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GFC and personal reflections, 10 years on

Last weekend marked 10 years since the fall of Lehman and their role in the start of the GFC, and it is a good time to reflect on that incredible time in financial markets.

The importance of liquidity

About 15 years ago, when I joined Macquarie Fixed Income, one of my first tasks was to work with Head of Research, Dean Stewart, on a piece called the ‘Importance of Liquidity in Fixed Income’. I didn’t know it at the time but that research would influence and shape our investment beliefs, philosophy and processes. It became the bedrock of our approach to markets and portfolio positioning during the most extreme financial market conditions, and is just as important today as it was back then.

The 2003 research paper was well received by clients and consultants, but it didn’t gain a following (or receive ‘likes’ or ‘retweets’ as it might today). It was five years before anyone would come to appreciate (or be reminded of) the true value and importance of liquidity.

Collateralised Debt Obligations: a lesson in the value of research

Linked to this time was the emergence and then proliferation of Collateralised Debt Obligations, or CDOs. Consistent with our belief that we must truly understand the risks involved before we invest in new markets or instruments, we investigated CDOs and again released a research paper to little fanfare. Okay, so it was complicated … even for fixed income.

The research concluded that CDOs were not liquid, not really AAA-rated and not at all diversified. The research suggested to perhaps buy one, though not many, due to cross-holding exposure, and only if the price truly rewarded for the risks involved, including liquidity risk. None of the CDOs met the requirements so we did not invest.

We then watched with interest as CDOs exploded in popularity from 2003 to 2007, evolving as:

  • Plain vanilla CDOs. These were mainly packages of loans to many companies.
  • ‘Synthetic’ CDOs. Synthetic means they were made up of derivatives, not loans to real companies, and we wondered in amazement why anyone would buy a security that had no economic purpose.
  • Subprime CDOs. Poor-quality loans, some even nicknamed NINJA loans (No Income, No Job or Assets).
  • CDO-squared. CDOs of other CDOs, with more wonderment and questions about their economic purpose.
  • Tranche CDO-Squared. CDOs of tranches of other CDOs, where banks and hedge funds began offloading their risk or shorting the market.
  • Leveraged-Super-Senior CDOs. I don’t even remember what they did.

While we didn't invest, we did the work on what we saw, with fascinated interest. The final straw was when financial institutions, some where we had little or no relationship, appeared very, very keen to sell us the new format CDOs.

And so, it began to unravel. The flow of credit which had been gushing in all its structured, derivative, opaque and levered forms, had stopped, and with it, its influence on economic growth. And all that leverage upon leverage on opaque collateral undermined trust in what were once supposedly safe AAA-rated assets. In markets as it is in life, trust is everything. The rest is history.

A lesson in hindsight: research, research, research

To this day we are often asked why we didn’t get caught up. The answer starts with the research and liquidity in particular. We did the work and stayed true to our findings.

Writing in hindsight is a wonderful thing. We don’t wish to claim anything close to foresight. And we don’t mean to suggest we didn’t feel every bump or learn painful lessons along the way. Indeed, things got far worse than any worst-case scenario we ever imagined. We did however, start from a solid place that was founded on sound research and principles.

Liquidity and the current market environment

We all know that tighter regulations have altered liquidity conditions vastly from 10 years ago. Even though there are now many new investment vehicles that purport seamless and plentiful liquidity (even when the underlying holdings are not very liquid), the reality is these claims are untested by any liquidity event of significance. And with the proliferation of exchange traded funds (ETFs) and passive funds, amid a market environment of unthinkable central banks' support, we like to say, “Everyone thinks they are a macro trader now”. All market professionals think they have that special edge to exit just before the herd rushes for the same exits.

And so, now like so many times in the past, perceptions of the value and importance of liquidity has diminished, and its existence, or tendency to quickly shift to lack thereof, is once again under-appreciated. Investors are giving up liquidity in the belief they don’t need it. We know that this will change one day, even if we cannot predict when.

Back in 2008 amid the chaos of markets, we were juggling newborns and infants (an uncanny number of daughters). Looking around now, we are 10 years older and wiser. Our children are entering their teenage years. And while now we can look back with some fondness on that chaotic time, we know that as in life, the challenges may have changed their form, but the same debt-related structural issues remain and seem destined to at least rhyme, if indeed they don’t repeat.

