1 00:00:15,396 --> 00:00:21,516 Speaker 1: Pushkin from Pushkin Industries. This is Deep Background, the show 2 00:00:21,556 --> 00:00:24,716 Speaker 1: where we explore the stories behind the stories in the news. 3 00:00:25,116 --> 00:00:28,476 Speaker 1: I'm Noah Feldman. Earlier this week I had a terrific 4 00:00:28,476 --> 00:00:32,596 Speaker 1: conversation with BoA's Weinstein, the founder and chief investment officer 5 00:00:32,636 --> 00:00:36,276 Speaker 1: at SABA Capital Management. We got such great feedback for 6 00:00:36,316 --> 00:00:38,876 Speaker 1: the conversation that we decided to give you a bonus. 7 00:00:39,356 --> 00:00:42,076 Speaker 1: A further conversation that Boas and I had about what 8 00:00:42,196 --> 00:00:45,556 Speaker 1: happened in March when the bond markets appeared to break. 9 00:00:46,436 --> 00:00:49,156 Speaker 1: For context, what you should keep in mind is that 10 00:00:49,556 --> 00:00:53,196 Speaker 1: high yield debt, so called junk bonds, were long thought 11 00:00:53,236 --> 00:00:56,436 Speaker 1: to be too risky to be held by ordinary investors, 12 00:00:56,916 --> 00:01:00,276 Speaker 1: but in recent years, as a result of such vehicles 13 00:01:00,436 --> 00:01:04,796 Speaker 1: as exchange traded funds ETFs and mutual funds, more and 14 00:01:04,956 --> 00:01:08,596 Speaker 1: more of the market in high yield junk bonds has 15 00:01:08,636 --> 00:01:13,356 Speaker 1: come to be held by consumers. Ultimately, that raises serious 16 00:01:13,396 --> 00:01:16,676 Speaker 1: questions about safety and about whether what Boas calls the 17 00:01:16,836 --> 00:01:21,836 Speaker 1: alchemy of packaging actually works. This part of the conversation 18 00:01:21,956 --> 00:01:24,756 Speaker 1: goes really deep behind the story, and I hope that 19 00:01:24,796 --> 00:01:31,236 Speaker 1: you'll learn as much from it as I did. The 20 00:01:31,316 --> 00:01:34,836 Speaker 1: dynamics and the market structure changed over the last decade 21 00:01:35,036 --> 00:01:38,436 Speaker 1: dramatically in a way that I think caused it more 22 00:01:38,516 --> 00:01:40,756 Speaker 1: or less in March to break. And I don't think 23 00:01:40,796 --> 00:01:44,316 Speaker 1: that story because bonds are followed far less than the inequities. 24 00:01:44,316 --> 00:01:47,196 Speaker 1: The bond market breaking for a few days really, to 25 00:01:47,276 --> 00:01:49,036 Speaker 1: me was one of the most shocking things I've seen 26 00:01:49,036 --> 00:01:53,996 Speaker 1: in my career. So let's dive into this moment where 27 00:01:54,036 --> 00:01:56,596 Speaker 1: the bond market breaks, and I want to take us 28 00:01:56,596 --> 00:01:58,996 Speaker 1: back to the background. So take us back to when 29 00:01:59,356 --> 00:02:04,156 Speaker 1: you first started in your business in the nineties. What 30 00:02:04,236 --> 00:02:08,876 Speaker 1: did the bond market look like that? So I joined 31 00:02:08,916 --> 00:02:11,996 Speaker 1: Will Street after graduating college in ninety five. I was 32 00:02:12,156 --> 00:02:16,596 Speaker 1: very influenced by the book Liar's Poker, actually told by 33 00:02:16,636 --> 00:02:21,316 Speaker 1: Michael Lewis also Pushkin podcast Maker, among many other distinctions. Yeah, 34 00:02:21,436 --> 00:02:23,636 Speaker 1: you know, in that story, aside from all the humor, 35 00:02:23,716 --> 00:02:26,716 Speaker 1: is the point that the participants in the bond market 36 00:02:26,836 --> 00:02:29,276 Speaker 1: that worked at these banks at the times Solomon Brothers 37 00:02:29,476 --> 00:02:32,756 Speaker 1: or Now City Group or Goldman Sachs, they were, in 38 00:02:32,796 --> 00:02:35,156 Speaker 1: their own minds and with the balance sheet given to 39 00:02:35,196 --> 00:02:39,876 Speaker 1: them by the bank, enormous risk takers and could house 40 00:02:39,876 --> 00:02:41,996 Speaker 1: a risk if it came to them, they could act 41 00:02:42,036 --> 00:02:44,356 Speaker 1: as a shock absorber. They didn't view themselves as a 42 00:02:44,396 --> 00:02:46,836 Speaker 1: shock absorber if there were too many sellers. They viewed 43 00:02:46,876 --> 00:02:50,116 Speaker 1: themselves as the world's greatest experts in junk bonds. At 44 00:02:50,156 --> 00:02:52,716 Speaker 1: that time, there were very few hedge funds, and most 45 00:02:52,756 --> 00:02:55,316 Speaker 1: of the great credit hedge funds came out of banks, 46 00:02:55,356 --> 00:02:57,996 Speaker 1: whether they were Drexel, Burnham, Lambert or the ones after. 