Yves here. Today Satyajit Das describes the areas of vulnerability in the financial system if stress levels increase. You’ll see it’s a mighty long list. Private equity and related areas feature prominently, as does the shadow banking system and forever wobbly Eurobanks. Even though many commentators have gotten excited about derivatives, Das reminds his audience that the most derivatives are centrally cleared, so it is the central clearinghouse that would be the derivatives TBTF entities. Das and I have both warned they are undercapitalized and would likely need a bailout in a crash.
However, many products have embedded derivatives, plus some customers (like many multinationals) are derivatives users. If enough end users get sick on bad derivatives cooking, they could disrupt the system by engaging strategies like large scale dumping of securities holdings, to meet margin calls or shore up cash balances.
We pointed out in ECONNED that the most likely outcome of the financial crisis was paradigm breakdown, as in repeatedly attempting to patch up the current system rather than engage in fundamental fixes, which would produce greater and greater disfunction, eventually producing political instability. Das describes how that is already happening and creating more financial risk.
By Satyajit Das, a former banker and author of numerous works on derivatives and several general titles: Traders, Guns & Money: Knowns and Unknowns in the Dazzling World of Derivatives (2006 and 2010), Extreme Money: The Masters of the Universe and the Cult of Risk (2011), Fortune’s Fool: Australia’s Choices (2022)
Asked about the impact of the French Revolution, Chinese Premier Zhou Enlai in 1972 allegedly stated: “Too early to say”. In fact, mistranslation or misunderstanding meant that Zhou was referring not to 1789 but the 1968 Paris student uprising. Fashionable comparisons between the financial crisis of 2008 and current volatility require a similar response. It requires a longer view of things than that in vogue in a world of tweets and clickbait. Part 1 of this two part piece- Bonfire of the Banks– examined the problems of the global banking sector. Part 2 – The Usual Suspects – looks at possible areas of contagion elsewhere within the financial system.
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While the current focus is on the banking sector, emerging financial and economic stresses are likely to reveal other exposures. This may include risky investments, the shadow banking system, structured products, trading and the bank-sovereign debt doom loop especially in Europe – the ‘usual suspects’.
Recent years have seen increased investment in venture capital (“VC”) and early/ late stage start-ups. While some of this may turn out to be sensible, a significant part financed two people in a garage on the basis of a skimpy PowerPoint deck as febrile FOMO (fear of missing out) obsessed investors chased the next new thing.
Abundant capital became its own strategy. Low interest rates, abundant liquidity combined with superior, privileged information and deal access, advantageous tax treatment and generous regulations encouraged investment. It stimulated the entry of ‘VC tourists’ or, as the National Venture Capital Association terms them ‘non-traditional capital’ – mutual funds, hedge funds, sovereign wealth funds etc. These new investors predictably drove up deal sizes and values while simultaneously devaluing expertise, due-diligence and common sense.
The apparently unlimited supply of cheap capital led to an explosion of firms with little or no possibility of creating a long-term viable, sustainable, self-financing operation. Fraud become a cost of doing business. The objective was to spend other people’s money to acquire customers to either on-sell onto the next fool or, more unlikely, emerge the victor in a desperate and expensive winner-takes-all race.
These unprofitable start-ups require near-continuous investment. Promoters and seed investors were reluctant to raise sufficient funding to cover needs till the business was even moderately operational or cash generating. They feared giving up their stakes at too low a valuation. Relying on direct experience of ‘uber-ised’ transport or ‘Deliveroo-ed’ take-away sustenance, firms assumed the permanent availability of on demand funding.
Some ventures have sufficient liquidity on hand to continue operations for some time but few have sufficient to allow the business to reach a self-financing stage. At best, many ventures will need to return to funding market at some stage, generally within 18-24 months, or close.
In absence of public information on these private enterprises, recent technology initial public offerings (“IPOs”) provide guidance to underlying cash positions. Only 17 percent of 91 recently listed tech firms reported a net profit while spending a cumulative $12 billion, on average using up 37 percent of their IPO proceeds. Most of the sample were high-growth, loss-making groups which were listed in 2020 and 2021 with 150 firms raising at least $100 million each. With their shares down an average of 35 percent since listing, further equity raisings would now be expensive and dilutive for existing investors.
