When Regulations Court Calamity

 | Feb 13, 2014 | 10:30 AM EST
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The lowest form of financial journalism in existence is to run around telling people there is going to be a crash. Nothing sells newsletters/blogs/magazines faster than fear mongering.

Let me be clear up front that I am not predicting a crash. Instead, I am going to outline some worrying market microstructure reashy one might occur at some point in the future, and how it would come to pass.

The corporate bond market (which includes sovereigns) is huge, trillions of dollars with tens of thousands of issues. Since 2009, it has gotten orders of magnitude larger, with companies taking advantage of easy credit conditions to issue debt. Corporate bonds do not trade on a public exchange; rather, they trade over the counter, in the dealer market.

You might have heard about the Volcker Rule, which prohibits proprietary trading by investment banks. It is having drastic effects on bond dealing, with truly massive unintended consequences.

There isn't enough space in this column to give the Volcker Rule a good walloping. Like most post-crisis regulation, it was introduced to preserve financial stability but will almost certainly end up introducing much more volatility.

Making a market in corporate bonds is not like making a market in a stock. If you are the General Electric (GE) market maker and someone sells you half a million shares of GE, chances are you are just going to turn around and sell GE. After all, it trades tens of millions of shares a day.

But in credit, there are only a few hundred liquid issues, but most bonds trade by appointment. To facilitate trading, the upstairs bond trader typically carries an inventory of bonds. But under Volcker, holding positions in securities for any length of time may constitute proprietary trading -- and is therefore prohibited. In response, bond traders have been carrying almost no inventory, and have little appetite to take down large positions, with corresponding effects on liquidity.

It's not hard to see that during the next crisis what will happen when some gorilla bond manager at a place like PIMCO, or a large pension fund, tries to move $10 billion in bonds. All hell is going to break loose. And because of the nature of markets, of course, everyone is going to try and do it at once.

 Imagine the world's biggest, most crowded movie theater, with the tiniest exit. It is possible for the entire bond market to gap, and re-price lower. The calamity that would ensure would mirror 1998.

You can't predict when this is going to happen, but it will, for sure -- give it time. The question is how to protect the portfolio. Big money managers might use index credit default swaptions. These are hard to replicate in the stock market, but you can get something close. The two corporate bond ETFs are iShares iBoxx $ Invst Grade Crp Bond (LQD), for investment grade bonds, and iShares iBoxx $ Corporate Yield Bond (HYG), for high yield. There are options on these. Deep out of the money put options, or put spreads on these -- long-dated -- are the way to go.

This is known as tail risk hedging. It's not like we're trying to predict a crash, but you want to be wearing your underwear if the tide goes out. I do not think that the S&P 500 Index (SPX) or SPDR S&P 500 (SPY) puts, or any of the major index options really help. They are too expensive, and it is not the right hedge. The stock market does not have the Achilles heel -- the bond market does. That is where the systemic weakness lies.

The coda here is that, once again, regulation will do the opposite of what is intended, but that is an essay for another day (and perhaps another forum).

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