Speaker 1: Pushkin from Pushkin Industries. This is Deep Background, the show
Speaker 1: where we explore the stories behind the stories in the news.
Speaker 1: I'm Noah Feldman. Earlier this week I had a terrific
Speaker 1: conversation with BoA's Weinstein, the founder and chief investment officer
Speaker 1: at SABA Capital Management. We got such great feedback for
Speaker 1: the conversation that we decided to give you a bonus.
Speaker 1: A further conversation that Boas and I had about what
Speaker 1: happened in March when the bond markets appeared to break.
Speaker 1: For context, what you should keep in mind is that
Speaker 1: high yield debt, so called junk bonds, were long thought
Speaker 1: to be too risky to be held by ordinary investors,
Speaker 1: but in recent years, as a result of such vehicles
Speaker 1: as exchange traded funds ETFs and mutual funds, more and
Speaker 1: more of the market in high yield junk bonds has
Speaker 1: come to be held by consumers. Ultimately, that raises serious
Speaker 1: questions about safety and about whether what Boas calls the
Speaker 1: alchemy of packaging actually works. This part of the conversation
Speaker 1: goes really deep behind the story, and I hope that
Speaker 1: you'll learn as much from it as I did. The
Speaker 1: dynamics and the market structure changed over the last decade
Speaker 1: dramatically in a way that I think caused it more
Speaker 1: or less in March to break. And I don't think
Speaker 1: that story because bonds are followed far less than the inequities.
Speaker 1: The bond market breaking for a few days really, to
Speaker 1: me was one of the most shocking things I've seen
Speaker 1: in my career. So let's dive into this moment where
Speaker 1: the bond market breaks, and I want to take us
Speaker 1: back to the background. So take us back to when
Speaker 1: you first started in your business in the nineties. What
Speaker 1: did the bond market look like that? So I joined
Speaker 1: Will Street after graduating college in ninety five. I was
Speaker 1: very influenced by the book Liar's Poker, actually told by
Speaker 1: Michael Lewis also Pushkin podcast Maker, among many other distinctions. Yeah,
Speaker 1: you know, in that story, aside from all the humor,
Speaker 1: is the point that the participants in the bond market
Speaker 1: that worked at these banks at the times Solomon Brothers
Speaker 1: or Now City Group or Goldman Sachs, they were, in
Speaker 1: their own minds and with the balance sheet given to
Speaker 1: them by the bank, enormous risk takers and could house
Speaker 1: a risk if it came to them, they could act
Speaker 1: as a shock absorber. They didn't view themselves as a
Speaker 1: shock absorber if there were too many sellers. They viewed
Speaker 1: themselves as the world's greatest experts in junk bonds. At
Speaker 1: that time, there were very few hedge funds, and most
Speaker 1: of the great credit hedge funds came out of banks,
Speaker 1: whether they were Drexel, Burnham, Lambert or the ones after.
Speaker 1: And so if you had a big sell off, really
Speaker 1: at any point in time, from the nineteen eighties through
Speaker 1: two thousand and eight, every bank had a trading desk
Speaker 1: that was there to buy bonds without necessarily needing to
Speaker 1: sell them the same day or same week. They could
Speaker 1: buy them and house them if they felt like they
Speaker 1: were good investments. So the market makers were investors. And
Speaker 1: just to clarify that for the civilian, if I'm understanding,
Speaker 1: you're correctly. What you're saying is if a moment came
Speaker 1: where people who held bonds thought, oh boy, it's time
Speaker 1: for me to get rid of these bonds. They're too
Speaker 1: risky for me and they're more likely to default, and
Speaker 1: I'm willing to sell them at a low price. The
Speaker 1: big investment banks, through their trading desks were like, great,
Speaker 1: we'll buy them from you at a low price, and
Speaker 1: then we'll just hang on to them till they are
Speaker 1: more valuable, and then we'll turn around and we'll make
Speaker 1: money on it, and we can afford to buy them
Speaker 1: from you low and hold on to them until the
Speaker 1: time comes to sell them higher. And that effectively wasn't
Speaker 1: their goal, of course, is to make money, But effectively
Speaker 1: that meant that if there was a sudden moment where
Speaker 1: most people who held this debt said, oh my god,
Speaker 1: let me sell it, there was someone there to buy it. Yes,
Speaker 1: So they provided balance to when there was a supply
Speaker 1: demand and balance. They were the demand. And in the
Speaker 1: last ten years before the global financial crisis, every bank
Speaker 1: basically had various groups that were not facing customers, that
Speaker 1: were literally many hedge funds inside of the bank, known
Speaker 1: as proprietary trading desks, who felt even more able to
Speaker 1: take on that risk because their mandate was to invest
Speaker 1: and not to trade with clients. And so you had
Speaker 1: enormous risk taking capacity at the banks, and that's something
Speaker 1: that's measurable. Every week the Federal Reserve reports what the
Speaker 1: aggregate number of bonds held by the investment banks was
Speaker 1: at times it was greater than one out of ten
Speaker 1: bonds was held by these counterparties. And then there came
Speaker 1: two thousand and seven, two thousand and eight, and everything changed.
