We received a number of comments regarding the post on declining dealer inventories. In particular there is a misconception (some of it is among US Congressional Democrats and even certain US regulators) that existing corporate bond market makers can be replaced by institutions that are not “bank holding companies”. Here is why this belief is misguided:
1. The smaller broker-dealers such as Jefferies have tried to step into the corporate bond markets in 09. Unfortunately the Fidelities of the world do not want to deal with small firms that are poorly capitalized, particularly for large transactions and new-issue bonds. After the MF Global's little problem, many were afraid to even transact with smaller dealers like Jefferies.
2. Imagine that you are Sprint/Nextel and you have to issue billions of new bonds because you need to roll debt as well as fund the introduction of the iPhone to your customer base (which is quite an expensive undertaking). The market is shaky (late 2011) and this must be done quickly. You need dealers with massive distribution capabilities. Do you go to Jefferies? Unlikely. You are going to hire JPMorgan and Citi as joint lead arrangers/bookrunners and BofA, Barclays, and DB as co-runners. Otherwise you don't stand a chance. Nothing against Jefferies, but there is no possible way they can execute on such a deal.
3. Some people pointed out that asset managers such as PIMCO or Blackrock could become market makers. Now if you are Fidelity, would you work with PIMCO, your key competitor, to make you markets in Sprint bonds? The conflicts of combining an asset management business with a dealer business are insurmountable.
4. Even if by some chance a smaller broker rose to the level of the big dealers, the Fed would quickly classify them as a Systemically Important Financial Institution and begin to apply the same regulatory restrictions.
5. There is this myth that under the original Glass–Steagall Act, corporate bond business was not permitted for large banks. Let's go back to the "happier times". That view is just incorrect. Affiliates of banking firms were involved in corporate bond businesses (as well as other credit businesses such as emerging markets) long before the Gramm-Leach-Bilely Act of 1999. The fact remains that there has never been a case of a commercial bank taking material losses due to its inventory of corporate bonds.
6. What's more, the US regulators seem to be OK with banks running inventories of US treasuries, but not corporate bonds. Someone needs to tell these folks that in the last few years, treasuries have been the most volatile asset class in fixed income. The chart below shows the 90-day historical volatility for 3 ETFs: TLO - a long bond treasury ETF, HYG - a HY bond ETF, and LQD - an investment grade bond ETF. Guess who won that race.
|TLO , HYG, LQD - 90 day volatility (Bloomberg)|
This "regulate it all and ask questions later" approach to the bond markets is simply misguided and will add little to the "safety" of the financial system. But certain politicians will surely benefit from its implantation and from the rhetoric that will score points with their constituents.