Wednesday, July 1, 2015

Bill Gross on the global bond market upon which Rick Lusk etc... and the City of Greensboro bet $102 million on

"...derivatives on a systemic basis represent increased leverage and therefore increased risk – presenting possible exit and liquidity problems in future months and years.

Mutual funds, hedge funds, and ETFs, are part of the “shadow banking system” where these modern “banks” are not required to maintain reserves or even emergency levels of cash.  Since they in effect now are the market, a rush for liquidity on the part of the investing public, whether they be individuals in 401Ks or institutional pension funds and insurance companies, would find the “market” selling to itself with the Federal Reserve severely limited in its ability to provide assistance. regulators have ample cause to wonder if the phrase “run on the bank” could apply to modern day investment structures that are lightly regulated and less liquid than traditional banks.

...regulators and thus large institutional asset managers are at least contemplating an inability to respond to potential outflows.

...the obvious risk – perhaps better labeled the “liquidity illusion” – is that all investors cannot fit through a narrow exit at the same time.

The financial industry/government may keep you stuck where you're invested,
whether you want to or not,
like Greece, Cyprus, Argentina, Zimbabwe etc...

But shadow banking structures – unlike cash securities – require counterparty relationships that require more and more margin if prices should decline.

The more your leveraged and the more you  lose, 
the more equity you have to put up on margin calls, 
the less equity you have, 
the higher likelihood you may have to sell at the worst time. 

While private equity and hedge funds have built-in “gates” to prevent an overnight exit, mutual funds and ETFs do not.  That an ETF can satisfy redemption with underlying bonds or shares, only raises the nightmare possibility of a disillusioned and uninformed public throwing in the towel once again after they receive thousands of individual odd lot pieces under such circumstances.

What if too many of the old folks watching CNBC and FOX Business
decide to sell at the same time
to salvage needed retirement funds?

But even in milder “left tail scenarios” it is price that makes the difference to mutual fund and ETF holders alike, and when liquidity is scarce, prices usually go down not up, given a Minsky moment. 

See below

Long used to the inevitability of capital gains, investors and markets have not been tested during a stretch of time when prices go down and policymakers’ hands are tied to perform their historical function of buyer of last resort.

It’s then that liquidity will be tested.

...what might precipitate such a “run on the shadow banks”?

1) A central bank mistake leading to lower bond prices and a stronger dollar.

2) Greece, and if so, the inevitable aftermath of default/restructuring leading to additional concerns for Eurozone peripherals.

3) China - “a riddle wrapped in a mystery, inside an enigma”. It is the “mystery meat” of economic sandwiches - you never know what’s in there. Credit has expanded more rapidly in recent years than any major economy in history, a sure warning sign.

4) Emerging market crisis - dollar denominated debt/overinvestment/commodity orientation - take your pick of potential culprits.

5) Geopolitical risks - too numerous to mention and too sensitive to print.

6) A butterfly’s wing - chaos theory suggests that a small change in “non-linear systems” could result in large changes elsewhere. Call this kooky, but in a levered financial system, small changes can upset the status quo.

Keep that butterfly net handy.

Should that moment occur, a cold rather than a hot shower may be an investor’s reward and the view will be something less than “gorgeous”.

So what to do?

Hold an appropriate amount of cash so that panic selling for you is off the table.

A wise investor from nearly a century ago - Bernard Baruch - counseled to “sell to the sleeping point”.

Mimic Mr. Baruch and have a good night.

-William H. Gross
"What is a Minsky Moment?

A Minsky moment is a sudden major collapse of asset values...

Sudden collapse via a minority perceived set of imbalances
that with enough of the population figuring it out,
affects a change in the confidence/belief/perception to the point
that too many become aware in too short of time.

Minsky moments occur after long periods of prosperity
and inflationary investment values
lead to increased leveraged (borrowed) speculation. 

Spiraling debt 
incurred in financing non income producing speculative investment
leads to cash flow problems for investors. 

The cash generated by their assets 
no longer is sufficient to pay off the debt they took on to acquire them. 

The banks lent too much,
consumers borrowed too much,
the Federal Reserve and other central banks
bailed out their patrons with funny money,
reflating a big bubble into a huge, global, simultaneous
government sponsored liquidity fest.

Losses on such speculative assets
prompt lenders to call in their loans. 
likely leading to collapse of asset values
leading to a sudden and precipitous collapse 
in market-clearing asset prices, 
a sharp drop in market liquidity, 
and a severe demand for cash."