Speaker 1: What happened to all of that death that was being
Speaker 1: held by the proprietary trading desks in the crisis. So
Speaker 1: of course they lost a lot of money in two
Speaker 1: thousand and eight, and by two thousand and nine, even
Speaker 1: though they had recovered a lot, and the banks actually
Speaker 1: posted their best years in history in this sort of trading.
Speaker 1: The Vulgar rule basically more or less banished that kind
Speaker 1: of risk taking, not just by the proprietary traders, but
Speaker 1: importantly by the market makers. And so if client wanted
Speaker 1: to sell and the amount was not trivial, the bank
Speaker 1: was basically, for all intense purposes not there to buy
Speaker 1: it if it didn't have a ready buyer or it
Speaker 1: couldn't find one in short order. And so that really
Speaker 1: changed one side of the market structure, which was we
Speaker 1: took away the shock absorber, and we took away the
Speaker 1: risk taking capacity by the banks. Even though you know,
Speaker 1: when you think about it, a bank buying the bonds
Speaker 1: of let's say Boeing a company that's having its own
Speaker 1: share of troubles right now if it loses money from
Speaker 1: doing so, is it that different than the bank losing
Speaker 1: money for making a loan to Boeing. In both cases,
Speaker 1: they're supporting Boeing in the loan case as a primary
Speaker 1: lender and in the bond case as let's say, a
Speaker 1: secondary investor in an actual existing market. But aside from
Speaker 1: ought it to be that way. The vocal rule though
Speaker 1: critiqued at the time by self serving banks, but they
Speaker 1: might have had a point. We're saying, look, when clients
Speaker 1: come to sell and the liquidity is very different than
Speaker 1: it is in normal times, who's going to be there
Speaker 1: to buy? And so that's one side of the equation.
Speaker 1: Can I push on that a little bit? So the
Speaker 1: vocal rule basically, I mean, I'm oversimplifying it drastically, but
Speaker 1: it basically said we the government do not want big
Speaker 1: banks to be sitting on a lot of risky investments
Speaker 1: because it's nice when they make money, but when they
Speaker 1: don't make money and they're suddenly losing it, everything can
Speaker 1: go south very very quickly and bring the financial system
Speaker 1: with it. If it was an effect of that, maybe
Speaker 1: even an intended effect of that that the banks couldn't
Speaker 1: buy up lots of risky bonds. I mean that sounds
Speaker 1: sort of like a good thing rather than a bad thing.
Speaker 1: Are you describing an unintended consequence, which is that they
Speaker 1: also couldn't be a buffer? Yeah? You know, maybe the
Speaker 1: answer is something in the middle which would have restrained
Speaker 1: the amount of risk they could take and therefore money
Speaker 1: they could lose, but would allow them to some degree
Speaker 1: to be there when you know there's ten sellers for
Speaker 1: every buyer. You know that unintended consequence is something that
Speaker 1: when you threw out the baby with the bathwater, you
Speaker 1: know you lost something there and you don't see it
Speaker 1: in normal times, but you saw it in March. So
Speaker 1: fast forward now with me to March. You don't have
Speaker 1: this big buffer. The banks are not capable of buying
Speaker 1: a lot of bonds when suddenly the prices go down.
Speaker 1: Suddenly everyone is panicking because we have a pandemic on
Speaker 1: our hands. What happened? How did the market break? Well,
Speaker 1: it's important to know two other things in this story, Okay.
Speaker 1: One of them is, over the past twelve years since
Speaker 1: the global financial crisis, the quantity of debt, the capital
Speaker 1: stock of bonds and loans issued by US corporations went
Speaker 1: up by about three hundred percent, So the amount of
Speaker 1: stuff out there held by people grew tremendously. Of course,
Speaker 1: the banks are not holding hardly any of it anymore.
Speaker 1: And the other thing is the question of who held it.