The need for funding coincides with decrease in the amount of new money available. New inflows into private equity have declined by around two-thirds from the 2021 level of around $600 billion. Start-up investments worldwide fell by a third in 2022. The number of funding mega-rounds (fund raisings of $100 million or more) fell by 71 percent. New unicorns (private firms valued at $1 billion plus) fell by 86 percent. It remains to be seen whether VC tourists, who have been amongst the largest losers, return.
Most private investments are liquified, to realise returns and generate cash, by trade sales or IPOs. With these market now closed for an unknown period, the ability of investors to free up funds for new investments is constrained.
There is the additional problem of valuations. Between 2021 and 2022, the valuations of private start-upstumbled by 56 percent. The average value of recently listed tech stocks in America dropped by 63 percent.
In 2022, Klarna, a Swedish buy-now-pay-later (also known as point-of-sale (POS) instalment loans) firm, suffered a 87 percent slide in value in one year. In March 2023, payment processing firm Stripe raised more than $6.5 billion implying a valuation which was $50 billion, some 47 percent below its 2021 peak. The cases are not isolated.
Lower valuations affect fund raising options, especially as founders and existing investors would be reluctant to recognise large losses on existing positions. There is a potentially dangerous feedback loops between private and public markets. The coincidence of losses on investments and capital calls may lead to a general liquidity contraction for investors, requiring them to undertake forced sales. The position is not confined to the US but also exists in Europe and emerging markets.
A mitigating factor is a record amount of undeployed capital held by managers ($300 billion) and sovereign investors (undisclosed but believed to be, at least, comparable). However, the targets and investment criteria remains uncertain.
Existing portfolios are likely to reviewed and managed down. New investments will need to meet stricter criteria with focus on profitability, cash flows, strategic sectors, and longer holding periods.
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Since the global financial crisis, higher risk or more complex lending or trading moved into the shadow banking system – non-bank financial institutions which include insurance companies, pension funds, mutual or hedge funds, family offices and specialty financiers. The Bank of International Settlements estimates its size at $227 trillion as at 2021, almost half the size of the global financial sector up from 42 percent in 2008.
A key driver of this migration has been tighter restrictions on banks. Shadow banks are opaque and lightly regulated, primarily as they often domiciled offshore as the crypto-bros have discovered to their substantial cost.
Traditional banks are deeply embedded in the shadow banking sector through trading relationships, custody and clearing (packaged as prime broking services). Some are minority investors in these off-balance-sheet vehicles as well arrangers of capital. Banks also provide leverage, often using derivative products or other off-balance sheet structures. Alternatively, they provide direct funding – ‘lending to the lender’- frequently backed by collateral. As the collapse of hedge fund Archegos illustrated, the extent to which it eliminates risk is debatable.
2008 highlighted how the shadow banking sector can transmit financial stress. More recently, the September 2022 dislocation in the UK government bond market triggered by liability driven investing (“LDI”) strategies of British defined benefit pension plan illustrates the potential for contagion.
Rapidly growing private markets, part of the shadow banking complex, invest in unlisted equity and debt, infrastructure and real estate assets. Much of these investments are in more risky transactions driven by higher return targets and often expensive funding.
Deterioration of markets would drive losses and dry up liquidity from this source. One fear is the significant gap between private investment values and equivalent public equivalents. In 2022, public markets fell 15 to 20 percent, the valuations of private start-ups decreased by 56 percent and the average value of recently listed tech stocks in America dropped by 63 percent. During the same period, the enterprise value of private equity investments, on average, remained flat to rose slightly.
Private investment valuations rely on net present value models for fixed-income like businesses (real estate, infrastructure, commodity) and mapping to equivalent public listed stocks for equity assets. The latter reflects the fact that this is the relevant benchmark for any eventual sale. There is now a significant gap between private investment values and equivalent public equivalents. Termed ‘volatility laundering’, this is achieved by generous assumptions, internal sales or funding (raising conflict of interest issues), reliance on illiquidity or opaque models or deferring revaluations.
