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No Steve Schwarzman, That's Not How "The Next Financial Crisis Will Happen"

Overnight, in a lengthy op-ed, Blackstone CEO, Steve Schwarzman described, in his opinion, "How the Next Financial Crisis Will Happen." In the article, the author, correctly, notes that bond market liquidity is collapsing - something that has been discussed here constantly for the past 3 years - yet incorrectly assigns the cause to "politicians and regulators" who "constructed an expansive and untested regulatory framework that will have unintended consequences for liquidity in our financial system."

The reason for the Blackstone CEO's conflicted position is obvious: for a company whose lifeblood is abundant credit, the only gating factor preventing it from recreating the LBO spree of the mid-2000s, and thus a massive windfall to the partners, is somewhat more stringent regulations than the unregulated free-for-all in which Wall Street was expected to "police" itself. We all know how that ended.

And while we can explain once again why Scwharzman is wrong (we will simply link back to the comprehensive explanation why liquidity has imploded at the end of this piece), we prefer to give the podium to Citi's chief credit strategist Matt King to disabuse Schwarzman and his Wall Street peers of the assumption that the collapse of liquidity is due solely to regulation, when in reality the answer is the disastrous central bank policy of the past 7 years coupled with the relentless ascent of Hiigh Frequency Trading.

Here are the choice excerpts from Matt King's May 4, 2015 note:

We take issue with the widespread notion that the problem is solely due to regulators having raised the cost of dealer balance sheet, and could be ameliorated if only there were greater investment in e-trading or a rise in non-dealer-to-non dealer activity. To be sure, we see the growth in regulation – leverage ratio and net stable funding ratio (NSFR) in particular – as one of the main reasons why rates markets are now starting to be afflicted, and indeed we expect further declines in repo volumes to add to such pressures. But illiquidity is a growing concern even in markets like equities and FX, which use barely any balance sheet at all, and where e-trading is the already the norm rather than the exception.

 

Instead, we argue that in addition to bank regulations, there is a broad-based problem insofar as the investor base across markets has developed a greater tendency to crowd into the same trades, to be the same way round at the same time. This “herding” effect leads to markets which trend strongly, often with low day-to-day volatility, but are prone to air pockets, and ultimately to abrupt corrections. Etrading if anything reinforces this tendency, by creating the illusion of lliquidity which evaporates under stress.... Because the herding is not directly backed by leverage, it is unlikely to be reduced by macroprudential regulation.

 

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One possibility is that regulation is once again the culprit. Greater constraints on dealers’ ability to act in a principal capacity, even for a few seconds, could be taking their toll. The Volcker Rule, for example, forbids dealers subject to US regulations from running positions except so as to facilitate client trades. It is possible that this has prompted dealers to become more cautious than previously, and that this increased caution is missed particularly on occasions when markets become volatile. While no numbers are available on even prop desk profits, never mind their balance sheet usage, some market participants do point to their importance as an uncorrelated source of risk-taking, in particular during moments of stress. Nor are dealers the only ones to have been subjected to increased regulation in recent years: others have pointed to the way in which accounting and capital requirements for insurance companies and pension funds may also cause them to move in an increasingly procyclical fashion.

 

The trouble is, this still feels like an incomplete explanation as to why short-term illiquidity problems should be affecting quite so many markets, including those where pension companies, insurers and even dealers have not historically been considered particularly important drivers of pricing. And above all, it does nothing at all to explain why illiquidity pockets should be being encountered so suddenly and with so little obvious cause. At least in historically famous illiquidity episodes – such as the LTCM-related crisis in 1998 – there was a glaring cause of sufficiently large magnitude to help explain the incident. Many recent air pockets seem to have started almost from nothing. To complete the picture, we think you need to look beyond the regulations and in a different direction.

 

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To sum up, we are left with a paradox. Markets are liquid when they work both ways. Market participants, though, find themselves increasingly needing to move the same way. This is not only because of procyclical regulation; it is also because central banks have become a far larger driver of markets than was true in the past. The more liquidity the central banks add, the more they disrupt the natural heterogeneity of the market. On the way in, it has mostly proved possible to accommodate this, as investors have moved gradually, and their purchases have been offset by new issuance. The way out may not prove so easy; indeed, we are not sure there is any way out at all.

And there it is: regulation is merely a small, procyclical part of the big "liquidity paradox" although now that Wall Street is screaming bloody murder and blaming it all on Volcker, Dodd Frank and other rules which nobody follows anyway, one can be certain that regulatory capital and leverage constraints will soon be quietly lifted. And since these are not the reason for the underlying illiquidty, the result will be an even more illiquid market, only one where the inherent leverage will be that much greater, leading to even more spectacular flash, and not so flash, crashes.

But that doesn't matter to people like Steve: all they care is to be able to push the LBO multiple from 10x to 15x or, heck, why not 20x. After all it is not like they won't find bond buyers for any ludicrously levered transaction, allowing them to soak up the equity quickly and efficiently, leaving an insolvent husk behind.

Which means the rich will get even richer, while leave even recorder debt behind, even greater defaults, and an even greater and more catastrophic collapse when everything crashes once again, which it will. After all even Citi admits "there may not be a way out at all."

But at least we now know why calls for regulatory repeal will intensify until, grudgingly, Wall Street's bought politicians concede and all the lunatics to once again take over the asylum. Which, incidentally, is at this junction the best possible outcome: with the biggest bubble in developed markets history unfolding before everyone eyes, and with most rational people able to willing to admit what is happening, yet powerless to stop it, the only way this insanity ever ends is by hitting its inevitable peak sooner rather then later... and allowing humanity to proceed with the reset as soon as possible.

One can only hope there are enough people left alive and who remember the stupidity and mistakes of the New Normal time of idiocy.

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Finally, for the real and complete answer why there is no bond market liquidity, read our post on the Liquidity Paradox, or why "The more liquidity central banks add, the less there is in markets."