47 00:02:58,076 --> 00:03:00,516 Speaker 1: And so if you had a big sell off, really 48 00:03:00,516 --> 00:03:03,556 Speaker 1: at any point in time, from the nineteen eighties through 49 00:03:03,796 --> 00:03:06,436 Speaker 1: two thousand and eight, every bank had a trading desk 50 00:03:06,476 --> 00:03:09,556 Speaker 1: that was there to buy bonds without necessarily needing to 51 00:03:09,556 --> 00:03:11,436 Speaker 1: sell them the same day or same week. They could 52 00:03:11,476 --> 00:03:13,956 Speaker 1: buy them and house them if they felt like they 53 00:03:13,956 --> 00:03:17,116 Speaker 1: were good investments. So the market makers were investors. And 54 00:03:17,196 --> 00:03:20,036 Speaker 1: just to clarify that for the civilian, if I'm understanding, 55 00:03:20,036 --> 00:03:22,476 Speaker 1: you're correctly. What you're saying is if a moment came 56 00:03:22,996 --> 00:03:26,556 Speaker 1: where people who held bonds thought, oh boy, it's time 57 00:03:26,556 --> 00:03:28,116 Speaker 1: for me to get rid of these bonds. They're too 58 00:03:28,196 --> 00:03:30,556 Speaker 1: risky for me and they're more likely to default, and 59 00:03:30,556 --> 00:03:32,796 Speaker 1: I'm willing to sell them at a low price. The 60 00:03:32,876 --> 00:03:36,236 Speaker 1: big investment banks, through their trading desks were like, great, 61 00:03:36,516 --> 00:03:38,956 Speaker 1: we'll buy them from you at a low price, and 62 00:03:38,996 --> 00:03:40,716 Speaker 1: then we'll just hang on to them till they are 63 00:03:40,756 --> 00:03:43,476 Speaker 1: more valuable, and then we'll turn around and we'll make 64 00:03:43,516 --> 00:03:45,916 Speaker 1: money on it, and we can afford to buy them 65 00:03:45,956 --> 00:03:47,636 Speaker 1: from you low and hold on to them until the 66 00:03:47,716 --> 00:03:50,836 Speaker 1: time comes to sell them higher. And that effectively wasn't 67 00:03:50,836 --> 00:03:53,116 Speaker 1: their goal, of course, is to make money, But effectively 68 00:03:53,116 --> 00:03:54,996 Speaker 1: that meant that if there was a sudden moment where 69 00:03:55,236 --> 00:03:56,996 Speaker 1: most people who held this debt said, oh my god, 70 00:03:57,076 --> 00:04:00,116 Speaker 1: let me sell it, there was someone there to buy it. Yes, 71 00:04:00,276 --> 00:04:04,196 Speaker 1: So they provided balance to when there was a supply 72 00:04:04,316 --> 00:04:06,996 Speaker 1: demand and balance. They were the demand. And in the 73 00:04:07,076 --> 00:04:10,596 Speaker 1: last ten years before the global financial crisis, every bank 74 00:04:10,716 --> 00:04:14,236 Speaker 1: basically had various groups that were not facing customers, that 75 00:04:14,276 --> 00:04:16,676 Speaker 1: were literally many hedge funds inside of the bank, known 76 00:04:16,716 --> 00:04:20,556 Speaker 1: as proprietary trading desks, who felt even more able to 77 00:04:20,596 --> 00:04:22,916 Speaker 1: take on that risk because their mandate was to invest 78 00:04:22,956 --> 00:04:24,756 Speaker 1: and not to trade with clients. And so you had 79 00:04:25,156 --> 00:04:27,636 Speaker 1: enormous risk taking capacity at the banks, and that's something 80 00:04:27,676 --> 00:04:30,916 Speaker 1: that's measurable. Every week the Federal Reserve reports what the 81 00:04:30,956 --> 00:04:34,476 Speaker 1: aggregate number of bonds held by the investment banks was 82 00:04:34,996 --> 00:04:37,116 Speaker 1: at times it was greater than one out of ten 83 00:04:37,156 --> 00:04:39,756 Speaker 1: bonds was held by these counterparties. And then there came 84 00:04:39,916 --> 00:04:42,516 Speaker 1: two thousand and seven, two thousand and eight, and everything changed. 85 00:04:42,596 --> 00:04:44,716 Speaker 1: What happened to all of that death that was being 86 00:04:44,796 --> 00:04:48,316 Speaker 1: held by the proprietary trading desks in the crisis. So 87 00:04:48,476 --> 00:04:50,356 Speaker 1: of course they lost a lot of money in two 88 00:04:50,396 --> 00:04:53,996 Speaker 1: thousand and eight, and by two thousand and nine, even 89 00:04:53,996 --> 00:04:55,996 Speaker 1: though they had recovered a lot, and the banks actually 90 00:04:55,996 --> 00:04:59,316 Speaker 1: posted their best years in history in this sort of trading. 