Reflections 10 years on - Part 1

May 2018

Brett Lewthwaite: Global Chief Investment Officer, Fixed Income | Global Co-Head, Fixed Income


Those who forget are bound to remember

This year marks 10 years since the Global Financial Crisis.

This is the first in a series of reflection pieces relating to that incredible time in financial markets. It’s a series written with the old quote below, recalling the lessons learnt and reminding ourselves and our readers…

“He who forgets will be destined to remember.” - Eddie Vedder

The importance of liquidity

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 he had written on the ‘Importance of Liquidity in Fixed Income’. I didn’t know it back then, but that piece of research would come to influence and shape our investment beliefs, philosophy and processes. It would also go on to become a differentiating bedrock pillar of how we would approach markets and portfolio positioning in some of the most extreme conditions financial markets had ever seen, and remain relevant throughout the years following, to be just as important today, as it was back then.

The ‘Importance of Liquidity’ research was written in 2003 and was well received by clients and consultants, but it didn’t gain a following (or get ‘likes’, or ‘retweets’ as it might today), being five years before anyone would come to appreciate (or be reminded) of the true value and importance of liquidity.

Conducting research like the ‘Importance of Liquidity’ piece was something that we at Macquarie Fixed Income have always firmly believed in. We come from a mindset that before we do anything, we must truly understand the risks involved with the markets and instruments we are trading in. While this sounds sensible and obvious, we are constantly surprised this isn’t as normal as it sounds.

Collateralised Debt Obligations – a lesson in the importance 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, Dean investigated CDOs releasing a research paper (again to little fanfare, ok 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 that of liquidity risk. Of course, none of them did. So we didn’t invest.

We then watched with interest as CDOs exploded in popularity from 2003 to 2007:

  • Firstly plain vanilla CDOs (packages of loans to many companies), but then more troubling,
  • ‘Synthetic’ CDOs. Synthetic means they were made up of derivatives, not loans to real companies. We wondered in amazement why anyone would buy a security that had no economic purpose; and then,
  • Subprime CDOs, i.e. poor quality loans, some even nicknamed NINJA loans (No Income, No Job or Assets), then
  • CDO-squared. CDOs of other CDOs – more wonderment and questions about the economic purpose of such a structure, and then
  • Tranche CDO-Squared (CDOs of tranches of other CDOs – these were where banks and hedge funds began offloading their risk or shorting the market, and then 
  • Leveraged-Super-Senior CDOs – I don’t even remember what they did.

While we had done the prerequisite research that resulted in us ‘staying away’, it doesn’t mean we didn’t do the work on what we saw – we did, with fascinated interest. All the way along, right up to when it seemed apparent the financial institutions (some where we had little or no relationship) appeared very, very keen to sell us the new format CDOs.

And so, as it began to unravel, we knew 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 would undermine 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, and what did we do differently. The answer starts with going back to doing the research. 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 – and this is what served us well.

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 they are untested in these claims 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, as we like to say “Everyone thinks they are a macro trader now”, and all 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 one day change, 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, wiser, and pleased to find we are all still working alongside each other. Our children are now entering their teenage years. And while now we can look back in 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, and stay true to our beliefs – again, even when others don’t.

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May 2018

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