When the equity and bond markets are both pointing in opposite directions, as they are at the moment, it is fashionable to trot out this question: which market is the most reliable as an indicator of what lies ahead? Time was when bond market investors, being vigilant for inflation and potential default, and naturally concerned, like bankers, more with what could go wrong than what might go right, could claim with some justice that their prices did the better job of guiding investors’ decisions.
In contrast equity markets, the natural home of the optimist, have historically been prone to serious pricing anomalies, as students of bubbles and market crashes well know. Efficient stock markets are not really that efficient at discounting the future. But before awarding the ears of the bull as a prize to the bond market, it is as well to reflect on some other considerations in the debate. Some of these are brought out in Michael Lewis’ new book The Big Short, was deservedly nominated last week as a finalist in the FT Business Book of The Year awards.
As you would expect, given its provenance, The Big Short is nicely written and tells a great story, with plenty of edge to the narrative. It describes the role played in the crisis by a few contrarian investors who saw through the folly of subprime lending and sought out ways to bet on the market for securitised mortgage lending falling apart, as eventually it did. One of its central themes turns out to be the myopia, feebleness and corruptibility of the modern bond markets.
For whatever claims the bond markets may have to prescience, there is no escaping the fact that, as one Mid West banker told the FT last year, virtually all recent financial crises have been generated “by the greed of the fixed income people. Go back and look at the history of Wall Street – Drexel Burnham, Salomon Brothers, Kidder Peabody, Bear Stearns, Long Term Capital Management, Lehman Brothers, Merrill Lynch – the fixed income guys blow up the firm every time”.
One reason is that the bond market today is simply bigger, more complex and less tightly regulated than the equity markets. When the credit markets came face to face with financial innovation in the 1980s, the results were spectacular – but so too were the consequences. The globalisation of markets and the explosive growth of credit derivatives have changed the game. By the time the seeds of the great financial crisis were being sown five years ago, just about every major investment bank, notes Lewis, was effectively run by its bond department. This was also, not uncoincidentally, where the greatest profitability was to be found.
Most of the CEOs of the banks that burned up during the crisis – think Lehman Brothers, Bear Stearns, Morgan Stanley – were former bond traders who, it turned out, if you want to take a charitable view, no longer understood fully how far things in the bond business had moved on since their heyday. (I am not sure that I would be so charitable). What they all did know for certain is that profits in most financial markets come from either monopoly or asymmetric information, and that the bond markets in their modern state had become ripe for plucking on both counts.
While the stock market, says Lewis, is relatively transparent and generally well policed (finance students, please discuss), the bond market, being dominated by institutional rather than retail investors, has proved to be anything but. Increasingly complex and opaque, the lack of effective policing played straight into the hands of the greedy, myopic and cynical bond departments of the biggest Wall Street firms who make up the villains of his piece.
It found its apotheosis in the obscurely-named, massively opaque and patently misunderstood Collaterised Debt Obligation (or CDO), an instrument that wondrously manufactured an immense pile of synthetic AAA-rated securities out of a bundle of securitised mortgage bonds of lousy quality, and ensured huge short term profits for the banks which were creating both supply and demand for the product. (In the end, ironically, many of the investment banks themselves turned out to own a lot of the junk themselves and had to be bailed out by the taxpayer).
As a result of that crisis, the government bond markets are also now being manipulated quite openly by the Federal Reserve and other central banks, albeit in the name of social utility rather than profit. However far you choose to follow Mr Lewis in his colourful and unflattering interpretation of how the crisis evolved, his central thesis – that bond markets are no longer the gnarled guardians of financial rectitude that some would have you believe they once were – is surely hard to deny. Investors who read great meaning into today’s bond prices do so at their peril.
Jonathan Davis has a new blog at http://iidaily.wordpress.com