The Attention Span of Mayflies
The memory and attention span of financial market participants can be compared to that of mayflies. The mayfly is a member of the order ephemeroptera, from the Greek term for 'short-lived' (literally: 'lasting a day'). The English word 'ephemeral' comes from the same root. You get our drift.
Not long after yesterday's post about the growing signs of unbridled speculation in credit markets was published, we came across an article in the WSJ, entitled “Borrowing Cash to Buy Complex Assets Is In Vogue Again”. We're not particularly surprised to come across such an article, but this is definitely an interesting addendum to yesterday's missive.
The topic are collateralized loan obligations, or CLOs for short. As the WSJ informs us, CLOs were among the structured credit products that held up comparatively well in the 2008 crisis, with not too many defaults occurring in their component loans. What's contained in a CLO? “CLOs are bonds typically backed by pools of low-rated corporate loans”, the WSJ informs us. Many CLOs are nevertheless sporting triple A ratings, either due to overcollateralization or due to being sliced into tranches of different seniority. Banks still hold quite a few of these securities, but they want, or rather have to, get rid of at least some of these holdings:
“Many banks own CLOs themselves, holding about $130 billion on their books. New regulations may mean some banks will be forced to sell some CLOs in the next few years.
Finding new buyers would help them offload the debt, while keeping prices relatively high. Some banks also are trying to ensure there will be demand for more CLOs they help create.
Banks "are resorting to creating economic incentives to get primarily hedge funds to step into this void," said Oliver Wriedt, senior managing director at CIFC Asset Management LLC, which manages CLOs.”
What 'economic incentives' might these be? Banks are trying to entice hedge funds to buy CLOs by offering them credit to buy them. We learn that hedge funds have once again 'come to embrace' leverage. In fact, buying CLOs without employing leverage is just not worth it. But there are evidently risks…
“Using borrowed money to buy securities may help hedge funds bolster returns, a useful strategy with interest rates at rock-bottom levels on many other mainstream debt investments.
Many investors steered clear of borrowed money after getting burned in the financial crisis, when they were forced to repay loans on securities whose value had fallen. But several investors said CLO returns wouldn't be attractive now without leverage.
Hedge funds "have finally come to grips with leverage and begun to embrace it" for CLOs, said Jean de Lavalette, head of securitized products sales at Société Générale.
But with leverage comes risk. Even a small drop in the market could force investors to pledge more cash and other collateral to offset the securities' decline. Losses are magnified when borrowed money is used.”
It sounds like courting disaster to us.
So what kind of leverage are we actually talking about?
“Overall, borrowed money is mostly being used to buy triple-A-rated CLOs, say bankers and investors. That contrasts with the run-up to the 2008 crisis, when huge sums were borrowed to finance bets on assets such as subprime mortgages.
CLOs performed better in the financial crisis than other esoteric offerings, such as collateralized debt obligations, backed by subprime mortgages. CDO investors suffered heavy losses following rating downgrades and defaults in the crisis, while CLOs were more resilient and suffered comparatively few defaults.
Banks have offered to lend some investors as much as $9 for every dollar that the buyers invest in CLOs, say traders and strategists. Others are being offered $8 for every $2.
An investor in a triple-A-rated CLO earning 1.50 percentage point over the London interbank offered rate—using 10% of his or her own money and paying 0.80 percentage point over Libor for the financing—could earn about 8% in a year.
That compares with annual interest rates near 2% on a standard triple-A CLO. Citigroup researchers in a mid-April note to clients predicted that the new source of financing could help drive up prices of triple-A-rated CLOs.”
Good grief. We will comment on this point by point.
There is actually no 'contrast' with the run-up to the 2008 crisis; the difference is merely cosmetic. Many of the CDOs and other structured mortgage finance products that lost up to 97% of their value in the worst cases were also 'triple A rated' just prior to the crisis. They were rated so highly because of the way they were structured, which made it appear highly unlikely that senior tranches would ever suffer losses.
Whether overcollateralization or the slicing into tranches of different seniority are employed, both achieve the same effect: it becomes possible to give a higher rating to dodgy debt, on the grounds that 'historically, only a certain small percentage has defaulted even in worst case scenarios'. This is precisely the reasoning that was used by rating agencies in the structured mortgage credit markets prior to the 2008 crisis. The main reason why CLOs fared better than mortgage backed credit instruments in the crisis was that the crisis was concentrated in real estate and mortgage credit. The next crisis will be concentrated in a different area. Most likely it will be corporate debt. Again, there is no 'contrast'.
