We’re starting to look for misconduct in the bond market because of widespread signals that problems in bonds could precipitate the next economic crisis here in the United States. If a market meltdown occurs, we think that the government will be looking for bond whistleblowers to identify misconduct at the major players. Unlike during the financial crisis of 2007-09, the SEC whistleblower program will be incentivizing individuals to report violations of the securities laws during the next crisis.
Major market leaders are already warning that bond market liquidity could be the next issue to spark “global panic,” “precipitate the next great financial crisis,” and evaporate trillions of dollars of wealth overnight. The President of Goldman Sachs, although not using this extreme language, is among them. Nouriel Roubini wrote a piece published on May 31, 2015 called “The Liquidity Time Bomb.” Major players like PIMCO are worried as well. PIMCO has cut back on its government debt, selling treasuries ahead of what is expected to be an imminent Fed rate hike. Art Cashin warned CNBC that Fed rate hikes could “start spontaneous combustion” in the bond market.
The trigger for this crisis is expected to be Federal Reserve moves to increase interest rates. Low interest rates since the last financial crisis have driven investors into the $3.7 trillion corporate bond market and government debt. If these players begin to sell bonds as they lose their luster amidst rate increases, there are concerns that no one will buy them and prices will go into free fall as investors panic. Interest rates can’t remain at or near zero forever. The Federal Reserve is expected to start hiking by the end of the year.
A similar free fall in securities prices during the last crisis took down Bear Stearns and Lehman Brothers, who were holding large portfolios of commercial mortgage backed securities. When prices began to plummet because there were no buyers, the liquidity crunch and the declining value of these leveraged assets caused a loss of confidence in their ability to weather the storm, precipitating their downfall.
Roubini pointed out the oddity of some of the moves that have been happening in bonds already. Back in October 2014, for example, US Treasury yields plummeted nearly 40 basis points in minutes, a move that should happen only once in three billion years according to statisticians.
Of course, when the financial markets are universally concerned about an event, the contrarian play is sometimes the safest. Governments do not like to let market volatility effect the economy if they can help it. And the Federal Reserve is certainly no slouch in responding to economic forces with appropriate monetary policy.
Yet, there were warning about the real estate bubble as well. And it spilled over not only to the financial markets but to the greater economy as well. The bond market is big, too. The U.S. bond market is estimated at $37 trillion, higher than the market capitalization of U.S. stocks of $22.5 trillion (calculated 10/21/14). If it tanks, the ripple effect could be widespread throughout the market and the economy.
This analysis doesn’t even touch the potential sovereign debt crisis that could happen if institutional investors stop buying government paper. The rates investors are accepting for Treasuries assume that their money is safe. What if a Greek default makes them question whether it really is safe? Changes in the assumptions about the potential for default were among the sparks to the crisis in Commercial Mortgage Backed Securities.
There’s also been a slower recovery in the U.S. economy following each recession. The public no longer has the wealth to dampen external shocks to the economy.
Why would no one buy bonds? In stocks, market makers normally act as the provider of liquidity when there are no buyers and an investor wishes to sell. Prior to 2008, the big banks provided that liquidity. Now, apparently, the government’s capital rules have caused them to trim their trading operations. Major bond dealers hold one quarter of the amount of corporate debt compared to their 2007 holdings. Institutional investors are already noting that trades in bonds are taking longer than normal to happen.
Banks are also blaming the bond sale reporting requirements. Because they must report trades, they can no longer fleece investors with impunity. With tighter margins, fewer banks are going to be willing to try to step in and catch bonds when prices are falling like a knife. With fewer players willing to take chances because of less profit potential and less capital committed to bond trading by the major banks, the potential for a liquidity crunch and a crisis emerges.
Others have pointed out that the Fed has been buying bonds in order to keep interest rates down through quantitative easing. If the Fed exits or cuts back in the market at a time when more bond holders want to sell, it could deepen the serious liquidity issues.
This is an issue of concern to government regulators already. FINRA met last week with regulators and financial firms to discuss the corporate bond market, and plans to hold another meeting in July.
The financial industry is also pushing for measures that would decrease transparency. They have argued for weakening the bond sale reporting rules. There are also talks between a financial firm and regulators about creating the first dark pool for corporate bonds. These measures might sound eerily similar to the 2004 SEC meeting which allowed large financial firms to take on more leverage.
If these sound a bit like business as usual Wall Street and fluctuating markets, why would we be looking for potential bond whistleblowers? Because we know from past experience that the financial institutions holding bonds and their employees may break the rules when the crisis strikes. They may try to manipulate bond prices in the market to protect themselves against mark-to-market accounting. They may commit accounting fraud to avoid a capital crunch or causing a run on their stock or assets as they disclose losses. Or they may come up with a way to break the law that we haven’t even thought of because we are whistleblower attorneys and not knee deep in the bond market.
The collapse of the bond market isn’t likely to be a soft landing without government fines, in other words. And where the government is handing out fines to large financial institutions, it needs whistleblowers to tell them where to look. This, in a nutshell, is why we are looking for bond traders and fixed income professionals. If your company is breaking the law, we would like to help you report it.