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Commentary: Those who forget are destined to remember

Brett Lewthwaite
Macquarie Investment Management’s Brett Lewthwaite

This year marks 10 years since the start of the global financial crisis, which brings to mind the quote:

"Those who cannot remember the past are condemned to repeat it." — George Santayana

Fifteen years ago, when I joined the Macquarie Fixed Income team, one of my first tasks was to work with Dean Stewart, head of research, on a piece called "Importance of Liquidity in Fixed Income."

I didn't know it then, but that research would come to influence and shape our investment beliefs, philosophy and processes. It would also become a differentiating bedrock of how we would approach markets and portfolio positioning in some of the most extreme conditions financial markets had ever seen and remain relevant throughout the years.

The "Importance of Liquidity" was well received by clients and consultants but didn't gain a following (or get "likes" or "retweets" as it might today), being five years before anyone would appreciate (or be reminded) of the true importance of liquidity.

Conducting research is something that we at Macquarie Fixed Income have always firmly believed in. We come from a mindset that before we do anything, we must truly understand the risks involved with the markets and instruments we are trading in. While this sounds sensible and obvious, we are constantly surprised that this isn't as normal as it sounds.

CDOs — Why research is key

Linked to this time was the emergence and then proliferation of collateralized debt obligations. Consistent with our belief that we must truly understand the risks involved before we invest in new markets or instruments, Dean investigated CDOs and released a research paper (again to little fanfare — though 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 that of liquidity risk. Of course, none met their requirements. So we didn't invest.

We then watched with interest as CDOs exploded in popularity from 2003 to 2007, including plain vanilla CDOs (packages of loans to many companies). Then, more troubling, came "synthetic" CDOs — synthetic meaning they were made up of derivatives, not loans to real companies. We wondered in amazement why anyone would buy a security that had no economic purpose. Those were followed by subprime CDOs — that is, poor quality loans. Some in the industry even nicknamed these NINJA — No Income, No Job or Assets — loans. Then arrived CDO-squared — CDOs of other CDOs. We experienced more wonderment about the economic purpose of such a structure. Then followed tranche CDO-squared — CDOs of tranches of other CDOs — that banks and hedge funds began using to offload risk or short the market. Finally there were leveraged-super-senior CDOs — I don't even remember what these did.

While we had done the prerequisite research that resulted in "staying away," it doesn't mean we didn't do the work on what we saw — we did, with fascinated interest. And we continued, right up to when it seemed apparent that the financial institutions, some where we had little or no relationship, appeared keen to sell us the new format CDOs.

As the market began to unravel, we knew the flow of credit that 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 would undermine 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

We are often asked why we didn't get caught up, and what we did differently. The answer starts with our research — on 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. 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. Although 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 they are untested in these claims by any significant liquidity event.

With the proliferation of ETFs and passive funds, amid a market environment of unthinkable central bank support, as we often say, "Everyone thinks they are a macro trader." The trouble is that they also think they have that special edge to exit just before the herd rushes for the same exits.

Perceptions of the value and importance of liquidity have diminished, and its existence, or tendency to quickly shift to lack thereof, is again underappreciated. Many investors are giving up liquidity in the belief they don't need it. We know this will change, even if we cannot predict when. So in the meantime, as investors, we should never lose sight of the real cost of liquidity. How liquid is the underlying investment? Am I getting rewarded enough for that "lock-up period"? What are the real counterparty and structuring risks that will impact the liquidity of this old "new product"? If you at least ask yourself those questions you might end up in a relatively better position when liquidity dries up.

Back in 2008 amid the chaos of markets, we were juggling newborns and infants (an uncanny number of daughters). We are now older, wiser and pleased to still work alongside each other. Our children are now entering their teens. And while we can look back in 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 and stay true to our beliefs — again, even when others don't.

Brett Lewthwaite, based in Sydney, is global co-head of fixed income at Macquarie Investment Management. This content represents the views of the author. It was submitted and edited under P&I guidelines but is not a product of P&I's editorial team.