Speaker 1: So let me just for a second go back to
Speaker 1: nineteen ninety five. I opened up my first account. I'd
Speaker 1: started it at Merrill Lynch after college, and I opened
Speaker 1: up a brokerage account, and I finally think I know
Speaker 1: a little thing or two about bonds. I've been doing
Speaker 1: it for a few years in my college summers. That
Speaker 1: gave me some confidence that maybe was misplaced. And so
Speaker 1: I wanted to buy a junk bond. And I remember
Speaker 1: my Merrill Lynch stockbroker telling me, even though I'm in
Speaker 1: the business, and I'm in this exact business, that this
Speaker 1: type of investment is unsuitable for me. I'm not a
Speaker 1: dentist who doesn't know very much about bonds compared to
Speaker 1: other things. I'm working at a bank in fixed income.
Speaker 1: Yet I'm unable to buy a junk bond because it's
Speaker 1: considered too risky, too complicated, unsuitable for retail. Now, if
Speaker 1: you fast forward to March, you have a market three
Speaker 1: times the size, and the retail investor grew to being
Speaker 1: the largest investor in the market. Approximately half of all
Speaker 1: of those bonds and loans are held by retail investors,
Speaker 1: one way or the other, through myriad of products that
Speaker 1: are themselves interesting and in some cases responsible for some
Speaker 1: of the challenges we saw last month. I don't want
Speaker 1: to miss out on the punchline story of how the
Speaker 1: market broke, but I do want to follow your comment
Speaker 1: about how it came to pass that an investment in
Speaker 1: a high yield bond, in a junk bond that you
Speaker 1: couldn't make as an ordinary retail investor nearly twenty years
Speaker 1: ago now is overwhelmingly where corporate debt is held. So
Speaker 1: say something about these vehicles, because what you're saying is
Speaker 1: that all of us basically own a whole bunch of
Speaker 1: corporate debt without fully realizing that. So ETFs are the
Speaker 1: most exchange traded funds are the most famous example, the
Speaker 1: most salient example. So describe how those work and how
Speaker 1: they enable people for better or worse. And it sounds
Speaker 1: like maybe for worse to hold these risky investments that
Speaker 1: in the olden days people thought were too risky, even
Speaker 1: for you. Yes, So prior to two thousand and eight,
Speaker 1: there were almost no ETFs that held junk rated bonds
Speaker 1: or loans. But what we saw after it was incredible
Speaker 1: demand for yields. Global interest rates were cut. We see
Speaker 1: negative interest rates in Japan, in Switzerland, in lots of
Speaker 1: places around the world, and there was not enough yields
Speaker 1: and people needed that to get fixed income, to meet
Speaker 1: their mortgage payments, whatever it may be. And so there
Speaker 1: was great demand at a time when stock seemed like
Speaker 1: an uncertain investment. The eye popping yields after two thousand
Speaker 1: and eight, the average junk bond yielded more than fifteen percent,
Speaker 1: and so that led to horizon products that we're also
Speaker 1: seeing a tremendous growth themselves, and so exchange traded funds
Speaker 1: stand out as the most obvious example. But you know,
Speaker 1: most people are familiar with mutual funds. The story would
Speaker 1: be the same, and that those funds are special and
Speaker 1: that they're open ended. They allow investors to exit every
Speaker 1: business day of the week, and they allow them to
Speaker 1: exit almost in almost every instance at what's called net
Speaker 1: asset value. And so the exchange traded fund goes. So
Speaker 1: it's a share on the New York Stock Exchange that
Speaker 1: holds a big pool of assets, let's say junk bonds. Okay,
Speaker 1: And because investors have a hard time accessing that market,
Speaker 1: you can't just buy a junk bond. It's not on
Speaker 1: the New York Stock Exchange. It requires you know, lots
Speaker 1: of special knowledge about how to execute in in what's
Speaker 1: called an over the counter market. So ETFs were seen
Speaker 1: really as an incredible opportunity. You can give investors one
Speaker 1: stop shopping where they get access to hundreds of bonds
Speaker 1: at the same time, whether they were carefully selected by
Speaker 1: a manager actively managing them, or they represented an index
Speaker 1: like the Dow Jones or the S ANDP. The growth
Speaker 1: in that space was enormous, and at the same time
Speaker 1: it was also growing tremendously for equities. The problem is
Speaker 1: that equities are highly liquid investments in ETFs that are
Speaker 1: promising investors they can get out the same day and
Speaker 1: are liquid in that big are trading with a difference
Speaker 1: between the price where you could buy or sell being
Speaker 1: just a penny. Are holding things that are highly a
Speaker 1: liquid that at times have a difference between where you
Speaker 1: could buy and sell at a dollar And so it
Speaker 1: raises this question, was this financial alchemy? Did somehow the
Speaker 1: ETF and the mutual fund being a daily liquidity product,
Speaker 1: did it solve this iliquidity problem? Did it allow investors
Speaker 1: to get in and out seamlessly whereas they were unable
Speaker 1: to before? And of course, from the standpoint of financial engineering,
Speaker 1: what you want is alchemy, right, you want it to work.