The Risks are Many …
So leverage of up to $9 for every dollar invested is offered, which will produce a return of 8% per year. If the next crisis does indeed focus on corporate debt, there may well be single trading days when 8% are lost in such instruments – without taking leverage into consideration, mind. One must not forget that during financial panics, sell orders are given first and questions are asked later. What will the liquidity in these structured products be under such circumstances? We can tell you already: all bids will simply disappear. Note that due to new regulations that are supposed to make the system 'safer' (ha!), banks are no longer the big traders in corporate bonds they once were. There are no longer any big market makers to fall back on in times of stress.
Citigroup is correct: while hedge funds are levering up, prices will rise. In all likelihood these securities are already overpriced – in fact, it is absolutely certain that they are, as money printing has distorted interest rates and consequently the prices of financial assets as well. Speaking of interest rates: obviously, default risk is not the only risk associated with these securities. There is interest rate risk as well. If rates rise, two things will happen: the borrowings that support holding such securities on margin will become more expensive, while the prices of the securities will fall at the same time. Anyone borrowing $9 for every dollar invested will be in a very uncomfortable position if that happens.
One may be tempted to say 'so what'? After all, hedge funds will never be bailed out by tax payers. However, one must not overlook the fact that the banks are not insulated against the risks these trades entail, since they are lending the money. In other words, they are only altering the composition of their risk exposure, but the risks remain the same, or may even turn out to be greater (depending on the speed and size of the coming denouement). This is aside from the fact that in the event of large players in the financial markets running into trouble, risk contagion in general cannot be avoided. One only needs to recall LTCM, a large credit hedge fund that keeled over in the Russian crisis (it was specialized in convergence trades, betting that credit spreads would decline, and reportedly employing huge leverage). The Fed forced large investment banks to put together a bail-out package for the listing fund, as it was fearing that otherwise systemic risks would snowball.
From the Wall Street Journal: CLO issuance is 'roaring back' – click to enlarge.
Lastly, the WSJ notes:
“CLO prices have begun to recover, and CLO issuance has picked up after a slow start to the year. More than $35 billion of CLOs were created so far in 2014, the most for that period since 2007, when $36.4 billion were created, according to S&P Capital IQ Leveraged Commentary & Data.”
This is not surprising, but it isn't particularly comforting.
Don't get us wrong – we have nothing against financial innovation. There will always be new financial products created to satisfy investor demand, and to optimize the intermediation of credit and risk. The problem is the monetary system itself, in short, the foundation on which all these activities rest. Since the 2008 crisis, the US broad true money supply has soared from $5.3 trillion to more than $10 trillion, and commercial banks haven't even increased their inflationary lending much as of yet. In the process, prices and risk perceptions have once again become extremely distorted. When fund managers begin to employ 10:1 leverage to obtain an 8% annual return and banks are eager to provide the necessary credit, it is simply yet another symptom of bubble conditions.
It is that time of the year again – our semi-annual funding drive begins today. Give us a little hand in offsetting the costs of running this blog, as advertising revenue alone is insufficient. You can help us reach our modest funding goal by donating either via paypal or bitcoin. Those of you who have made a ton of money based on some of the things we have said in these pages (we actually made a few good calls lately!), please feel free to up your donations accordingly (we are sorry if you have followed one of our bad calls. This is of course your own fault). Other than that, we can only repeat that donations to this site are apt to secure many benefits. These range from sound sleep, to children including you in their songs, to the potential of obtaining privileges in the afterlife (the latter cannot be guaranteed, but it seems highly likely). As always, we are greatly honored by your readership and hope that our special mixture of entertainment and education is adding a little value to your life!
Bitcoin address: 1DRkVzUmkGaz9xAP81us86zzxh5VMEhNke
Most read in the last 20 days:
- A Striking Chart
The Economy and the Stock Market As long time readers know, we are always paying close attention to the manufacturing sector, which is far more important to the US economy than is generally believed. In terms of gross output it is the largest sector of the economy, and it should of course be obvious that saving, investment and production are the only ways to create wealth. What's left of the Brooklyn Domino Sugar Refinery. Photo credit: Paul Raphaelson Contrary...
- Trump and Putin Narrowly Escape Assassination Attempt
The Gloves are Coming Off First a little bit of recent history. Readers are probably aware that some questions about the occasionally malfunctioning Deep State android... no, wait, we'll start again. Questions have recently been raised about the health of presidential candidate Hillary Clinton by various “alt-right” tinfoil hat-wearing conspiracy theorists, such as this one. The monsters are normally hiding under Hillary's bed, but lately they have come out into the open...