The position is reminiscent of 2000 when the dotcom bubble deflated and also 2008. On both occasions, private funds did not fully recognise or report impairments and were able to take advantage of liquidity fuelled recoveries. It is not clear whether the same will occur this time.
An unpleasant revaluation shock in private markets and large write-downs are not impossible.
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Structured products, especially securitised debt which were prominent in 2008, are a familiar area of concern.
Collateralised Loan Obligations (“CLOs”) are packages of mainly low rated debt used in private equity. The vehicles use different forms of credit enhancement and rating models to structure high quality debt. They also entail explicit and often subtle embedded leverage. If the credit cycle turns, then higher default rates will result in cash losses to holders of risky lower rated tranches. While higher rated securitisation tranches may not suffer actual losses, downgrades and mark-to-market losses are likely. Where used as collateral for borrowing, margin calls may require sales which would realise these losses.
Non-agency mortgage backed securities, commercial real estate and auto-loan securitisations may be affected by declines in asset values and defaults. Limitations on withdrawals at the bellwether $125 billion Blackstone Real Estate Income Trust as investors rushed to exit and default on a €531 million ($563 million) securitisation backed by a portfolio of offices and stores owned by Finnish company Sponda Oy highlights emerging weaknesses.
Investors own large volumes of bank hybrid capital securities, which regulators can force to be written down or converted into equity at their option. Under the terms of the UBS merger, Swiss Franc 16 billion ($17.3 billion) of CS’s Additional Tier 1 (“AT1”) capital bonds were written off in their entirety. Around Swiss Franc 1 billion ($1.1 billion) of other capital was also written off.
Introduced in Europe after the global financial crisis, these types of securities are designed to absorb losses when the issuer encounters distress (its capital ratios fall below a predetermined level) to shift risk of a bank failure to investors. The CS write-off is the largest such loss to date. The previous record was a €1.35 billion ($1.4 billion) loss suffered by junior bondholders of Spanish lender Banco Popular SA in 2017 when it was absorbed by Banco Santander SA.
Amusingly, investors were surprised at the write-down of AT1 securities arguing that it altered the understood order of priority. Fund managers complained that the payment to shareholders was being favoured over AT1 holders. The CS bond documentation allows Swiss regulators not to follow any order of priority and the securities to be written down in ‘a viability event’ including the bank receiving ‘an irrevocable commitment of extraordinary support from the Public Sector’.
In effect, the bonds worked as intended and documented. Financially dyslexic investors ignored the higher returns (6 to 9.75 percent) received in compensation for assuming this risk. Outrage and the threat of legal action (the convoluted documentation could provide lifetime employment for lawyers) notwithstanding, the losses may affect the $275 billion European AT1 market as well as the larger market for bank capital instruments.
Retail and private banking clients globally, especially wealth management investors in Asia, hold significant quantities of complex, highly engineered derivative based products. Bought in search of yield during the prolonged period of low rates without full understanding of the structure and review of the detailed documentation, potential losses could be significant.
After the CS AT1 write-offs, the Financial Times published a primer of the structure which might have been useful to investors especially prior to purchase.
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Higher volatility will generate trading losses. Abnormally large daily moves in equities, currencies and interest rates have become normal. Bond market volatility, in particular, is at its highest level in over 30 years. In a single week, US 2-year and 10-year yields fell 0.74 percent and 0.26 percent per annum respectively, the largest changes since 1987.
Several investment banks, hedge funds and trading firm have reported losses. Common causes include bets on interest rates, erratic prices movements and illiquidity which activated stop losses on positions. Quantitative investment strategies, reliant on market trends and historical data analysis, have been especially affected.
The extensive use of derivatives to provide exposure to prices and leverage (especially via the ubiquitous carry trade where low cost funding is used to purchase higher returning investments) may prove another source of instability. At a minimum, higher volatility across all asset classes will create increased margin requirements triggering cash needs.
