A Full Trunk Of Combustible Junk------The Wages Of ZIRP And Folly Of Illiquidity Transformation

Shuffling uncomfortably with paint brushes in hand in the tight monetary corner into which they have painted themselves, our monetary suzerains are about to demonstrate the folly of their seven-year stint of "extraordinary" policy accommodation.

Even as ZIRP and QE have failed to rejuvenate the main street economy, they did trigger a far-reaching scramble for yield that has now left the casino bobby-trapped with FEDS (financially explosive devices). The current rumblings in the junkyard are just the warning signs of the explosions sure to follow.

These little nasties are not the product of free financial markets and honest price discovery; they are the deformed off-spring of relentless financial repression and the systematic falsification of prices in the money and capital markets.

As shown below, the volume of outstanding high yield debt has reached record levels; and more importantly, it has climbed in a relentless progression over the Fed's serial bubble cycles.

On the eve of the dotcom collapse, there was about $375 billion of high yield bonds and bank loans outstanding----a figure which was not in the slightest set back by the dotcom crash and recession which followed.

In fact, by the time Greenspan had slashed money market rates from 6.5% on Christmas eve 2000 to 1.0% by the end of 2003, the amount of high yield debt outstanding had doubled to $700 billion; and it eventually grew another half trillion dollars as the housing/credit bubble inflated, reaching $1.2 trillion by 2007.

During the Great Recession the level of outstandings temporarily plateaued, but there was no purge of the rot or liquidation on a net basis of the excesses that had been generated during the Greenspan housing/credit boom.

Instead, the US economy's great junk debt pile was just rolled over in a vast refi operation triggered by ZIRP and the Fed's massive suppression of bond yields via QE.

Specifically, leveraged bank loan balances were paid down by about 10% between the 2007 peak and 2010 to about $500 billion.

But at the same time junk bond issuance soared, driven by the scramble for yield among money managers and retail investors alike. Accordingly, even during the purported dark days of the financial crisis and its aftermath, junk bond outstandings rose from $700 billion in 2007 to $985 billion by the end of 2010.

That's a 40% gain during what was allegedly the greatest financial meltdown in modern history. In a word, the Fed's drastic interest rate repression policies literally herded capital into the high risk precincts of the market.

And thereafter it was off to the races. By the end of October 2015, another $725 billion had been issued, bringing total junk bonds outstanding to $1.7 trillion.

So put it this way. During the Fed's 84 month long sojourn at the zero bound, the Wall Street junk bond underwriters were busy like never before. They managed to issue $1 trillion in new junk bonds, and at the lowest spreads in the 35 year history of the high yield market.

Indeed, the scene was as far removed from the crisis environment which had triggered the Fed spree of money printing and extraordinary policies in the first place as to suggest a monumental disconnect.

To wit, massive new risks were being accumulated in the financial system, but until the past few months junk bond prices had climbed steadily higher, meaning that as spreads narrowed to the vanishing point and that the junk bond asset class was generating record double digit returns year after year.

Leveraged Debt Outstanding - Click to enlarge

But the junk bond boom wasn't the end of it. After treading water during 2009-2010, the senior leveraged loan market came roaring back, too.  At the end of October, outstanding had risen to $875 billion or by 75% from their post-recession low at $500 billion.

On the surface this seems in conflict with the mantra of Fed apologists that the banking system has been fixed and stress tested, and that the kind of toxic asset meltdown in the banking system that occurred in the fall of 2008 had been banished to the distant past.

Not exactly. The risk inherent in highly leveraged loans had just been shuffled off to a venue outside of the regulated banking system, and one that is far more unstable and dangerous.

To wit, CLO's (collateralized loan obligations) have been resurrected after their near death experience in 2008-2009, and are now being issued at record rates.

Needless to say, their Wall Street sponsors are busy at their patented craft---something which might be called "illiquidity transformation".

What I mean by that is that CLO sponsors gather highly illiquid senior bank loan assets into pools or investment trusts, and then lure yield hungry institutional mangers and retail investors into sliced and diced debt securities collateralized by these loan pools.

Needless to say, the new CLO securities are tradable and liquid by the hour; the underlying collateral most definitely is not.

