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:
- Gold Price Skyrockets in India after Currency Ban – Part III
When Money Dies In part-I of the dispatch we talked about what happened during the first two days after Indian Prime Minister, Narendra Modi banned Rs 500 and Rs 1000 banknotes, comprising of 88% of the monetary value of cash in circulation. In part-II, we talked about the scenes, chaos, desperation, and massive loss of productive capacity that this ban had led to over the next few days. Indian prime minister Narendra Modi – another finger-wagger, as can be seen in this...
- Gold Price Skyrockets in India after Currency Ban – Part IV
A Market Gripped by Fear The Indian Prime Minister announced on 8th November 2016 that Rs 500 and Rs 1,000 banknotes would no longer be legal tender. Linked are Part-I, Part-II and Part-III updates on the rapidly encroaching police state. The economic and social mess that Modi has created is unprecedented. It will go down in history as an epitome of naivety and arrogance due to Modi’s self-centered desire to increase tax-collection at any cost. Indian jewelry...
- A Note on Gold and India – What is Driving the Gold Price?
Hidden Motives It is well-known that India's government wants to coerce its population into “modernizing” its financial behavior and abandoning its traditions. The recent ban on large-denomination banknotes was not only meant to fight corruption. Obviously, this very bad Indian has way too much cash. Just look at him, he looks suspicious! Photo via thenewsminute.com In fact, as our friend Jayant Bhandari has pointed out, fresh avenues for corruption ...
- Gold Price Skyrockets in India after Currency Ban – Part V
A Brief Recap India's Prime Minister announced on 8th November 2016 that Rs 500 and Rs 1,000 banknotes will no longer be legal tender. Linked are Part-I, Part-II, Part-III, and Part-IV, which provide updates on the rapidly encroaching police state Expect a continuation of new social engineering notifications, each sabotaging wealth-creation, confiscating people’s wealth, and tyrannizing those who refuse to be a part of the herd, in the process destroying the very backbone of the...
- Attaining Self-Destruct Velocity
Bad Monday Some Monday mornings are better than others. Others are worse than some. For one Amazon employee, this past Monday morning was particularly bad. No doubt, the poor fellow would have been better off he’d called in sick to work. Such a simple decision would have saved him from extreme agony. But, unfortunately, he showed up at Amazon’s Seattle headquarters and put on a public and painful display of madness. Good-bye cruel world! On this our planet,...
- All Aboard! Trump’s Express Train to the Future
Free Money! BALTIMORE – Last week, the Dow punched up above 19,000 – a new all-time record. And on Monday, the Dow, the S&P 500, the Nasdaq, and the small-cap Russell 2000 each hit new all-time highs. The last time that happened was on the last day of December 1999. Ironically, two events that were almost universally expected to trigger large stock market declines were followed by quite rapid and strong gains. Would the market have fallen if Hillary Clinton had won...
- India's Currency Debacle – An Interview with Jayant Bhandari
A Major Crisis Last week Jayant Bhandari related the story of the overnight ban of certain banknotes in India under cover of “stamping out corruption” (see Gold Price Skyrockets In India after Currency Ban Part 1 and Part 2 for the details). Banned 500 rupee banknotes The problem is inter alia that the sudden ban of these banknotes has hit the Indian economy quite hard, given that 97% of all transactions in the country are cash-based. Not only that, it has...
- Will the Swamp Swallow Trump?
Permanently Skewed TRUMP HOTEL, New York – Trump’s rambling army – professionals, amateurs, camp followers, and profiteers – is marching south, down the I-95 corridor. There, on the banks of the Potomac, it will fight its next big battle. Lieutenants in Trump's army: Bannon, Flynn & Sessions Photo credit: Drew Angerer / AFP Here at the Diary, we do not like to get involved in politics. But this is a special time in the history of our planet – a...
- There Are Two Types of Credit — One of Them Leads to Booms and Busts
Stumped by the Bust In the slump of a cycle, businesses that were thriving begin to experience difficulties or go under. They do so not because of firm-specific entrepreneurial errors but rather in tandem with whole sectors of the economy. People who were wealthy yesterday have become poor today. Factories that were busy yesterday are shut down today, and workers are out of jobs. What has caused the bust? The modern-day economic orthodoxy continues to be unable to provide...
- Gold Bull Market Remains Intact – Long Term Fundamentals Outweigh Short Term Market Gyrations
A Strong First Half of the Year, Followed by Another Retreat In early 2016 gold had a big bull run. The precious metal rose close to 25% this year, pushed higher in a summer rally that peaked on July 10th. Gold experienced a bumpy ride over the remainder of the summer though, as investors became increasingly concerned about a potential rate hike by the Federal Reserve. Uncertainty returned to gold market and has intensified further since then. Initially, gold rallied sharply...
- Too Early for “Inflation Bets”?
The Trump Trade After 35 years of waiting... so many false signals... so often deceived... so often disappointed... bond bears gathered on rooftops as though awaiting the Second Coming. Many times, investors have said to themselves, “This is it! This is the end of the Great Bull Market in Bonds!” The long bond's long cycle – red rectangles indicate when the post 1980 bull market was held to be “over” or “over for sure” or “100% over”, etc. We have...
- US True Money Supply Growth Jumps, Part 1: A Shift in Liabilities
A Very Odd Growth Spurt in the True Money Supply The growth rates of various “Austrian” measures of the US money supply (such as TMS-2 and money AMS) have accelerated significantly in recent months. That is quite surprising, as the Fed hasn't been engaged in QE for quite some time and year-on-year growth in commercial bank credit has actually slowed down rather than accelerating of late. The only exception to this is mortgage lending growth - at least until recently. Growth in...