Creditflux Newsletter

Here is a recipe that is sure to make a mess. Take a fundamentally illiquid asset, such as a leveraged loan, a credit curve trade or an index tranche. Squeeze it into an investment vehicle and bake for half an hour. Finally, promise investors in that vehicle that they can get their money back whenever they want.

The problem with this (as you will instantly recognise) is the mismatch between assets and liabilities. What turned the 2007/2008 crisis from an overdue correction in overvalued credit into a meltdown was the gulf between long-dated holdings and short-dated promises.

Banks, of course, have always used this dangerous recipe and they were consumed by the flambé in large numbers. But there were other unwise cooks in 2007 and 2008, such as SIVs and money market funds.

As the very first event of the crisis demonstrated, hedge funds with overly generous redemption clauses were also part of the problem. The promises of liquidity made by two Bear Stearns funds led them to collapse when investors ran for the exits faster than an Italian cruise ship captain.

So have regulators learned the lessons of the crisis and issued new health and safety guidelines to the financial kitchens of the world? No, they have not.

In Europe, for example, Ucits funds are growing dramatically because they have an official seal of approval in the form of a European Union directive. In the eyes of European law makers, Ucits funds offer two things that make them eminently suitable for retail investors. First, they are governed by sophisticated mathematical risk management tools, such as value at risk. Let’s leave the merits or otherwise of those models for another day. Second, they must offer investors the chance to redeem at least fortnightly.

Asset managers, including credit managers, have seized on the opportunity to pursue hedge fund-like strategies in these funds, which can be sold onshore to investors throughout the European Union. (Despite their retail-suitable packaging, it is insurance companies and pension funds that really drive demand for Ucits funds.) The result is that credit investments are increasingly being channelled into funds that, on the face of it, offer even more generous redemption terms than Bear Stearns’ ill-fated vehicles.

Across the Atlantic you can see a similar process at work. Regulations to clamp down on securitisation have helped to dampen demand for CLOs. Mutual funds, many of which promise daily liquidity, are filling the gap. In other words, a 10-year or more vehicle is being replaced as the dominant loan investor by one promising daily liquidity. It should come as no surprise that prices in the loan market have become more volatile.

Fortunately, while regulators may be pushing the market in the direction of more dangerous structures, market participants are often resisting. The reality of Ucits credit funds is not as scary as it sounds, with investors usually prepared to accept limits on their right to withdraw capital. Their super-liquidity is a fiction happily maintained by investors and managers in the interest of keeping the regulators on board.

Meanwhile, many of the new retail credit funds launched in the past three years are closed end funds. These provide excellent liquidity to investors in good times and prevent fire-sales in bad.

Both developments suggest that managers and investors are still all too aware of the dangers of flighty capital: how it can cost managers their jobs and investors everything they’ve invested. Let’s hope that both camps have long memories.