91 00:04:59,636 --> 00:05:03,516 Speaker 1: The Vulgar rule basically more or less banished that kind 92 00:05:03,556 --> 00:05:06,156 Speaker 1: of risk taking, not just by the proprietary traders, but 93 00:05:06,276 --> 00:05:09,676 Speaker 1: importantly by the market makers. And so if client wanted 94 00:05:09,756 --> 00:05:13,276 Speaker 1: to sell and the amount was not trivial, the bank 95 00:05:13,436 --> 00:05:16,596 Speaker 1: was basically, for all intense purposes not there to buy 96 00:05:16,596 --> 00:05:18,676 Speaker 1: it if it didn't have a ready buyer or it 97 00:05:18,676 --> 00:05:20,996 Speaker 1: couldn't find one in short order. And so that really 98 00:05:21,076 --> 00:05:24,116 Speaker 1: changed one side of the market structure, which was we 99 00:05:24,196 --> 00:05:26,396 Speaker 1: took away the shock absorber, and we took away the 100 00:05:26,476 --> 00:05:29,276 Speaker 1: risk taking capacity by the banks. Even though you know, 101 00:05:29,276 --> 00:05:31,476 Speaker 1: when you think about it, a bank buying the bonds 102 00:05:31,516 --> 00:05:34,276 Speaker 1: of let's say Boeing a company that's having its own 103 00:05:34,316 --> 00:05:36,836 Speaker 1: share of troubles right now if it loses money from 104 00:05:36,876 --> 00:05:40,636 Speaker 1: doing so, is it that different than the bank losing 105 00:05:40,676 --> 00:05:43,316 Speaker 1: money for making a loan to Boeing. In both cases, 106 00:05:43,316 --> 00:05:46,276 Speaker 1: they're supporting Boeing in the loan case as a primary 107 00:05:46,396 --> 00:05:48,756 Speaker 1: lender and in the bond case as let's say, a 108 00:05:48,796 --> 00:05:53,076 Speaker 1: secondary investor in an actual existing market. But aside from 109 00:05:53,196 --> 00:05:55,636 Speaker 1: ought it to be that way. The vocal rule though 110 00:05:55,876 --> 00:05:58,796 Speaker 1: critiqued at the time by self serving banks, but they 111 00:05:58,836 --> 00:06:01,636 Speaker 1: might have had a point. We're saying, look, when clients 112 00:06:01,636 --> 00:06:04,556 Speaker 1: come to sell and the liquidity is very different than 113 00:06:04,596 --> 00:06:06,676 Speaker 1: it is in normal times, who's going to be there 114 00:06:06,716 --> 00:06:08,916 Speaker 1: to buy? And so that's one side of the equation. 115 00:06:09,516 --> 00:06:11,596 Speaker 1: Can I push on that a little bit? So the 116 00:06:11,676 --> 00:06:14,676 Speaker 1: vocal rule basically, I mean, I'm oversimplifying it drastically, but 117 00:06:14,676 --> 00:06:18,756 Speaker 1: it basically said we the government do not want big 118 00:06:18,796 --> 00:06:22,716 Speaker 1: banks to be sitting on a lot of risky investments 119 00:06:23,276 --> 00:06:25,556 Speaker 1: because it's nice when they make money, but when they 120 00:06:25,596 --> 00:06:28,436 Speaker 1: don't make money and they're suddenly losing it, everything can 121 00:06:28,436 --> 00:06:31,476 Speaker 1: go south very very quickly and bring the financial system 122 00:06:31,556 --> 00:06:34,116 Speaker 1: with it. If it was an effect of that, maybe 123 00:06:34,156 --> 00:06:38,036 Speaker 1: even an intended effect of that that the banks couldn't 124 00:06:38,436 --> 00:06:42,156 Speaker 1: buy up lots of risky bonds. I mean that sounds 125 00:06:42,196 --> 00:06:44,236 Speaker 1: sort of like a good thing rather than a bad thing. 126 00:06:44,276 --> 00:06:46,956 Speaker 1: Are you describing an unintended consequence, which is that they 127 00:06:47,036 --> 00:06:50,596 Speaker 1: also couldn't be a buffer? Yeah? You know, maybe the 128 00:06:50,636 --> 00:06:53,276 Speaker 1: answer is something in the middle which would have restrained 129 00:06:53,316 --> 00:06:55,396 Speaker 1: the amount of risk they could take and therefore money 130 00:06:55,436 --> 00:06:58,196 Speaker 1: they could lose, but would allow them to some degree 131 00:06:58,276 --> 00:07:00,796 Speaker 1: to be there when you know there's ten sellers for 132 00:07:00,876 --> 00:07:04,156 Speaker 1: every buyer. You know that unintended consequence is something that 133 00:07:04,236 --> 00:07:06,556 Speaker 1: when you threw out the baby with the bathwater, you 134 00:07:06,596 --> 00:07:08,716 Speaker 1: know you lost something there and you don't see it 135 00:07:08,756 --> 00:07:11,636 Speaker 1: in normal times, but you saw it in March. So 136 00:07:11,676 --> 00:07:14,356 Speaker 1: fast forward now with me to March. You don't have 137 00:07:14,396 --> 00:07:17,396 Speaker 1: this big buffer. The banks are not capable of buying 138 00:07:17,436 --> 00:07:20,196 Speaker 1: a lot of bonds when suddenly the prices go down. 139 00:07:20,676 --> 00:07:24,476 Speaker 1: Suddenly everyone is