Global Financial Crisis 2.0? Part 5

Chapter 5: This time, the banks aren’t the real problem. The risky leverage has moved elsewhere, and that’s what you need to worry about

Did you know that there have been 290 global rate hikes in the last 12 months? Crazy, right?

But as we’ve seen, the effects are rarely immediate. Monetary policy (from central banks) acts with an uncertain impact, and a definite lag.

It’s understandable that folks in the market are focused on SVB and the immediate contagion. Understandable, but myopic. What they SHOULD be looking at is where the leverage has moved. 

And it’s not with the banking system any more.

Since 2008, most of the leverage has moved from the banking system to asset managers

By asset manager, I mean any outfit whose job it is to grow the value of a portfolio on behalf of an entity like a fund or company. Basically, a professional allocator of investment capital. 

I’m sure you’ve heard of the big-dog asset managers…

They’ve got a measly $21T in combined AUM. 😂

In fact (and this is wild), these three firms own 15%-20% of most American companies.

But more importantly, these guys (along with other asset managers and private equity houses) took over the leverage game. What was once provided almost exclusively by banks is now on the books of these asset managers.

Admittedly, they use “alternatives” to traditional bank financing — offerings that deal in private credit, infrastructure and real estate. But it’s still leverage.

And it’s still a liability.

This shift from banks to asset managers can be traced back to the Global Financial Crisis

Remember, the banking system got regulated up the wazoo thanks to Dodd-Frank and other post-GFC reforms. One rule within Dodd-Frank, called the Volcker Rule, did two things important to this conversation:

1. It prohibited banks (depository institutions) from engaging in “proprietary trading.” This means that a bank can’t serve as a principal of a trading account in buying or selling financial instruments.
2. It prohibited banks from investing in or sponsoring others’ hedge funds or private equity funds, or maintaining their own.

In short, banks can no longer offer leverage to those riskier investment vehicles

But the demand for leverage didn’t go anywhere.

Nor did the supply; there was still plenty of “dry powder” (aka cash) around waiting for someone to borrow it.

And asset managers were happy to take up the leverage torch that the banks were no longer allowed to carry. 

And there’s no shortage of smaller managers who’ve been happy to take that leverage

Nowadays everybody’s got a “hedge fund.” Everyone and their mother has a fund or syndication for which they want leverage.

Heck, half the guys I meet where I live Puerto Rico run one of these garage-band hedge funds. And they’re really just traders who convinced investors to hand over some capital…and in many cases levered it up through some channel that leads back to one of the bigger asset managers.

Consider for a moment how fund managers are incentivized

They make more in management fees the greater their AUM (Assets Under Management).

They make more in carried interest the greater their AUM (carried interest is the manager’s percentage split of gains realized).

They make more in management fees AND carried interest the LESS they personally invest. (The latter is kind of like how a wrap lender’s ROI goes up the less he/she contributes to a private money lending deal).

The more leverage they use, the more assets they can buy. This increases their AUM, which again means they make more in management fees and carried interest.

The cheaper the leverage they take on, the greater spread they make (until that cheap debt adjusts or needs to be refinanced, which is the issue we’re seeing now). 

Add all that up, and you’ve got a recipe for indiscriminate leverage

Which might have been OK if managers had made better investment decisions. But most didn’t.

Like banks, many managers bought bonds that have done nothing but depreciate. They bought MBSs when interest rates were at record lows and thus locked in low yields. They invested in stocks, ETFs and Mutual Funds as the market was peaking, leading to a subsequent loss of share value and portfolio value.

The big managers provided leverage to smaller ones on real estate, right as the housing market was going bananas. The big ones provided debt capital to companies at inflated valuations.

Meaning, they effectively overpaid for the assets in THEIR portfolios, and provided too much leverage on assets in OTHERS’ portfolios. Whoops.

Sure, some bought hard assets like real estate that will go up and to the right over time

But what happens as the market corrects, and they’re so leveraged that their real estate portfolio goes underwater?

That could spook a lot of investors and lead to withdrawal requests. How will they pay off investors and make payments on all that debt?

Bottom line: while banks everywhere ARE sitting on massive unrealized losses, those losses aren’t due to offering leverage willy-nilly like in the early 2000’s.

This time it’s asset managers who’ve been too liberal in extending credit.

Just think about how this correction has unfolded…

Which beneficiaries of Zero Interest-Rate Policy/Quantitative Easing were the first to fall?

Answer: crypto-based and high-growth public tech companies. The riskiest bets went bust first.

And we’ve observed a rolling correction since then, with non-tech companies, real estate and now banking all coming back down to earth. 

What we’re seeing now is part of a larger evolving narrative that has been underway for 18 months and contains many chapters, with a number of chapters (i.e. problems) yet to play out.

The next problem could be far larger. As in, systemic.

When I think systemic, I think structural… inherent… pervasive… extensive.