A Tiger Can’t Change Its Stripes

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Oh, wait. That’s not a tiger. That’s a raccoon.


In Epsilon Theory-speak, a raccoon is a financial scammer, a fraud.

Raccoons are everywhere in the investment world. I hate raccoons.

Over the past few days you’ve probably seen an article or two about Bill Hwang and the collapse of Archegos Capital, Hwang’s hedge fund with an estimated $10-15 billion in assets that was levered up more than 5x across multiple prime brokers, and came tumbling down in a “margin call” last Friday. And yes, I’ll explain in a minute why I put that in air quotes.

Almost certainly, the article you saw about Bill Hwang described him as a Tiger Cub and not a raccoon, which is too bad. I’m trying to change that animal association with this note.

Hwang is called a Tiger Cub because, like many other hedge fund luminaries (Chase Coleman, Lee Ainslie, Steve Mandel, Andreas Halvorsen, John Griffin, etc. etc.), he used to work for Julian Robertson’s OG hedge fund, Tiger Management. As the story goes, Hwang was an equity sales guy for Hyundai Securities, where he won an annual cash prize “for charity” that Robertson used to give to the “person outside the firm who contributed the most to the firm’s success”, which led to a job … LOL. This, of course, was in the heady pre-Reg FD days for golden age hedge funds like Tiger and SAC (Stevie Cohen) and Quantum (George Soros), when the line between legal and illegal inside information was, shall we say, a bit more blurry than it is today, and guys like Hwang thrived.

What is Reg FD? Specifically, it’s the 2000-vintage SEC regulation that requires publicly traded companies to eliminate selective disclosure of any information that could be deemed to be material and non-public. More broadly, Reg FD is my shorthand for the enormous efforts that the SEC and the DOJ have undertaken to make guys like Bill Hwang obsolete, even at the very real and very damaging cost of placing all private information in markets and all discretionary alpha generation under regulatory suspicion.

There are some dandy Epsilon Theory notes on Reg FD enforcement and its impact on alpha generation, notably here and here. From one of those notes, Pricing Power (pt. 3) – Government Collaboration:

In 2009 the SEC established an Office of Quantitative Research and an Office of Risk Assessment and Interactive Data, and – for operational surveillance – an Office of Analytics and Research within its Trading and Markets Division. In July 2013, the SEC announced the creation of a Center for Risk and Quantitative Analysis, to “provide guidance to the Enforcement Division’s leadership.” Taken together, these offices form the equivalent of the SEC’s version of the CIA. These offices are extremely well funded, draw some really top-notch people from the private sector, and coordinate closely with the FBI. Today’s SEC may not quite be the functional equivalent of the NSA from a data gathering and pattern inference perspective, but it’s nothing to sneeze at, either. And on the traditional surveillance side, the DOJ has been given amazing latitude by the courts of late to pursue widespread wire taps and related private communication intercepts across a wide swath of the financial services industry.

I can’t emphasize strongly enough the importance of these surveillance institutions as a tool in the political effort to transform capital markets into a political utility.

How? By taking sleepy regulatory edicts that were on the books but extremely hard to prosecute – such as the 2003 Global Research Analyst Settlement or, more importantly, Reg FD, originally adopted way back in August, 2000 – and using Big Data and Big Compute to turn them into powerful weapons.

Prior to 2009 it was very difficult for the SEC or FBI to identify any but the most egregious infractions of Reg FD, such as an email leaked by a disgruntled employee or a massive dumping or purchase of a stock. Since 2009, however, the SEC can sift through all of the trading in a company’s stock, look for what they consider to be suspicious patterns – which is by definition idiosyncratic outperformance, i.e., alpha generation – and then work backwards to create a link with, say, a 1-on-1 meeting at a sell-side conference between the company’s CFO and an analyst from the trading firm.

Basically, everything that gave Bill Hwang his “edge” – all of his contacts with corporate management who were willing to whisper in his ear, all of his go-to strategies of piling-in and piling-on with other hedgies – all of that has been in the SEC and DOJ crosshairs since 2009.

Julian Robertson famously broke up the Tiger Management band as the Nasdaq bubble burst in early 2000, and the so-called Tiger Cubs went their separate ways, seeded by Julian and his investors. Hwang set up Tiger Asia, where he had great returns for many years by following the playbook that had worked so well for him in the mothership, and he became a billionaire in his own right. That playbook, however, which was probably a hot steaming mess of collusion and insider trading even before Reg-FD, was certainly a hot steaming mess after Reg-FD, and once the SEC really started to enforce all this in 2009, it was only a matter of time before the feds nailed Hwang to the wall.