panicking because we have a pandemic on 140 00:07:24,476 --> 00:07:27,476 Speaker 1: our hands. What happened? How did the market break? Well, 141 00:07:27,516 --> 00:07:30,396 Speaker 1: it's important to know two other things in this story, Okay. 142 00:07:30,476 --> 00:07:33,156 Speaker 1: One of them is, over the past twelve years since 143 00:07:33,236 --> 00:07:37,076 Speaker 1: the global financial crisis, the quantity of debt, the capital 144 00:07:37,116 --> 00:07:41,756 Speaker 1: stock of bonds and loans issued by US corporations went 145 00:07:41,836 --> 00:07:44,876 Speaker 1: up by about three hundred percent, So the amount of 146 00:07:44,916 --> 00:07:48,316 Speaker 1: stuff out there held by people grew tremendously. Of course, 147 00:07:48,356 --> 00:07:50,436 Speaker 1: the banks are not holding hardly any of it anymore. 148 00:07:50,756 --> 00:07:52,876 Speaker 1: And the other thing is the question of who held it. 149 00:07:53,036 --> 00:07:54,996 Speaker 1: So let me just for a second go back to 150 00:07:55,196 --> 00:07:58,596 Speaker 1: nineteen ninety five. I opened up my first account. I'd 151 00:07:58,636 --> 00:08:00,916 Speaker 1: started it at Merrill Lynch after college, and I opened 152 00:08:00,956 --> 00:08:03,236 Speaker 1: up a brokerage account, and I finally think I know 153 00:08:03,316 --> 00:08:06,436 Speaker 1: a little thing or two about bonds. I've been doing 154 00:08:06,436 --> 00:08:08,356 Speaker 1: it for a few years in my college summers. That 155 00:08:08,436 --> 00:08:11,516 Speaker 1: gave me some confidence that maybe was misplaced. And so 156 00:08:11,596 --> 00:08:14,356 Speaker 1: I wanted to buy a junk bond. And I remember 157 00:08:14,436 --> 00:08:18,276 Speaker 1: my Merrill Lynch stockbroker telling me, even though I'm in 158 00:08:18,316 --> 00:08:21,236 Speaker 1: the business, and I'm in this exact business, that this 159 00:08:21,316 --> 00:08:24,476 Speaker 1: type of investment is unsuitable for me. I'm not a 160 00:08:24,556 --> 00:08:27,756 Speaker 1: dentist who doesn't know very much about bonds compared to 161 00:08:28,116 --> 00:08:31,556 Speaker 1: other things. I'm working at a bank in fixed income. 162 00:08:31,876 --> 00:08:34,516 Speaker 1: Yet I'm unable to buy a junk bond because it's 163 00:08:34,516 --> 00:08:38,716 Speaker 1: considered too risky, too complicated, unsuitable for retail. Now, if 164 00:08:38,716 --> 00:08:41,836 Speaker 1: you fast forward to March, you have a market three 165 00:08:41,876 --> 00:08:45,756 Speaker 1: times the size, and the retail investor grew to being 166 00:08:46,316 --> 00:08:49,716 Speaker 1: the largest investor in the market. Approximately half of all 167 00:08:49,756 --> 00:08:53,076 Speaker 1: of those bonds and loans are held by retail investors, 168 00:08:53,356 --> 00:08:56,076 Speaker 1: one way or the other, through myriad of products that 169 00:08:56,356 --> 00:09:00,996 Speaker 1: are themselves interesting and in some cases responsible for some 170 00:09:01,036 --> 00:09:03,356 Speaker 1: of the challenges we saw last month. I don't want 171 00:09:03,356 --> 00:09:05,516 Speaker 1: to miss out on the punchline story of how the 172 00:09:05,596 --> 00:09:08,476 Speaker 1: market broke, but I do want to follow your comment 173 00:09:08,516 --> 00:09:12,396 Speaker 1: about how it came to pass that an investment in 174 00:09:12,436 --> 00:09:14,156 Speaker 1: a high yield bond, in a junk bond that you 175 00:09:14,156 --> 00:09:17,876 Speaker 1: couldn't make as an ordinary retail investor nearly twenty years 176 00:09:17,916 --> 00:09:23,116 Speaker 1: ago now is overwhelmingly where corporate debt is held. So 177 00:09:23,196 --> 00:09:25,996 Speaker 1: say something about these vehicles, because what you're saying is 178 00:09:25,996 --> 00:09:28,916 Speaker 1: that all of us basically own a whole bunch of 179 00:09:28,956 --> 00:09:32,556 Speaker 1: corporate debt without fully realizing that. So ETFs are the 180 00:09:32,596 --> 00:09:35,756 Speaker 1: most exchange traded funds are the most famous example, the 181 00:09:35,796 --> 00:09:38,756 Speaker 1: most salient example. So describe how those work and how 182 00:09:38,796 --> 00:09:41,236 Speaker 1: they enable people for better or worse. And it sounds 183 00:09:41,276 --> 00:09:44,276 Speaker 1: like maybe for worse to hold these risky investments that 184 00:09:44,316 --> 00:09:46,796 Speaker 1: in the olden days people thought were too risky, even 185 00:09:46,836 --> 00:09:50,756 