The principles of how to navigate them haven’t changed, and the next 10 years will require similar resolve to do the work necessary to understand the risks.


Brett Lewthwaite is the Global CIO, Fixed Income and Global Co-Head of Fixed Income at Macquarie Group. This is general information not personal advice and does not consider the circumstances of any individual.

Garry Mackrell
September 20, 2018

Regrettably,history is destined to be repeated each investment generation.
I can recall in the 1980s the same hostile conversations with local government officials and others with fiduciary responsibilities questioning why the wholesale deposit rates being offered by the dealing room at CBA were as much as 2-3% below those being offered by various fringe players ,including notably Nugan Hand Bank.
I agree with Warren that,while issuers and those providing ratings have very clear obligations and responsibilities,investing in stuff that is complex/ non-transparent and generally looks to be too good to be true,is always that.

September 18, 2018

Brett - can you explain how you assessed/measured liquidity?

What you said about the popularity of CDOs is spot on and the question is why. I blame the ratings agencies and financial experts who used them.

In the GFC, Basis Capital, running the Basis Capital Yield Fund, was heavily invested in US CDOs and one of the first Australian funds hit by sub-prime related losses. At the time Basis ran into trouble it had glowing five star ratings from the major researchers in Australia. Basis was being spruiked to all, right up until the day it suspended redemptions.
So-called financial experts were proven by events to be ignorant of the real risks involved, their recommendations careless, if not reckless.

Many small investors and retirees who had diligently read the reports of the trusted ratings agencies and considered advice from the ‘experts’ invested heavily in Basis Yield. And lost. Could these losses have been mitigated by a better understanding of how to assess comparative liquidity, if that was a factor in risk and reliability?

Personal reflections of the GFC, 10 years on should also recall the huge losses made by various managed funds. Investors who entrusted their savings with some property security funds (whose names have been moderated out from my other post), were particularly impacted. A $100k investment in one property securities fund was worth just $4k in 2009 – surely a performance worthy of a case study in financial incompetence.

Warren Bird
September 18, 2018

Good article, Brett. Thanks for sharing your thoughts.

AlanB you are right that there was an awful lot of terrible advice about funds like Basis that drew in money from local councils and charities, as well as some individual investors. The lure of seemingly amazing returns will always deceive some people into overlooking risk.

But there were warnings and many of the funds that got caught heard the warnings. So you can't just blame the agencies - the people who worked at local councils and on the investment committees of some charities (not necessarily the one you named in another post) who made the decision to invest have to take some responsibility. Let me explain why.

Most of them had previously been invested in Cash-Plus funds with firms like Macquarie (Brett's firm) or Colonial First State (where I was Head of Fixed Interest). When they took money out of our funds to invest in Basis or other structures they were told by us that this was highly risky. They didn't want to know.

I was a speaker on a panel at a conference in late 2006 or early 2007. I spoke on this very topic. There were people in the audience who were the finance people at local councils. They were quite aggressive in their opposition to what I was saying. They argued that I was just trying to cover up our own incompetence because we weren't capable of generating a bank bill plus 4% return from AAA ratings whereas these other clever folk could! It was the nearest thing to being verbally abused in public that I've ever experienced.

I spoke particularly of tail risk - the idea that, yes, while everything was going well those investments would do better than our Cash-Plus Fund. But when they went wrong, they'd go completely wrong and you'd end up earning Cash minus a lot, probably all of it!

They didn't listen, but they were warned. They made the explicit decision to look like heroes to their employers. Of course, later on many of them went to court and won compensation for having been lied to by the issuers! I'm glad for the ratepayers and supporters of the charities caught up in this that they won their court case, but somewhere along the line there's a group of decision-makers who are being overlooked in this whole saga.

If nothing else, they owe people like me and Brett - whose papers at Macquarie were just another warning for those who were willing to listen - an apology. We weren't wrong, we weren't incompetent, we knew what we were talking about.

I also think we need to be careful not to tar all CDO's and all structured product with the same brush. Most CDO's, especially those backed by a decently diversified pool of corporate bonds, performed well over the episode. Their price dropped at the time, but they recovered and paid what they'd promised. It was mostly the structures that went into the US sub-prime market that were troublesome.

But your anger and frustration is understandable.


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