Speaker 1: You want to say, well, here is this ordinarily somewhat
Speaker 1: illiquid asset, corporate debt or sometimes illiquid asset, but we
Speaker 1: want ordinary people to be able to get access to
Speaker 1: this high risk debt because they then then get high yields.
Speaker 1: So if we bundle it in this way, then we
Speaker 1: can solve the problem somewhat magically. And it sounds like
Speaker 1: what you're saying is the magic didn't fully work and
Speaker 1: that it really didn't fully work in March when the
Speaker 1: market broke. So maybe that brings us to the crucial
Speaker 1: moment in March what happened. Yes, so the magic doesn't
Speaker 1: work if there aren't enough buyers for every seller. So
Speaker 1: if there is a seller of this ETF and there's
Speaker 1: a buyer at TTF, no animals were harmed in the
Speaker 1: filming of this movie, No bonds need to be traded.
Speaker 1: People can trade the shares of ETF back and forth,
Speaker 1: back and forth without any bonds being traded, and it's
Speaker 1: very important to understand that. But at the moment where
Speaker 1: there's ten sellers for every buyer, and maybe it was
Speaker 1: one hundred, which is what happens with retail investors. Retail
Speaker 1: investors are so procyclical in their behavior. They sell when
Speaker 1: the market is falling as a group, and they buy
Speaker 1: when the market is rising. And when they all headed
Speaker 1: for the exit in March, there weren't enough new buyers
Speaker 1: willing to buy, so then what happens. So what happened
Speaker 1: was there's a mechanism in the ETF meant to make
Speaker 1: this alchemy work, which is, if ever there's too many sellers,
Speaker 1: you can just redeem your shares back to the market maker,
Speaker 1: back to the institution that's overseeing this box, this pool,
Speaker 1: and they'll go and sell the bonds and they'll give
Speaker 1: you back your net asset value. So if ever they
Speaker 1: are not enough buyers, they can go and sell bonds
Speaker 1: and take the cash from those sales and give you
Speaker 1: back your money. But the problem is that the bond
Speaker 1: market had frozen. It froze for the reasons we've already discussed,
Speaker 1: and there was just there were no legitimately closed bids
Speaker 1: for taking that risk near where the price of those
Speaker 1: shares were, and so we saw a degradation in the
Speaker 1: price of ETFs way beyond what the underlying bonds would suggest.
Speaker 1: And so if you invested a dollar and the pool
Speaker 1: was worth a dollar, just to put numbers on it,
Speaker 1: in the biggest ETFs, we saw an extra loss on
Speaker 1: top of the normal loss of five percent on some
Speaker 1: days in March, and in some smaller ETFs we saw
Speaker 1: losses of twenty to twenty five percent on top of
Speaker 1: what you lost for the COVID related markets off. And
Speaker 1: so what happened was basically the market makers step back
Speaker 1: and said, we're not going to buy these ETFs for
Speaker 1: what they're worth, because we can't get what they're worth,
Speaker 1: because that's really the mismatches. We have to give your
Speaker 1: money today, and it will take us weeks and months,
Speaker 1: and who knows where we'll get out of those bonds.
Speaker 1: And so ETFs basically broke in March, and I think
Speaker 1: that's what's led the FED to take the extraordinary step
Speaker 1: of buying high yield ETFs and agreeing to it's you know,
Speaker 1: even just saying they would do it restored some confidence,
Speaker 1: but it was done really to just to keep the
Speaker 1: market from breaking further. When that breaking was happening, was
Speaker 1: there a contractual violation there? I mean, mom and Pop
Speaker 1: believed that they could redeem their ETF and the market
Speaker 1: maker was refusing to do it. So who bore that loss?
Speaker 1: I mean, did mom and pop bear that loss? Or
Speaker 1: did the market maker have to redeem and just do
Speaker 1: it at a big haircut? So in the initial trades,
Speaker 1: the market maker felt like, okay, i'll buy them at
Speaker 1: any V and that asked value, I'll buy them slightly lower,
Speaker 1: But at some point they just kept buying them. And
Speaker 1: when something is for sale, without the market maker being
Speaker 1: able to offload the risk, they'll take a step back.