Speaker 1: for you. Yes, So prior to two thousand and eight, 186 00:09:50,836 --> 00:09:55,516 Speaker 1: there were almost no ETFs that held junk rated bonds 187 00:09:55,596 --> 00:09:58,396 Speaker 1: or loans. But what we saw after it was incredible 188 00:09:58,476 --> 00:10:01,916 Speaker 1: demand for yields. Global interest rates were cut. We see 189 00:10:01,996 --> 00:10:05,276 Speaker 1: negative interest rates in Japan, in Switzerland, in lots of 190 00:10:05,316 --> 00:10:07,756 Speaker 1: places around the world, and there was not enough yields 191 00:10:07,796 --> 00:10:10,276 Speaker 1: and people needed that to get fixed income, to meet 192 00:10:10,316 --> 00:10:13,036 Speaker 1: their mortgage payments, whatever it may be. And so there 193 00:10:13,156 --> 00:10:15,596 Speaker 1: was great demand at a time when stock seemed like 194 00:10:15,636 --> 00:10:18,836 Speaker 1: an uncertain investment. The eye popping yields after two thousand 195 00:10:18,836 --> 00:10:21,836 Speaker 1: and eight, the average junk bond yielded more than fifteen percent, 196 00:10:22,196 --> 00:10:25,196 Speaker 1: and so that led to horizon products that we're also 197 00:10:25,476 --> 00:10:29,356 Speaker 1: seeing a tremendous growth themselves, and so exchange traded funds 198 00:10:29,436 --> 00:10:32,876 Speaker 1: stand out as the most obvious example. But you know, 199 00:10:33,156 --> 00:10:35,716 Speaker 1: most people are familiar with mutual funds. The story would 200 00:10:35,716 --> 00:10:38,596 Speaker 1: be the same, and that those funds are special and 201 00:10:38,636 --> 00:10:41,916 Speaker 1: that they're open ended. They allow investors to exit every 202 00:10:41,996 --> 00:10:44,116 Speaker 1: business day of the week, and they allow them to 203 00:10:44,156 --> 00:10:47,756 Speaker 1: exit almost in almost every instance at what's called net 204 00:10:47,796 --> 00:10:51,276 Speaker 1: asset value. And so the exchange traded fund goes. So 205 00:10:51,436 --> 00:10:53,796 Speaker 1: it's a share on the New York Stock Exchange that 206 00:10:53,836 --> 00:10:57,476 Speaker 1: holds a big pool of assets, let's say junk bonds. Okay, 207 00:10:57,716 --> 00:11:01,116 Speaker 1: And because investors have a hard time accessing that market, 208 00:11:01,156 --> 00:11:03,916 Speaker 1: you can't just buy a junk bond. It's not on 209 00:11:03,956 --> 00:11:06,836 Speaker 1: the New York Stock Exchange. It requires you know, lots 210 00:11:06,836 --> 00:11:09,676 Speaker 1: of special knowledge about how to execute in in what's 211 00:11:09,676 --> 00:11:12,276 Speaker 1: called an over the counter market. So ETFs were seen 212 00:11:12,356 --> 00:11:17,036 Speaker 1: really as an incredible opportunity. You can give investors one 213 00:11:17,076 --> 00:11:19,676 Speaker 1: stop shopping where they get access to hundreds of bonds 214 00:11:19,676 --> 00:11:23,436 Speaker 1: at the same time, whether they were carefully selected by 215 00:11:23,556 --> 00:11:27,276 Speaker 1: a manager actively managing them, or they represented an index 216 00:11:27,356 --> 00:11:30,476 Speaker 1: like the Dow Jones or the S ANDP. The growth 217 00:11:30,516 --> 00:11:33,796 Speaker 1: in that space was enormous, and at the same time 218 00:11:33,836 --> 00:11:37,156 Speaker 1: it was also growing tremendously for equities. The problem is 219 00:11:37,596 --> 00:11:41,876 Speaker 1: that equities are highly liquid investments in ETFs that are 220 00:11:41,876 --> 00:11:45,036 Speaker 1: promising investors they can get out the same day and 221 00:11:45,156 --> 00:11:47,836 Speaker 1: are liquid in that big are trading with a difference 222 00:11:47,876 --> 00:11:50,196 Speaker 1: between the price where you could buy or sell being 223 00:11:50,236 --> 00:11:52,676 Speaker 1: just a penny. Are holding things that are highly a 224 00:11:52,716 --> 00:11:55,476 Speaker 1: liquid that at times have a difference between where you 225 00:11:55,476 --> 00:11:57,676 Speaker 1: could buy and sell at a dollar And so it 226 00:11:57,756 --> 00:12:01,716 Speaker 1: raises this question, was this financial alchemy? Did somehow the 227 00:12:01,796 --> 00:12:05,356 Speaker 1: ETF and the mutual fund being a daily liquidity product, 228 00:12:05,636 --> 00:12:08,516 Speaker 1: did it solve this iliquidity problem? Did it allow investors 229 00:12:08,516 --> 00:12:11,236 Speaker 1: to get in and out seamlessly whereas they were unable 230 00:12:11,276 --> 00:12:16,396 Speaker 1: to before? And of course, from the standpoint of financial engineering, 231 00:12:16,516 --> 00:12:19,196 Speaker 1: what you want is alchemy, right, you want it to work. 232 00:12:19,276 --> 00:12:22,996 Speaker 1: You want to say, well, here is this ordinarily somewhat 233 00:12:22,996 --> 00:12:26,596 Speaker 1: illiquid asset, corporate debt or sometimes illiquid asset, but we 234 00:12:26,636 --> 00:12:28,556 Speaker 1: want ordinary people to be able to get access to 235 00:12:28,596 --> 00:12:32,036 Speaker 1: this high risk debt because they then then get high yields. 