The Next Crisis Will Be Different From The Last

Regulators Are Getting Worried About their Own Handiwork

Readers may recall a remark we made when we discussed the dangerous boom in low grade corporate debt. This was in connection with one of the weak links in the chain, if you will. We noted among other things in passing that:

“…new regulations have forced the banks to vastly reduce their proprietary trading activities. They have essentially withdrawn from the function of “market makers” in these securities.”

The question we pondered was actually whether banks, by virtue of having removed themselves from a lot of proprietary trading and market making, would be less exposed to a putative credit crisis as a result. Certainly it could be argued that the growth in excess reserves has made banks far less vulnerable to “bank run” type situations, but as we pointed out, one cannot simply ignore the interconnectedness of financial markets. In this particular case, other entities have intensified their trading activities, and these others receive funding from banks. In essence, some types of risk are now merely one step removed, but they have not disappeared.

However, there is another reason why the above should be seen as potentially quite worrisome. That is the fact that the new regulatory hurdles leave certain market segments – especially corporate bond markets – far less liquid than they once used to be. We were reminded of this when Bill Fleckenstein mentioned in a missive a few weeks ago that one of his contacts in the fixed income trading universe had warned of the risks posed by mutual funds investing in various grades of corporate debt (and we presume, by extension, other funds active in these areas, as well as certain ETFs). The specific worry expressed by this investor was that if these funds were ever hit by a wave of redemptions, they would be forced to sell into what would essentially be a vacuum.

It appears regulators have woken up to the problem, which is often a sign that we have passed the point of no return quite some time ago (as they are often the last ones to notice a problem, even if they have caused it themselves):