Speaker 1: What's supposed to happen is arbit treasures are supposed to
Speaker 1: step in and say, i'll buy a dollar for ninety
Speaker 1: five cents, I'll take on these portfolio bonds. I'll sell
Speaker 1: them myself. But again, in a broken bond market, people
Speaker 1: didn't have confidence of that, and that's where things really
Speaker 1: went off the rails. What's the regulatory solution to that?
Speaker 1: I mean, you could imagine two directions. One is the
Speaker 1: insurance model that the government will give some insurance, which
Speaker 1: is de facto what actually happened, But that seems to
Speaker 1: create terrible incentives because then people will take on all
Speaker 1: kinds of risk they shouldn't take because the government's effectively
Speaker 1: guaranteeing their investment. The other option would be to say, well,
Speaker 1: g maybe these ETFs can't be over the counter retail
Speaker 1: products sold to mom and pop if they're not actually
Speaker 1: capable of sustaining asset value at a moment when people
Speaker 1: run for the run for the hills. So in that theory,
Speaker 1: you know, maybe we should go back to the days
Speaker 1: when you couldn't buy junk bonds because it's actually too
Speaker 1: risky for mom and pop. You know, as much as
Speaker 1: people don't want to talk about going backwards, I think
Speaker 1: we did go too far in the other direction. And
Speaker 1: it really was the perfect storm of retail being too
Speaker 1: big a player in the credit market. And I only
Speaker 1: mentioned we only mentioned two products. I mean, there are
Speaker 1: products like collateralized loan obligations, closed end funds, business development
Speaker 1: companies that all faced a similar fate. Even if they
Speaker 1: didn't all have to sell on day one, they all
Speaker 1: had issues like margin calls and things that all fed
Speaker 1: into this. And so you know, the answer is probably
Speaker 1: somewhere where there is a regulatory limit on the amount
Speaker 1: of high yield credit risk that should be in daily
Speaker 1: liquidity funds, because it really is illusory, this idea that
Speaker 1: this thing that is so tricky to get in and
Speaker 1: out of gets packaged into a daily liquidity vehicle. It's
Speaker 1: really in some ways unsuitable. And it doesn't matter if
Speaker 1: it's not very big, but when it becomes the biggest player,
Speaker 1: it's incredibly important. One crucial question that emerges from this
Speaker 1: part of the conversation that I had with Boas is
Speaker 1: the regulatory question of whether, going forward, it's still safe
Speaker 1: for ordinary investors to hold mutual funds ETFs or other
Speaker 1: vehicles that expose them to substantial risk from high yield
Speaker 1: corporate bonds from junk bonds. The losses that took place
Speaker 1: in the market were not only a product of everyone
Speaker 1: wanting to sell at the same time. They also revealed,
Speaker 1: as Boas suggests, an underlying decline in the value of
Speaker 1: the assets held by the ETFs or their mutual funds
Speaker 1: below what their aggregate value should have been, even in
Speaker 1: a falling market. That's a puzzle, and it's a puzzle
Speaker 1: that's going to have to be solved not just at
Speaker 1: the conceptual level, but at the practical, real world regulatory level.
Speaker 1: I hope you enjoyed this special bonus conversation, and until
Speaker 1: I speak to you next time, be careful, be safe,
Speaker 1: and be well. Deep background is brought to you by
Speaker 1: Pushkin Industries. Our producer is Lydia Jane Cott, with research
Speaker 1: help from zooe Win and mastering by Jason Gambrel and
Speaker 1: Martin Gonzalez. Our showrunner is Sophie mckibbon. Our theme music
Speaker 1: is composed by Luis Garratt. Special thanks to the Pushkin Brass,
Speaker 1: Malcolm Gladwell, Jacob Weisberg, and Mia Lovell. I'm Noah Feldman.
Speaker 1: I also write a regular column for Bloomberg Opinion, which
Speaker 1: you can find at Bloomberg dot com slash Feldman. To
Speaker 1: discover Bloomberg's original slate of podcasts, go to Bloomberg dot
Speaker 1: com slash podcasts. And one last thing. I just wrote
Speaker 1: a book called The Winter, a Tragedy. I would be
Speaker 1: delighted if you checked it out. You can always let
Speaker 1: me know what you think on Twitter about this episode,
Speaker 1: or the book, or anything else. My handle is Noah R. Feltman.
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