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Net Net: Promoting innovation and managing change

Bill Gross: Here's what could trigger a 'run on the shadow banks'

Bill Gross expects gradual hike

Bill Gross thinks conditions are ripe for a significant liquidity crisis in the markets, and he points a finger at his old firm for its potential to be at the center of the storm.

In his monthly note to investors, the Janus Capital Group fund manager said there are six specific triggers for such an event in which there would not be enough buyers to accommodate sellers in a panicked bond market. (Tweet This)

"Long used to the inevitability of capital gains, investors and markets have not been tested during a stretch of time when prices go down and policymakers' hands are tied to perform their historical function of buyer of last resort," Gross wrote. "It's then that liquidity will be tested."

The comments come as fixed income investors face challenges on multiple fronts: Looming debt defaults from both Puerto Rico and Greece, and the latter's potential exit from the euro zone, along with the likelihood of a Federal Reserve rate hike later this year.

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The conditions Gross cited for a market meltdown are:

1) A central bank mistake leading to lower bond prices and a stronger dollar.

2) Greece, and if so, the inevitable aftermath of default/restructuring leading to additional concerns for euro zone peripherals.

3) China— "a riddle wrapped in a mystery, inside an enigma." It is the "mystery meat" of economic sandwiches—you never know what's in there. Credit has expanded more rapidly in recent years than any major economy in history, a sure warning sign.

4) Emerging market crisis—dollar denominated debt/overinvestment/commodity orientation—take your pick of potential culprits.

5) Geopolitical risks—too numerous to mention and too sensitive to print.

6) A butterfly's wing—chaos theory suggests that a small change in "non-linear systems" could result in large changes elsewhere. Call this kooky, but in a levered financial system, small changes can upset the status quo. Keep that butterfly net handy.

Unlike the financial crisis, where Wall Street's largest investment banks came under duress when liquidity dried up, Gross said the next wave will involve nonbank institutions like Pimco, the Newport Beach, California-based firm he co-founded more than 40 years but left in 2014.

Bill Gross
Tim Boyle | Bloomberg | Getty Images

Dodd-Frank reform legislation transferred that risk from too big to fail institutions, which aren't allowed to engage in some of the trading activity that precipitated the crisis, to large outfits that have stepped in to fill the void. Gross specifically points to Pimco (as well as Prudential, BlackRock, MetLife "and at least several others):

While Dodd Frank legislation has made actual banks less risky, their risks have really just been transferred to somewhere else in the system. With trading turnover having declined by 35 percent in the investment grade bond market ... and 55 percent in the high yield market since 2005, financial regulators have ample cause to wonder if the phrase "run on the bank" could apply to modern day investment structures that are lightly regulated and less liquid than traditional banks. Thus, current discussions involving "SIFI" designation—"Strategically Important Financial Institutions"—are being hotly contested by those that may be just that. Not "too big to fail" but "too important to neglect" could be the market's future mantra.

Gross warned of the "liquidity illusion" moment when "all investors cannot fit through a narrow exit at the same time." That would trigger what he called "a run on the shadow banks," a term for nonbank lenders that became a pejorative during the financial crisis.

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He said Pimco represents a particular danger for its reliance on derivatives it said will provide liquidity during times of crisis. Gross specifically mentions comments from CEO Doug Hodge who spoke in a "friendly" Wall Street Journal piece recently.

Hodge himself admitted to internal proprietary "liquidity" provisions, adding that it used derivatives for exposures "to support cash buffers and inflows" (sic). The fact is that derivatives on a systemic basis represent increased leverage and therefore increased risk—presenting possible exit and liquidity problems in future months and years. 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 and Prudential officials declined to comment on Gross' letter. Representatives from BlackRock and MetLife did not respond to requests for comment.

Interestingly, Gross concedes that in his new role running the Janus Unconstrained Bond Fund he's trying to help turn the firm into a "too important" company like Pimco. He's got a long way to go—even after a year and a half of hemorrhaging investor cash, Pimco's $1.6 trillion in assets still dwarfs Janus' $190 billion.

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The two firms are, however, heading in opposite directions in that respect. Pimco's $107.3 billion Total Return fund, which Gross managed and until recently was the largest bond fund in the world, has seen outflows of $125.2 billion over the past year. Pimco itself has seen $201.1 billion in investor outflows since January 2014, around the time that former CEO Mohamed El-Erian left the firm and triggered a lasting period of turmoil there. Janus, by contrast, has brought in $1.24 billion this year.

In the event Gross' scenario plays out, he said "a cold rather than a hot shower may be an investor's reward and the view will be something less that 'gorgeous.' So what to do? Hold an appropriate amount of cash so that panic selling for you is off the table."