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.

 

Cosmetic Differences

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.”

 

(emphasis added)

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.

 

MI-CC732B_CLO_J_20140504170904

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.

 

Conclusion:

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.

 

 
 

Emigrate While You Can... Learn More

 
 

 
 

Dear Readers!

You may have noticed that our so-called “semiannual” funding drive, which started sometime in the summer if memory serves, has seamlessly segued into the winter. In fact, the year is almost over! We assure you this is not merely evidence of our chutzpa; rather, it is indicative of the fact that ad income still needs to be supplemented in order to support upkeep of the site. Naturally, the traditional benefits that can be spontaneously triggered by donations to this site remain operative regardless of the season - ranging from a boost to general well-being/happiness (inter alia featuring improved sleep & appetite), children including you in their songs, up to the likely allotment of privileges in the afterlife, etc., etc., but the Christmas season is probably an especially propitious time to cross our palms with silver. A special thank you to all readers who have already chipped in, your generosity is greatly appreciated. Regardless of that, we are honored by everybody's readership and hope we have managed to add a little value to your life.

   

Bitcoin address: 1DRkVzUmkGaz9xAP81us86zzxh5VMEhNke

   
 

Your comment:

You must be logged in to post a comment.

Most read in the last 20 days:

  • Modi’s Great Leap Forward
      India’s Currency Ban – Part VIII India’s Prime Minister, Narendra Modi, announced on 8th November 2016 that Rs 500 (~$7.50) and Rs 1,000 (~$15) banknotes would no longer be legal tender. Linked are Part-I, Part-II, Part-III, Part-IV, Part-V, Part-VI and Part-VII, which provide updates on the demonetization saga and how Modi is acting as a catalyst to hasten the rapid degradation of India and what remains of its institutions.   India’s Pride and Joy   Indians are...
  • Global Recession and Other Visions for 2017
      Conjuring Up Visions Today’s a day for considering new hopes, new dreams, and new hallucinations.  The New Year is here, after all.  Now is the time to turn over a new leaf and start afresh. Naturally, 2017 will be the year you get exactly what’s coming to you. Both good and bad.  But what else will happen?   Image of a recently discarded vision... Image by Michael Del Mundo   Here we begin by closing our eyes and slowing our breath.  We let our mind...
  • US Financial Markets – Alarm Bells are Ringing
      A Shift in Expectations When discussing the outlook for so-called “risk assets”, i.e., mainly stocks and corporate bonds (particularly low-grade bonds) and their counterparts on the “safe haven” end of the spectrum (such as gold and government bonds with strong ratings), one has to consider different time frames and the indicators applicable to these time frames. Since Donald Trump's election victory, there have been sizable moves in stocks, gold and treasury bonds, as the election...
  • The Great El Monte Public Pension Swindle
      Nowhere City California There are places in Southern California where, although the sun always shines, they haven’t seen a ray of light for over 50-years.  There’s a no man’s land of urban blight along Interstate 10, from East Los Angeles through the San Gabriel Valley, where cities you’ve never heard of and would never go to, are jumbled together like shipping containers on Terminal Island.  El Monte, California, is one of those places.   Advice dispensed on Interstate...
  • A Trade Deal Trump Cannot Improve
      Worst in Class BALTIMORE – People can believe whatever they want. But sooner or later, real life intervenes. We just like to see the looks on their faces when it does. By that measure, 2017 may be our best year ever. Rarely have so many people believed so many impossible things.   Alice laughed. "There's no use trying," she said: "one can't believe impossible things." "I daresay you haven't had much practice," said the Queen. "When I was your age, I always did it for...
  • Pope Francis Now International Monetary Guru
      Neo-Marxist Pope Francis Argues for Global Central Bank As the new year dawns, it seems the current occupant of St. Peter’s Chair will take on a new function which is outside the purview of the office that the Divine Founder of his institution had clearly mandated.   Neo-Papist transmogrification. We highly recommend the economic thought of one of Francis' storied predecessors, John Paul II, which we have written about on previous occasions. In “A Tale of Two Popes” and...
  • Where’s the Outrage?
      Blind to Crony Socialism Whenever a failed CEO is fired with a cushy payoff, the outrage is swift and voluminous.  The liberal press usually misrepresents this as a hypocritical “jobs for the boys” program within the capitalist class.  In reality, the payoffs are almost always contractual obligations, often for deferred compensation, that the companies vigorously try to avoid.  Believe me.  I’ve been on both sides of this kind of dispute (except, of course, for the “failed”...
  • Trump’s Trade Catastrophe?
      “Trade Cheaters” It is worse than “voodoo economics,” says former Treasury Secretary Larry Summers. It is the “economic equivalent of creationism.” Wait a minute -  Larry Summers is wrong about almost everything. Could he be right about this?   Larry Summers, the man who is usually wrong about almost everything. As we have always argued, the economy is much safer when he sleeps, so his tendency to fall asleep on all sorts of occasions should definitely be welcomed....
  • Money Creation and the Boom-Bust Cycle
      A Difference of Opinions In his various writings, Murray Rothbard argued that in a free market economy that operates on a gold standard, the creation of credit that is not fully backed up by gold (fractional-reserve banking) sets in motion the menace of the boom-bust cycle. In his The Case for 100 Percent Gold Dollar Rothbard wrote:   I therefore advocate as the soundest monetary system and the only one fully compatible with the free market and with the absence of force or fraud...
  • Trump’s Plan to Close the Trade Deficit with China
      Rags to Riches Jack Ma is an amiable fellow.  Back in 1994, while visiting the United States he decided to give that newfangled internet thing a whirl.  At a moment of peak inspiration, he executed his first search engine request by typing in the word beer.   Jack Ma, founder and CEO of Alibaba, China's largest e-commerce firm. Once he was a school teacher, but it turned out that he had enormous entrepreneurial talent and that the world of wheelers, dealers, movers and...
  • Side Notes, January 14 - Red Flags Over Goldman Sachs
      Red Flags Over Goldman Sachs Just to prove that I am an even-handed insulter, here is a rant about my former employer, Goldman Sachs. The scandal at 1MDB, the Malaysian sovereign wealth fund from which it appears that billions were stolen by politicians all the way up to the Prime Minister, continues to unfold.   The main players in the 1MDB scandal. Irony alert: apparently money siphoned off from 1MDB was used to inter alia finance Martin Scorcese's movie “The Wolf of...
  • Silver’s Got Fundamentals - Precious Metals Supply-Demand Report
      Supply-Demand Fundamentals Improve Noticeably Last week was another short week, due to the New Year holiday. We look forward to getting back to our regularly scheduled market action.   Photo via thedailycoin.org   The prices of both metals moved up again this week. Something very noticeable is occurring in the supply and demand fundamentals. We will give an update on that, but first, here’s the graph of the metals’ prices.   Prices of gold and silver...

Austrian Theory and Investment

Support Acting Man

Own physical gold and silver outside a bank

Archive

j9TJzzN

350x200

Realtime Charts

 

Gold in USD:

[Most Recent Quotes from www.kitco.com]

 


 

Gold in EUR:

[Most Recent Quotes from www.kitco.com]

 


 

Silver in USD:

[Most Recent Quotes from www.kitco.com]

 


 

Platinum in USD:

[Most Recent Quotes from www.kitco.com]

 


 

USD - Index:

[Most Recent USD from www.kitco.com]

 

THE GOLD CARTEL: Government Intervention on Gold, the Mega Bubble in Paper and What This Means for Your Future

 
Buy Silver Now!
 
Buy Gold Now!
 

Oilprice.com