Baseball, Bond Markets And Unintended Consequences

by: Andres Capital Management


Illiquidity and volatility in bond markets.

Impact of regulatory changes on capital markets.

Proliferation of electronic trading platforms.

Unintended consequences -- winners and losers.

By Freddie Offenberg, Andres Capital Management Team

The year they lowered the mound… the pros and consequences. In 1969 major league baseball decided to lower the height of the pitching mound from fifteen inches to ten inches. They did so out of perceived necessity, fear and greed. They did so in response to the what occurred in 1968… The Year of the Pitcher. Throughout the sixties , pitching had become so dominant that the average score that season was 4-2. Bob Gibson of the Cardinals posted an E.R.A. of 1.12 , the lowest in modern baseball history while the average E.R.A. for all of baseball was under 3.00! Offensive production was way down and attendance was waning. American sports fans love scoring and home runs and so the owners decided to do something about it.

Fast forward to 1989…. following fifty-plus years of relative stability in the capital markets, the Federal Reserve (the Fed) began to succumb to pressure from the bank holding companies to loosen the restrictions put in place by the Banking Act of 1933, commonly referred to as the Glass-Steagall Act.

Specifically Section 20 of the act, which prohibited banks from engaging in or having any affiliation with any organization engaged in the underwriting, trading or distribution of stocks and bonds, (US Government and municipal bonds were exempt from these restrictions). This was done for the purpose of separating commercial banking and investment banking. It was during that year that the Fed granted expanded Section 20 powers to five banks. They were J.P. Morgan, Chase Manhattan, Security Pacific Bank, Bankers Trust and Bank of America. Around the same time, a new group of predators, very large foreign banks, began opening their own securities companies in the U.S. quickly gaining a foothold as formidable new players in the capital markets. Names now familiar to all such as Deutsche Bank, HSBC, Barclays and UBS were raising the stakes.

The pressures to continue to peel back the layers of Glass-Steagall were gathering steam and the gauntlet had clearly been thrown by the larger foreign invaders. The size of the debt markets were expanding rapidly with the growth in the still young junk bond market, emerging market issuance and the explosion in securitization. The reaction was becoming very clear… it was time to lower the mound.

The only way to compete was to get bigger and the way to get there required deregulation and consolidation with globalization and advances in technology as enabling forces. By the end of the 1990s, the number of banking institutions shrank by forty per cent domestically; with the passage of the Gramm-Leach-Bliley bill nailing the coffin shut on Glass-Steagall effectively blurring the lines of form and function in the financial industry forever. In a relatively short period, many iconic Wall Street firms were simply swallowed up. Names like Shearson, Dillon Read, Bache Halsey Stuart, Kidder Peabody, Loeb Rhoades, First Boston, Dean Witter, Blyth Eastman Dillon and finally Salomon Brothers. Manufacturers Hanover merged with Chemical Bank who merged with Chase who acquired Banc One and Hambrecht and Quist , only to combine with JP Morgan. All the major banks in Boston, Philadelphia, Chicago and Los Angeles were gone. Many regional firms and trading communities were either merging or simply closing. To paraphrase Bob Dylan, the times they were a-changin.

While there were certainly numerous events reshaping the financial industry landscape, the purpose of this discussion is to focus on those systemic, structural and regulatory changes impacting the bond markets. In an ongoing effort to gain competitive advantage, investment banks, commercial banks, insurance companies and asset managers were combining, concentrating capital, resources and risk at the top. During the same period, in an effort to provide greater price disclosure for bond investors, regulators initiated TRACE (trade reporting and compliance engine), a program requiring fixed-income dealers to report OTC transactions and prices to the Finra system. Suddenly, any interested party, most significantly the large buy-side institutions were able to see what the dealers had paid for bonds. This "transparency" began to eliminate what used to be proprietary information, providing greater price negotiation power to the buyers and reducing both the market knowledge premium and steadily, the profit margins for traders. Concurrently, in an attempt to make the bond markets function more like the stock market, advances in information technology opened the door for the development of "electronic trading platforms" such as MarketAxess, TradeWeb, BondDesk and the massive growth and use of the Bloomberg System. As with any changes to the status quo, there are consequences, ripple effects and trade-offs to follow. The continued growth and success of these platforms has intensified the competition for the large institutional share of the business at the same time reducing dealer margins and staffing needs. It has been a huge win for the buy side and to some extent the large dealers. The amount of market information accessible to accounts was squeezing the small and mid-sized firms, and their ability to compete. A bond trading operation is an expensive activity, requiring capital commitment to own and finance inventories. Additionally, there are hedging costs, carry costs and market risk to contend with. For a while the growth in the size of new issuance and the size of the deals was offsetting the impact of these changes.

The massive scope and damage inflicted by the financial crisis was not just incredibly costly, but also revealed multiple weaknesses, risks and abuses in the global financial markets. Questionable accounting methods, off-balance sheet reporting, over leveraging and excessive credit exposure all contributed to the ensuing disintegration of confidence and challenged the integrity of the entire system. One of the responses was a new round of regulation and the passage of Dodd-Frank. The subsequent series of events included the collapse of Bear Stearns, Lehman Brothers, the housing and MBS markets and widespread economic failure. Dodd-Frank was an attempt to address these abuses and to restore stability. The reaction was to enact policies that would produce fundamental changes for the financial community. Some of the regulations for the newly dubbed significant financial entities included the reduction of proprietary trading activities at the banks, limits to risk-taking, increased capital and balance sheet requirements and general de-leveraging. The unintended consequences of these changes are taking their toll on the fixed-income markets. There are fewer market makers, the number of primary govt dealers is half of what it was ten years ago, average daily trading activity is declining and trading revenues have been falling.

Reduced liquidity and increased volatility are the current conditions in bond land. The institutional community is very unhappy with the street because there are fewer bidders for large size and the bid ask spread is getting wider again, and why not? The ecosystem has been damaged. The food chain is failing. The little fish who provided distribution and diffused risk are disappearing. This is a business, not the American Red Cross! If dealers can't earn profits, they will continue to figure out how or they will abandon the business. So far, Wall Street's reaction to the new status quo has been to reduce dealer inventories, take less risk, shrink overhead and watch competition fall by the wayside. The hardest hit are the smaller investors and advisors, as wider bid/offer spreads and illiquidity result in less efficient markets for all. So, how is the fixed income investor to effectively navigate the perils and opportunities that exist in the current environment? The best path to achieving investing goals is to engage the services of an honest and knowledgeable investment professional with the skills and experience to optimize execution and returns. This can require patience and timing. So, if you want a good at-bat, wait for your pitch.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.