That happened in 2012, when the SEC brought criminal charges for insider trading against Tiger Asia and Hwang personally, charges that Hwang et al pleaded guilty to and paid a $60 million fine to resolve. Hwang was sentenced to one year probation. Again … LOL.

Tiger Asia had to be wound down, and like Stevie Cohen did with his similarly implicated (but never criminally convicted) SAC Capital, Hwang turned his hedge fund into a “family office” – Archegos Capital. But within a few years Hwang started taking outside investors and was back in full swing as a hedge fund master of the universe. Just like Stevie did with his “family office”, Point 72. Again … LOL.

Did Hwang learn his lesson and change his raccoon … err, tiger stripes? Okay, this time I’m actually going to laugh out loud. Bwahahahaha!

What Hwang learned was how to avoid getting caught.

With the establishment of Archegos Capital, Hwang stopped owning or shorting stocks directly. Instead, he took his positions in the form of total return swaps and similar instruments with Wall Street banks. A total return swap is a contract with a broker/dealer counterparty where you agree to be on the opposite sides of the economic outcomes of a referenced security (or any referenced data flow that can be mapped against a time series of prices, really). In other words, you don’t buy shares of stock in a company directly. You buy a contract with, say, Goldman Sachs that they will owe you money if the stock goes up (or if the company pays out a dividend or makes some other cash distribution, hence the “total return” moniker here) and you will owe them money if the stock goes down. Or vice versa if you’re short. A total return swap is a pure derivative, a distilled bet on something else going up or down in price, a zero sum game played between Big Boys who know the risks and take them with eyes wide open.

In the days and weeks to come, you’ll hear the usual suspects say that swaps and derivatives are the “problem” here. Pfft. The problem is doing business with convicted criminals like Bill Hwang.

Want my keenest Wall Street observation? Once a raccoon, always a raccoon.

Want my best financial services career advice? Never do business with a raccoon. Never.

Tigers can’t change their stripes. Neither can raccoons.

At some point in your career, maybe more than one point, you’ll be sorely tempted to invest with or partner with a raccoon. Why? Because the money will be really, really good. Because the raccoon will convincingly explain to you that Others took advantage of his “passion” for the deal or the business opportunity in the past, that he’s really a misunderstood bull or bear or tiger, not a thieving raccoon. This will be a lie. It will end up costing you money, and maybe a lot more than that, if you give in to the temptation. Just like it did for the banks that decided to work with Bill Hwang after his 2012 conviction.

It seemed like such a no-brainer. Under almost any conceivable conditions (almost!), market risk on the total return swaps that Hwang was proposing could be hedged more cheaply than the trading fees, structuring fees and net interest margin that these banks charged Archegos, yielding a “risk-free” income stream of millions of dollars per year. Besides, Bill Hwang is such a charming man. Such a family man. Such a godly man. This is a man we can trust!

So here’s how the Archegos scam worked. An investment portfolio based on total return swaps and spread across a lot of prime brokers had two wonderful qualities for a raccoon like Hwang:

  • Massive embedded leverage. These swaps are bought on margin, not cash, meaning that Hwang could receive the full economic outcome of a dollar’s worth of stock for posting, say, 15 cents in cash as collateral.
  • Zero reporting requirements with regulatory authorities. The only thing that Archegos “owned” are these private derivative contracts with TBTF banks, leaving Hwang free to run the old Tiger Asia playbook of collusion and insider trading without having that pesky SEC tracking his trades.

Laissez les bon temps rouler!

So how did this scam fall apart?

Well, here’s what did NOT go wrong for Hwang. I don’t think Hwang blew up because positions like Viacom and Discovery went horribly south on him. I don’t think he blew up because he got a margin call, as you and I understand the term. Look at all of the positions that are getting liquidated … this portfolio wasn’t down before it got sold out beneath him. To be sure, the last month or two hasn’t been great for the what-me-worry, infinite-duration stocks that Archegos loved to press. But even if he was doubling down on losses in true degenerate gambler style, this isn’t a portfolio that has broken down to a degree that would clearly put your prime brokers into all-out panic mode.

This is a portfolio that needed the sails trimmed, not blown out.

So why did the banks blow it out? I think something else triggered the decision by Goldman Sachs and Morgan Stanley to exercise whatever liquidation provisions they had in their custody and counterparty/credit agreements with Archegos. I think this was a “margin call”, not a margin call.