- Why the Fed Destroyed the Market Economy
What Have You Done for Me Lately? Swing voters are a fickle bunch. One election they vote Democrat. The next they vote Republican. For they have no particular ideology or political philosophy to base their judgment upon. The primacy of the wallet. They don’t give a rip about questions of small government or big government. Nor do they have any druthers about the welfare or warfare state. In effect, they really don’t care. What’s important to the...
- Donald’s Electoral Struggle
Wicked and Terrible After touting her pro-labor union record, the Wicked Witch of Chappaqua rhetorically asked, “why am I not 50 points ahead?” Her chief rival bluntly responded: “because you’re terrible.”* No truer words have been uttered by any of the candidates about one of their opponents since the start of this extraordinary presidential campaign! Electoral map (note that the coloration may no longer be applicable...) That Hillary Clinton is...
- Janet Yellen’s Shame
Playing Politics In honest capitalism, you do what you can to get other people to voluntarily give you money. This usually involves providing goods or services they think are worth the price. You may get a little wild and crazy from time to time, but you are always called to order by your customers. In the market economy, consumers reign supreme. There is no such thing as a “lost” vote in the marketplace; every penny spent affects production. Mises noted: “Consumers...
- Get Ready for a New Crisis – in Corporate Debt
Imposter Dollar OUZILLY, France – We’re going back to basics here at the Diary. We’re getting everyone on the same page... learning together... connecting the dots... trying to figure out what is going on. The new three dollar bill issued by the Apprehensive States of America. We made a breakthrough when we identified the source of so many of today’s bizarre and grotesque trends. It’s the money – the new post-1971 dollar. This new dollar is green. You...
- The Economy, the Stock Market and the Fed
John Hussman on Recent Developments We always look forward to John Hussman's weekly missive on the markets. Some people say that he is a “permabear”, but we don't think that is a fair characterization. He is rightly wary of the stock market's historically extremely high valuation and the loose monetary policy driving the surge in asset prices. The S&P 500 Index and the NYSE advance-decline line. Most market internals weakened steadily until early February 2016, but...
- Hanjin Marooning in San Pedro Bay
Global Trade Reversal Expansions and contractions in global trade have played out over long secular trends for thousands of years. The Silk Road, for example, was established by the Han Dynasty of China in 130 BC, and allowed for continuous trade between East and West for nearly 1,600 years. In addition to economic trade, the Silk Road was also a conduit for culture and knowledge among its network of civilizations. A map of the main ancient Silk Road - click to...
- Great Causes, a Sea of Debt and the 2017 Recession
Great Cause NORMANDY, FRANCE – We continue our work with the bomb squad. Myth disposal is dangerous work: People love their myths more than they love life itself. They may kill for money. But they die for their religions, their governments, their clans... and their ideas. Famous French hippie and author Voltaire. He wears the same sardonic grin in every painting, whether he's depicted at a young or an old age, doesn't matter. His real name was François-Marie Arouet; he...
- The Donald Versus Killary: War or Peace?
War: A Warning from the Past Although history does not exactly repeat itself, it does provide parallels and sometimes quite ominous ones. Such is the case with the current U.S. Presidential election and the one which occurred one hundred years earlier. The Donald probably has the better slogan... The dominating question which hung over the 1916 campaign was whether the country would remain neutral in regard to the horrific slaughter which was taking place on the...
- A Rift in the Space-Time Continuum
Weird and Unnatural NORMANDY, France – First, a quick look at the markets. The Dow bounced on Monday, recovering 239 points of the nearly 400 it lost on Friday. Why the comeback? FOMC member Lael Brainard: her comments on Monday were touted as the “reason” for the stock market recovering half of Friday's losses. We suspect the real reason is the triple witching on Friday... Photo via twitter.com The financial press has a ready answer: “Stocks gain...
- Crimea: Digging For The Truth
Renewed Escalation This summer witnessed a renewed escalation between Russia and Ukraine after Russian President Vladimir Putin accused Ukraine of sending saboteurs to attack Russian troops, targeting “critical infrastructure”. Kiev denied the allegations and claimed Russia’s “fantasy” was nothing but a false pretense to launch a “new invasion”. August 10: Russian president Putin announces that there was an altercation involving a group of Ukrainian saboteurs at...