236 00:12:32,116 --> 00:12:34,676 Speaker 1: So if we bundle it in this way, then we 237 00:12:34,716 --> 00:12:38,916 Speaker 1: can solve the problem somewhat magically. And it sounds like 238 00:12:38,916 --> 00:12:41,756 Speaker 1: what you're saying is the magic didn't fully work and 239 00:12:41,916 --> 00:12:44,596 Speaker 1: that it really didn't fully work in March when the 240 00:12:44,636 --> 00:12:46,956 Speaker 1: market broke. So maybe that brings us to the crucial 241 00:12:46,956 --> 00:12:50,916 Speaker 1: moment in March what happened. Yes, so the magic doesn't 242 00:12:50,916 --> 00:12:55,396 Speaker 1: work if there aren't enough buyers for every seller. So 243 00:12:55,436 --> 00:12:57,556 Speaker 1: if there is a seller of this ETF and there's 244 00:12:57,556 --> 00:12:59,956 Speaker 1: a buyer at TTF, no animals were harmed in the 245 00:12:59,956 --> 00:13:02,436 Speaker 1: filming of this movie, No bonds need to be traded. 246 00:13:02,716 --> 00:13:05,156 Speaker 1: People can trade the shares of ETF back and forth, 247 00:13:05,196 --> 00:13:07,796 Speaker 1: back and forth without any bonds being traded, and it's 248 00:13:07,876 --> 00:13:10,276 Speaker 1: very important to understand that. But at the moment where 249 00:13:10,316 --> 00:13:12,396 Speaker 1: there's ten sellers for every buyer, and maybe it was 250 00:13:12,436 --> 00:13:15,916 Speaker 1: one hundred, which is what happens with retail investors. Retail 251 00:13:15,956 --> 00:13:19,396 Speaker 1: investors are so procyclical in their behavior. They sell when 252 00:13:19,436 --> 00:13:21,836 Speaker 1: the market is falling as a group, and they buy 253 00:13:21,836 --> 00:13:24,196 Speaker 1: when the market is rising. And when they all headed 254 00:13:24,236 --> 00:13:27,476 Speaker 1: for the exit in March, there weren't enough new buyers 255 00:13:27,476 --> 00:13:30,276 Speaker 1: willing to buy, so then what happens. So what happened 256 00:13:30,356 --> 00:13:32,836 Speaker 1: was there's a mechanism in the ETF meant to make 257 00:13:32,876 --> 00:13:36,676 Speaker 1: this alchemy work, which is, if ever there's too many sellers, 258 00:13:36,956 --> 00:13:39,996 Speaker 1: you can just redeem your shares back to the market maker, 259 00:13:40,076 --> 00:13:43,876 Speaker 1: back to the institution that's overseeing this box, this pool, 260 00:13:44,116 --> 00:13:46,076 Speaker 1: and they'll go and sell the bonds and they'll give 261 00:13:46,076 --> 00:13:48,596 Speaker 1: you back your net asset value. So if ever they 262 00:13:48,636 --> 00:13:50,996 Speaker 1: are not enough buyers, they can go and sell bonds 263 00:13:51,316 --> 00:13:53,836 Speaker 1: and take the cash from those sales and give you 264 00:13:53,836 --> 00:13:56,836 Speaker 1: back your money. But the problem is that the bond 265 00:13:56,836 --> 00:13:59,636 Speaker 1: market had frozen. It froze for the reasons we've already discussed, 266 00:13:59,956 --> 00:14:03,476 Speaker 1: and there was just there were no legitimately closed bids 267 00:14:03,596 --> 00:14:06,676 Speaker 1: for taking that risk near where the price of those 268 00:14:06,676 --> 00:14:09,476 Speaker 1: shares were, and so we saw a degradation in the 269 00:14:09,516 --> 00:14:14,556 Speaker 1: price of ETFs way beyond what the underlying bonds would suggest. 