The Financial Times is not exactly a rumor mill—-so its recent headline amounts to a thunderbolt:
“Fed Looks At Exit Fees On Bond Funds”
And so the shoes begin to fall. Owing to the Fed’s brutal financial repression since December 2008 (i.e. zero yield on short-term funds), there has been massive scramble for yield that has driven trillions into corporate and high yield bond funds.
What this means is that liquid funds which would have normally been parked in bank deposits or money market funds have been artificially displaced. That is, they have been chased by the dictates of the monetary politburo into far more illiquid and risky investment vehicles owing to zero yields in their preferred financial venues.
But now it is dawning on at least some of the more market savvy occupants of the Eccles Building that they have created a monumental financial log-jam waiting to happen. In their jargon, the migration of trillions into bond funds since the financial crisis has resulted in a sweeping “maturity transformation”. As former governor Jeremy Stein succinctly put it,
“It may be the essence of shadow banking is … giving people a liquid claim on illiquid assets.”
What Stein means is that the traditional money markets existed for a reason—even if returns were inferior to what could be obtained in longer duration fixed income securities or investments with equity-like features such as junk bonds. Corporations and individuals who invested in money market instruments, including bank CDs, were willing to absorb the yield penalty in return for the assurance of absolute daily liquidity that the funds in question required.
But zero return is not a market driven liquidity penalty; it is an arbitrary prohibition imposed on the market by the monetary politburo. So now we have a giant anomaly. Trillions of daily liquidity demanding investments are potentially stuck in bond funds which could not provide it during a crisis. In effect, any attempt by bond funds managers to meet a surge of redemptions calls would make the crisis surrounding the Reserve Prime Fund’s “breaking the buck” in September 2008 seem like a Sunday School picnic.
The reason is that the Fed created a massively artificial demand for bond fund investments during the 6-year stretch of ZIRP. Accordingly, in the event that liquidity-seeking investors call their funds, which they are entitled to do by bond mutual funds, there would be a massive imbalance in the market. This is especially true because traditional Wall Street market makers have significantly shrunk their balance sheet positions and available capital owing to Dodd-Frank.
So drastically imbalanced markets under crisis conditions would gap down and potentially go even bidless for many higher risk, less liquid corporate issues. As mark-to market losses mounted, of course, investor demands for liquidity would sky-rocket, begetting even more fire sale dumping of corporates and junk bonds and even deeper discounts and losses.
In short, in its mindless drive to manipulate financial markets and generate artificial demand for credit, the Fed has created the potential for a massive run on bond funds should a new financial crisis be triggered by one black swan or another. And once again it is evident that the market’s natural process of “price discovery” has been destroyed in favor of ham-handed “price administration” by our monetary central planners.
Yet the monster they have already created—-a massive log-jam at the bond fund exit gates—-would pale compared to the deformations and anomalies that would result from the imposition of a government dictated exist fee on unsuspecting investors. Even the announcement of a rule-making would potentially trigger the very kind of sell-off that it would be designed to prevent. And if corporate bond prices took a tumble, it would not take long for equity markets to recognize that the massive flow of new debt capital which has been used to fund record stock buybacks could suddenly dry up.
Not surprisingly, the big bond houses are lining up in favor of government imposed exits fees and gates. They would like nothing better than to keep investors captive, collect the fees and blame Washington for the inconvenience to investors.
The next round of crony capitalism is already underway.
Exit fees would seek to discourage retail investors from withdrawing funds, thereby making their claims less liquid and making a fire sale of the assets more unlikely.
Such fees could be highly unpopular with retail investors unable to access funds without paying a fee. But some in the industry would welcome them; BlackRock, the world’s largest asset manager, has called for international rules setting exit fees on some funds.