A true stress test to the central counterparty (“CCP”) system designed to reduce credit risk on derivative transactions is possible. Any malfunction would cause a major disruption for financial markets.
The risk of unexpected trading losses and disorderly and uncontrolled liquidation cannot be discounted.
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The European Central Bank’s (“ECB”) has hidden the Euro-zone sovereign debt doom loop by its aggressive support of government debt of weaker Euro-zone members or, as in the case of Greece, an unrealistic restructuring.
Government debt is high and rising – France (113 percent of GDP), Greece (193 percent), Italy (151 percent), Portugal (127 percent) and Spain (118 percent). Budget positions are deteriorating due to slowing growth and spending on cost-of-living subsidies, especially to ameliorate the effect of energy expenses. If credit margins for over-indebted countries rise relative to benchmark German bond rate and growth rates will fall below interest rates on borrowings, public finances will become more difficult to manage. The effectiveness of the ECB’s Transmission Protection Instrument, designed to lower the borrowing costs of vulnerable members, may soon be tested.
Euro-zone banks hold around €3 trillion ($3.2 trillion) of sovereign bonds, around 9 percent of total assets. Italian banks hold the most domestic sovereign debt relative to capital (194 percent). The equivalent for Spain is 105 percent, Germany 67 percent, France 60 percent and the Netherlands 46 percent. There are different levels of home bias. French and Italian banks exposure to domestic debt is around 90 percent. In contrast, the home bias is 82 percent in Spain, 74 percent in Germany and 59 percent in the Netherlands.
A dislocation would set off the sovereign doom loop:
- Rating downgrades of a country result in falls in the value of government bonds held by banks who face calls for additional collateral draining liquidity from markets.
- The deterioration in a sovereign’s credit quality increases the amount of capital that banks must hold on certain transactions, not only with the sovereign but entities in that jurisdiction.
- Banks are forced to hedge this risk, usually by purchasing credit insurance on the sovereign or shorting government bonds exacerbating losses. Alternatively, they can use proxies, shorting equity indices, major stocks or the currency spreading losses and volatility into other asset markets. Correlation between major asset classes becomes unstable, especially in a risk-on risk-off trading environment.
- The increasing financial risk, higher funding costs and reduced market access of banks adversely affected by losses on government bond investments and the reduced ability of the government to provide emergency support sets off a chain reaction of actual losses in the inter-bank markets, requiring further hedging, compounding the spiral. Loss of trading liquidity, uniform rules, similar risk models and herding behaviour, where participants have similar positions and strategies, can prove additional accelerants.
Individual Euro-zone nations lack of independent monetary policy, fiscal capacity, currency flexibility and ability to monetise away debt would re-emerge as policy constraints. Any new debt crisis will expose simmering divisions between debt and inflation-phobic creditor and debtor nations.
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John Kenneth Galbraith in The Great Crash, 1929 described ‘bezzle’ – theft where there is an often lengthy of time period between the crime and its discovery. The person robbed continues to feel richer as he does not know as yet of his loss. Bezzle, which increases under benign conditions, is only exposed by changes in the environment. Over the last decade, investors have been bezzle-d’ by investments offering high returns which did not adequately compensate for the real risk that only emerges much later. If a major financial crisis develops, losses on these bezzle based investments will be revealed impoverish investors.
For the moment, financial markets are holding. But as one analyst of the 1929 crash observed: “Everyone was prepared to hold their ground, but the ground gave way.”
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The complexity of the highly interconnected financial and economic system makes predictions about the exact sequence of events in a crisis foolish. As founder of GMO Jeremy Grantham noted in October 2008: “I want to emphasize how little I understand all of the intricate workings of the global financial system. I hope that someone else gets it, because I don’t. And I have no idea, really, how this will work out. I certainly wish it hadn’t happened. It is just so intricate that all I can conclude, by instinct and by reading the history books, is that it will be longer, harder and more complicated than we expect.”
The problems currently are within the global banking and financial sector. But financial dislocations feed back into the real economy. There are two primary channels. First, reductions in income and losses of capital affect earnings and savings. Depending on magnitude, it may decrease consumption and investments.