And then just to make the whole thing even more combustible, some CLO's borrow money to buy assets, and thereby effect internal leverage. At the same time, other prime brokers and financial operators advance margin loans to investors to finance their purchases of the various tiers of CLO debt paper, thereby effecting outside leverage.

Somewhere in there it all adds up to quadruple leverage-----starting with the LBO company issuers of the leveraged loan bank paper and tracking all the way through to investor margin loans.

So just get some investor margin calls and you quickly have a fiery chain reaction. That's because the false attraction of CLOs is that they can be sold into the secondary market at any nanosecond in time.

Yet if there is not enough demand in the secondary market, CLO managers are obligated to redeem all paper offered, meaning that they have to sell the illiquid loan assets in their pools in order to generate cash.

And these pools truly are illiquid because that is the middle name of the whole CLO concoction. Especially, in the post Dodd-Frank world, banks do not want to own for more than a few seconds the leveraged loans they syndicate or participate in because they appropriately face a hefty capital charge.

So they sell this loan paper to fly-by-night CLOs. And this description is used advisedly.

As is evident in the above chart, CLO's are not permanent investment organizations that operate through the thick and thin of market cycles; they are purely cookie-cutter legal entities stamped out by fund companies and Wall Street dealers whenever the credit cycle gathers momentum and investors lapse into amnesia about the flameouts last time around.

Stated differently, CLOs are supremely pro-bubble cycle. They are the buyers of first  and primary resort for leveraged bank loans when the credit cycle is inflating, and the fire sale disposer of such paper into bidless markets when  economic recession, rising defaults and falling loan prices trigger investor flight and redemptions.

It is rather certain that in an honest free market CLOs would not even exist. But even if they did they would trade at a permanent massive discount to their underlying collateral owing to the giant illiquidity transformation inherent in the structure of these trusts.

In any event, the liquidation cycle is already well underway. Leveraged loan prices are falling and new CLO formation has dried up. Next will come surging investor redemptions and another rout in the junk loan sector.

Here's the thing, however. Leveraged bank loans now outstanding amount to nearly $900 billion, meaning that outstandings are up 80% from the post crisis bottom.

This massive inflation of leveraged credit has been essential to the financial engineering spree-----especially M&A deals and stock buybacks-----which have levitated the stock market during the Fed's sojourn into radical monetary experimentation.

But the CLO surge is now over and done, and so is the leverage-based  financial engineering bid for stocks in the casino.

Now what is coming down the pike is that great unwind of another cycle of illiquidity transformation in the high yield debt market-----both bank and bond.

At the end of the day, all of these debt instruments represent they same gambit. Namely, high risk, longer term and illiquid debt is sold to investors through non-bank vehicles which inherently create an illiquidity transformation.

While CLOs are perhaps the most egregious case, the same structural dynamic is true for the roughly $75 trillion of junk bonds owned by ETFs, and the hundreds of billions owned by high yield mutual funds, hybrid mutual funds and a motely array of credit-focused hedge funds.

We have been hearing from some of these in the past week.

In all cases, investor redemption rights are immediate and largely unconstrained and un-penalized except for hedge fund redemption gates.  On the other side of the ledger, however, is a steaming pile of illiquid, risky and underpriced loans and bonds that now totals nearly $2.6 trillion.

That amounts to a FED and then some.

It also amounts to Lehman all over again. Back in Septembers 2008, the illiquidity mismatch was on the balance sheets of the big Wall Street brokers and banks.

They were stuffed to the gills with the dodgy leftovers from their CDO securitization labs, real estate deals and leveraged junk underwritings, but had funded themselves with hot money in wholesale funds markets such as repo and commercial paper.

Thus, when wholesale funding failed, they were forced to barf up their illiquid and over-marked dregs or so-called "toxic assets" into a bidless market. The so-called run on the banks was entirely a run on wholesale funding in the canyons of Wall Street.

So here is a news flash for our monetary central planners who claim that their recent stumbling efforts at "prudential regulation" have eliminated the illiquidity mismatch that triggered the last crisis.

No they haven't. Repression of bond yields and the consequent herding of investors and gamblers into the $2.6 trillion high yield debt market has only relocated the site of the next round of carnage.

 

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