Pimco claims to use derivatives as a safe haven from liquidity scares, but Bill Gross scoffs at the idea.
Liquidity is an undeniable problem right now, Gross writes in his latest investment outlook. Pimco CEO Doug Hodge has said that his firm has “liquidity provisions,” using derivatives for exposures “to support cash buffers and inflows.” Derivatives represent increased leverage and increased risk, Gross emphasizes, creating future liquidity problems. Regulations that have made the banks less risky have merely transferred the risk elsewhere in the system. Writes Gross:
Mutual funds, hedge funds, and ETFs, are part of the “shadow banking system” where these modern “banks” are not required to maintain reserves or even emergency levels of cash. Since they in effect now are the market, a rush for liquidity on the part of the investing public, whether they be individuals in 401ks or institutional pension funds and insurance companies, would find the “market” selling to itself with the Federal Reserve severely limited in its ability to provide assistance.
Pimco’s use of derivatives as a safe have is “counterintuitive,” says Gross. Shadow banking structures need counterparty relationships with heavy margins. ETFs and mutual funds don’t have blocks in place to protect against mass overnight exits. A run on the shadow banks is a good possibility, looking at the current state of Greece and the world’s quick reactions to every central bank tweak. Gross advises investors to prepare themselves with enough cash so that a panic selling doesn’t need to happen.
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