Second, a banking crisis reduces the availability of funding and increases its cost. Small and medium-sized banks play an important role in economies. In the US, banks with less than $250 billion in assets provide roughly 50 percent of all commercial and industrial lending, 60 percent of residential real estate lending, 80 percent of commercial real estate lending, and 45 percent of consumer lending. More stringent regulation, tighter lending standards and the likely consolidation in banking will also reduce the supply of funding.
The real economy effects will intensify any economic slowdown driving new stages of the adjustment.
In most recent crisis, governments have stepped in to bailout (that unpalatable ‘B’ word that most not be said) the financial system and broader economy. The widespread assumption is that this time will be no different. However, there are important differences in the policy options available compared to those present in 2008.
- Debt levels are much higher meaning borrowing to fund bank rescues and support the economy is more difficult.
- Interest rates are relatively low in nominal terms and negative in real (after adjusting for inflation) terms. Persistent inflation means that policymakers must grapple with keeping rates high or loosening monetary policy to prevent financial deterioration. While high interest rates may be ineffective against the supply side factors underlying higher prices, there remains a risk that inflation becomes entrenched inflicting not inconsequential damage. The scope for the magnitude rate cuts needed (around 3 to 5 percent in past cycles) is limited.
- Since 2009, the size of central bank balance sheets has grown significantly. Since 2007, the US Federal Reserve balance sheet grew from just under $1 trillion (7 percent of GDP) to nearly $9 trillion (34 percent of GDP). Other central bank balance sheets have experienced similar growth – the ECB is at more than 60 percent of GDP, the Bank of England’s around 40 percent and the Bank of Japan’s 127 percent. Further growth may be difficult especially given the large unrealised losses on their existing investments. The US Fed has around $330 billion of unrealized losses, nearly 8 times its $42 billion in capital.
- The recovery after 2008 was assisted by robust growth in emerging markets, led by China. These countries now have multiple challenges. Strong emerging market activity and Chinese credit expansion (bank assets increased between 2007 and 2022 from less than $8.0 trillion to over $60 trillion) are unlikely to cushion any downturn.
There are non-financial factors.
A fissiparous US polity faces gridlock on everything from increasing its debt ceiling, prosecuting the former President for promoting insurrection or influencing elections, a woman’s reproductive freedoms and trans-gender rights. Social tensions are driving civic unrest everywhere, as evidenced by strikes and protests, for example in the UK and France. While there is deep-seated dissatisfaction with those with power, restive populations cannot agree on actions, seeking simple and quick solutions that do not require them personally to incur major costs or inconvenience.
The relative geopolitical stability of 2008 is in the past. Current tensions between major powers mean that the likelihood of a co-ordinated response is low. Instead, trade restrictions, sanctions, deglobalisation and containment now dominate discourse. It is difficult to see China rushing to the aid of Western economies and institutions at a time when the US and its allies are keen to restrict its rise as an economic and great power rival.
The probable response is low rates, government support and generous infusions of money, the policies popularised by former Fed Chairman Alan Greenspan, the ‘Maestro’ to sycophants. Because it is expedient, easy money is seen as a solution when it is the issue. In essence, it will be another kick of the can down the road although the available tarmac is now much diminished.
The global economy may now be trapped in an easy money-forever cycle. A weak economy or financial crisis forces policymakers to implement fiscal measures and more monetary expansion. If the economy responds and the financial sector stabilises, then there are attempts to withdrawal the stimulus. Higher interest rates slow the economy and trigger financial crises, setting off a new round of the cycle.
If the economy does not respond or external shocks occur, then there is pressure for additional stimuli, as policymakers seek to maintain control. All the while, debt levels continue to increase, making the position ever more intractable.
Economist Ludwig von Mises was pessimistic on the denouement. “There is no means of avoiding the final collapse of a boom brought about by credit expansion… The alternative is only whether the crisis should come sooner as a result of a voluntary abandonment of further credit expansion, or later as a final and total catastrophe of the currency system involved.”
© 2023 Satyajit Das All Rights Reserved
A condensed version is published in the New Indian Express.