270 00:14:14,596 --> 00:14:16,916 Speaker 1: And so if you invested a dollar and the pool 271 00:14:16,956 --> 00:14:18,756 Speaker 1: was worth a dollar, just to put numbers on it, 272 00:14:18,956 --> 00:14:22,276 Speaker 1: in the biggest ETFs, we saw an extra loss on 273 00:14:22,316 --> 00:14:25,156 Speaker 1: top of the normal loss of five percent on some 274 00:14:25,236 --> 00:14:27,756 Speaker 1: days in March, and in some smaller ETFs we saw 275 00:14:27,836 --> 00:14:31,076 Speaker 1: losses of twenty to twenty five percent on top of 276 00:14:31,116 --> 00:14:33,956 Speaker 1: what you lost for the COVID related markets off. And 277 00:14:33,996 --> 00:14:36,956 Speaker 1: so what happened was basically the market makers step back 278 00:14:37,076 --> 00:14:40,356 Speaker 1: and said, we're not going to buy these ETFs for 279 00:14:40,436 --> 00:14:42,556 Speaker 1: what they're worth, because we can't get what they're worth, 280 00:14:42,596 --> 00:14:45,596 Speaker 1: because that's really the mismatches. We have to give your 281 00:14:45,596 --> 00:14:47,676 Speaker 1: money today, and it will take us weeks and months, 282 00:14:47,676 --> 00:14:49,596 Speaker 1: and who knows where we'll get out of those bonds. 283 00:14:49,636 --> 00:14:52,556 Speaker 1: And so ETFs basically broke in March, and I think 284 00:14:52,596 --> 00:14:55,996 Speaker 1: that's what's led the FED to take the extraordinary step 285 00:14:56,436 --> 00:15:00,596 Speaker 1: of buying high yield ETFs and agreeing to it's you know, 286 00:15:00,636 --> 00:15:02,916 Speaker 1: even just saying they would do it restored some confidence, 287 00:15:03,076 --> 00:15:05,516 Speaker 1: but it was done really to just to keep the 288 00:15:05,556 --> 00:15:09,636 Speaker 1: market from breaking further. When that breaking was happening, was 289 00:15:09,676 --> 00:15:12,676 Speaker 1: there a contractual violation there? I mean, mom and Pop 290 00:15:12,796 --> 00:15:15,996 Speaker 1: believed that they could redeem their ETF and the market 291 00:15:16,036 --> 00:15:19,116 Speaker 1: maker was refusing to do it. So who bore that loss? 292 00:15:19,196 --> 00:15:21,316 Speaker 1: I mean, did mom and pop bear that loss? Or 293 00:15:21,396 --> 00:15:23,996 Speaker 1: did the market maker have to redeem and just do 294 00:15:24,076 --> 00:15:26,836 Speaker 1: it at a big haircut? So in the initial trades, 295 00:15:26,876 --> 00:15:29,596 Speaker 1: the market maker felt like, okay, i'll buy them at 296 00:15:29,596 --> 00:15:32,276 Speaker 1: any V and that asked value, I'll buy them slightly lower, 297 00:15:32,396 --> 00:15:34,476 Speaker 1: But at some point they just kept buying them. And 298 00:15:34,596 --> 00:15:37,516 Speaker 1: when something is for sale, without the market maker being 299 00:15:37,556 --> 00:15:39,876 Speaker 1: able to offload the risk, they'll take a step back. 300 00:15:40,116 --> 00:15:42,916 Speaker 1: What's supposed to happen is arbit treasures are supposed to 301 00:15:42,916 --> 00:15:45,436 Speaker 1: step in and say, i'll buy a dollar for ninety 302 00:15:45,476 --> 00:15:48,276 Speaker 1: five cents, I'll take on these portfolio bonds. I'll sell 303 00:15:48,316 --> 00:15:51,796 Speaker 1: them myself. But again, in a broken bond market, people 304 00:15:51,836 --> 00:15:54,076 Speaker 1: didn't have confidence of that, and that's where things really 305 00:15:54,476 --> 00:15:58,276 Speaker 1: went off the rails. What's the regulatory solution to that? 306 00:15:58,316 --> 00:16:01,436 Speaker 1: I mean, you could imagine two directions. One is the 307 00:16:01,476 --> 00:16:04,876 Speaker 1: insurance model that the government will give some insurance, which 308 00:16:04,876 --> 00:16:07,516 Speaker 1: is de facto what actually happened, But that seems to 309 00:16:07,516 --> 00:16:10,756 Speaker 1: create terrible incentives because then people will take on all 310 00:16:10,836 --> 00:16:13,836 Speaker 1: kinds of risk they shouldn't take because the government's effectively 311 00:16:13,876 --> 00:16:17,156 Speaker 1: guaranteeing their investment. The other option would be to say, well, 312 00:16:17,236 --> 00:16:21,876 Speaker 1: g maybe these ETFs can't be over the counter retail 313 00:16:22,076 --> 00:16:26,316 Speaker 1: products sold to mom and pop if they're not actually 314 00:16:26,916 --> 00:16:29,996 Speaker 1: capable of sustaining asset value at a moment when people 315 00:16:30,076 --> 00:16:32,516 Speaker 1: run for the run for the hills. So in that theory, 316 00:16:32,836 --> 00:16:34,316 Speaker 1: you know, maybe we should go back to the days 317 00:16:34,356 --> 00:16:37,276 Speaker 1: when you couldn't buy junk bonds because it's actually too 318 00:16:37,316 --> 00:16:41,436 Speaker 1: risky for mom and pop. You know, as much as 319 00:16:41,436 --> 00:16:43,556 Speaker 1: people don't want to talk about going backwards, I think 320 00:16:43,596 --> 00:16:46,236 Speaker 1: we did go too far in the other direction. And 321 00:16:46,436 --> 00:16:49,716 Speaker 1: it really was the perfect storm of retail being too 322 00:16:49,796 --> 00:16:52,236 Speaker 1: big a player in the credit market. And I only 323 00:16:52,276 --> 00:16:54,356 Speaker 1: mentioned we only mentioned two products. I mean, there are 324 00:16:54,556 --> 00:17:00,156 Speaker 1: products like collateralized loan obligations, closed end funds, business development 325 00:17:00,156 --> 00:17:03,156 Speaker 1: companies that all faced a similar fate. Even if they 326 00:17:03,196 --> 00:17:05,636 Speaker 1: didn't all have to sell on day one, they all 327 00:17:05,636 --> 00:17:08,876 Speaker 1: had issues like margin calls and things that all fed 328 00:17:08,876 --> 00:17:11,236 Speaker 1: into this. And so you know, the answer is probably 329 00:17:11,276 --> 00:17:14,916 Speaker 1: somewhere where there is a regulatory limit on the amount 330 00:17:15,076 --> 00:17:18,596 Speaker 1: of high yield credit risk that should be in daily 331 00:17:18,596 --> 00:17:22,156 Speaker 1: liquidity funds, because it really is illusory, this idea that 332 00:17:22,236 --> 00:17:23,996 Speaker 1: this thing that is so tricky to get in and 333 00:17:23,996 --> 00:17:26,756 Speaker 1: out of gets packaged into a daily liquidity vehicle. It's 334 00:17:26,756 --> 00:17:29,476 Speaker 1: really in some ways unsuitable. And it doesn't matter if 335 00:17:29,516 --> 00:17:31,996 Speaker 1: it's not very big, but when it becomes the biggest player, 336 00:17:32,476 --> 00:17:36,716 Speaker 1: it's incredibly important. One crucial question that emerges from this 337 00:17:36,756 --> 00:17:39,116 Speaker 1: part of the conversation that I had with Boas is 338 00:17:39,116 --> 00:17:43,636 Speaker 1: the regulatory question of whether, going forward, it's still safe 339 00:17:43,956 --> 00:17:48,156 Speaker 1: for ordinary investors to hold mutual funds ETFs or other 340 00:17:48,236 --> 00:17:52,356 Speaker 1: vehicles that expose them to substantial risk from high yield 341 00:17:52,436 --> 00:17:55,996 Speaker 1: corporate bonds from junk bonds. The losses that took place 342 00:17:55,996 --> 00:17:58,276 Speaker 1: in the market were not only a product of everyone 343 00:17:58,316 --> 00:18:01,276 Speaker 1: wanting to sell at the same time. They also revealed, 344 00:18:01,316 --> 00:18:05,356 Speaker 1: as Boas suggests, an underlying decline in the value of 345 00:18:05,436 --> 00:18:08,276 Speaker 1: the assets held by the ETFs or their mutual funds 346 00:18:08,596 --> 00:18:12,596 Speaker 1: below what their aggregate value should have been, even in 347 00:18:12,716 --> 00:18:16,476 Speaker 1: a falling market. That's a puzzle, and it's a puzzle 348 00:18:16,516 --> 00:18:18,076 Speaker 1: that's going to have to be solved not just at 349 00:18:18,076 --> 00:18:22,476 Speaker 1: the conceptual level, but at the practical, real world regulatory level. 350 00:18:23,676 --> 00:18:26,956 Speaker 1: I hope you enjoyed this special bonus conversation, and until 351 00:18:26,956 --> 00:18:29,636 Speaker 1: I speak to you next time, be careful, be safe, 352 00:18:29,796 --> 00:18:32,996 Speaker 1: and be well. Deep background is brought to you by 353 00:18:33,076 --> 00:18:37,036 Speaker 1: Pushkin Industries. Our producer is Lydia Jane Cott, with research 354 00:18:37,076 --> 00:18:40,316 Speaker 1: help from zooe Win and mastering by Jason Gambrel and 355 00:18:40,396 --> 00:18:44,876 Speaker 1: Martin Gonzalez. Our showrunner is Sophie mckibbon. Our theme music 356 00:18:44,956 --> 00:18:48,396 Speaker 1: is composed by Luis Garratt. Special thanks to the Pushkin Brass, 357 00:18:48,636 --> 00:18:52,916 Speaker 1: Malcolm Gladwell, Jacob Weisberg, and Mia Lovell. I'm Noah Feldman. 358 00:18:53,316 --> 00:18:56,276 Speaker 1: I also write a regular column for Bloomberg Opinion, which 359 00:18:56,276 --> 00:19:00,036 Speaker 1: you can find at Bloomberg dot com slash Feldman. To 360 00:19:00,076 --> 00:19:03,636 Speaker 1: discover Bloomberg's original slate of podcasts, go to Bloomberg dot 361 00:19:03,636 --> 00:19:07,916 Speaker 1: com slash podcasts. And one last thing. I just wrote 362 00:19:07,916 --> 00:19:11,316 Speaker 1: a book called The Winter, a Tragedy. I would be 363 00:19:11,356 --> 00:19:13,476 Speaker 1: delighted if you checked it out. You can always let 364 00:19:13,476 --> 00:19:15,676 Speaker 1: me know what you think on Twitter about this episode, 365 00:19:15,836 --> 00:19:19,436 Speaker 1: or the book, or anything else. My handle is Noah R. Feltman. 366 00:19:19,956 --> 00:19:21,396 Speaker 1: This is deep background