not liquid, not really AAA-rated and not at all diversified. The research suggested to perhaps buy one, though not many, due to cross-holding exposure, and only if the price truly rewarded for the risks involved, including liquidity risk. None of the CDOs met the requirements so we did not invest.
We then watched with interest as CDOs exploded in popularity from 2003 to 2007, evolving as:
- Plain vanilla CDOs. These were mainly packages of loans to many companies.
- ‘Synthetic’ CDOs. Synthetic means they were made up of derivatives, not loans to real companies, and we wondered in amazement why anyone would buy a security that had no economic purpose.
- Subprime CDOs. Poor-quality loans, some even nicknamed NINJA loans (No Income, No Job or Assets).
- CDO-squared. CDOs of other CDOs, with more wonderment and questions about their economic purpose.
- Tranche CDO-Squared. CDOs of tranches of other CDOs, where banks and hedge funds began offloading their risk or shorting the market.
- Leveraged-Super-Senior CDOs. I don’t even remember what they did.
While we didn't invest, we did the work on what we saw, with fascinated interest. The final straw was when financial institutions, some where we had little or no relationship, appeared very, very keen to sell us the new format CDOs.
And so, it began to unravel. The flow of credit which had been gushing in all its structured, derivative, opaque and levered forms, had stopped, and with it, its influence on economic growth. And all that leverage upon leverage on opaque collateral undermined trust in what were once supposedly safe AAA-rated assets. In markets as it is in life, trust is everything. The rest is history.
A lesson in hindsight: research, research, research
To this day we are often asked why we didn’t get caught up. The answer starts with the research and liquidity in particular. We did the work and stayed true to our findings.
Writing in hindsight is a wonderful thing. We don’t wish to claim anything close to foresight. And we don’t mean to suggest we didn’t feel every bump or learn painful lessons along the way. Indeed, things got far worse than any worst-case scenario we ever imagined. We did however, start from a solid place that was founded on sound research and principles.
Liquidity and the current market environment
We all know that tighter regulations have altered liquidity conditions vastly from 10 years ago. Even though there are now many new investment vehicles that purport seamless and plentiful liquidity (even when the underlying holdings are not very liquid), the reality is these claims are untested by any liquidity event of significance. And with the proliferation of exchange traded funds (ETFs) and passive funds, amid a market environment of unthinkable central banks' support, we like to say, “Everyone thinks they are a macro trader now”. All market professionals think they have that special edge to exit just before the herd rushes for the same exits.
And so, now like so many times in the past, perceptions of the value and importance of liquidity has diminished, and its existence, or tendency to quickly shift to lack thereof, is once again under-appreciated. Investors are giving up liquidity in the belief they don’t need it. We know that this will change one day, even if we cannot predict when.
Back in 2008 amid the chaos of markets, we were juggling newborns and infants (an uncanny number of daughters). Looking around now, we are 10 years older and wiser. Our children are entering their teenage years. And while now we can look back with some fondness on that chaotic time, we know that as in life, the challenges may have changed their form, but the same debt-related structural issues remain and seem destined to at least rhyme, if indeed they don’t repeat.
The principles of how to navigate them haven’t changed, and the next 10 years will require similar resolve to do the work necessary to understand the risks.
Brett Lewthwaite is the Global CIO, Fixed Income and Global Co-Head of Fixed Income at Macquarie Group. This is general information not personal advice and does not consider the circumstances of any individual.