What can trigger a “margin call”, by which I mean a forced liquidation of positions held at your prime broker even if you’re not in violation of net capital requirements? I can think of two possibilities:

  • Goldman Sachs got wind of Archegos borrowing with other prime brokers by pledging the same collateral they pledged to Goldman (let’s call it the Max Bialystock con after the raccoon impresario of The Producers).
  • The general counsel’s office at Goldman and Morgan Stanley both got a letter from the Justice Dept. with some … ummm … pointed questions about the trades they were executing on behalf of or in connection with Archegos, an unregistered investment fund with some … ummm … questionable investors.

If I were a betting man (and I am), I’d be prepared to wager a not insubstantial amount of money that both of these for-cause reasons to tear up the ISDA and liquidate the Archegos positions came into play, with the DOJ letter being the spur to the general counsels at Goldman Sachs and Morgan Stanley et al having a phone call and enjoying a “wait, you have how much exposure to Bill?” moment.

See, that’s the thing with running the Bialystock Con … you can never let your investors (or lenders) compare notes.


A few minutes later, the head trader at Archegos gets a phone call from Goldman.

“It seems that you are in violation of section (18b), subsection (iv) of your ISDA, so we’re going to need $15 billion in cash in the next thirty seconds, otherwise we will begin liquidating your positions with massive, multi-billion dollar block trades. Yes, we’re going to do this just as sloppily as we can. Also, as per section (27), subsection (i) it is our responsibility to notify you that we have received inquiries from statutory regulatory authorities of appropriate jurisdiction in regards to your trading accounts. Have a nice day!”

While he’s listening to this, the head trader’s assistant informs him that Morgan Stanley is on hold.


I have no idea if this is how any of the events on Thursday and Friday actually went down. Almost certainly it’s not. But that’s how I’d write the screenplay.

Who gets left holding the bag here? Well, it sure ain’t Goldman Sachs and whatever other prime brokers did the liquidation on Friday. They got their cash by getting out first. Same as it ever was. The bag-holders are the prime brokers who saw their screens and telephones blowing up unexpectedly on Friday afternoon NYC-time, banks like Nomura and Credit Suisse. Man, I bet that was a miserable weekend in Geneva and Tokyo. Same as it ever was.

But that’s just the first wave of bag-holders, the forced sellers whose losses on these positions are big enough to be a problem for markets in and of themselves. The second wave of bag-holders … well, that’s us.

What do you get when you give a raccoon like Bill Hwang tens of billions of dollars AND invisibility from regulators so that he can run his collusion and insider trading schemes to his heart’s content? You get a rolling series of squeezes and corners. You get a market that is completely disconnected from reality. You get ridiculous Chinese companies pumped and dumped through US listings. You get a Tesla that’s valued at a trillion dollars. You get Gamestop.

Hunger Games

You have been told that the odds are ever in your favor. You have been told this for your entire life.

More and more, you suspect this is a lie.

I’m not saying that Hwang is responsible for all of this. I think he’s responsible for some of this. 

And I think there are a lot more Bill Hwangs out there.

The Best Way to Rob a Bank

The collapse of Greensill Capital is the first Big Fraud I’ve seen in 13 years with the sheer heft and star power to ripple through markets in a systemic way. Not since Madoff.

There is a tide that is flowing out today, and it’s revealing Lex Greensill and Bill Hwang in 2021 just as surely as it revealed Jeff Skilling in 2001 and Bernie Madoff in 2008. The big trade around Skilling and Madoff wasn’t directly on their specific scams and frauds, but on what their specific scams and frauds showed us about systemic rot in the financial system. It’s exactly the same with Greensill and Hwang today. The big trade isn’t on some company that Greensill was propping up through “supply-chain lending” or on some company that Hwang was short-squeezing or pumping. The big trade isn’t even on some common denominator sponsor for both Greensill and Hwang like Credit Suisse (although … wow). No, those are one-off, idiosyncratic trades. Interesting prop trades, sure, but limited.

The big trade is figuring out what happens when the squeezes and corners from insane hedge fund and shadow banking leverage come undone.


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Tiger King

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I assume that by now you’ve read one of the WSJ or Bloomberg articles on Bill Hwang and the collapse of Archegos Capital, a hedge fund with an estimated $10-15 billion in AUM that was levered up more than 5x across multiple prime brokers, and came tumbling down in a “margin call” last Friday. And yes, I’ll explain why I used the quote marks in a second. There are so many touchpoints between these events and what we’ve been focused on here at Epsilon Theory that I hardly know where to start, but let’s see where this goes …

Like many other hedge fund luminaries (Chase Coleman, Lee Ainslie, Steve Mandel, Andreas Halvorsen, John Griffin, etc. etc.), Hwang is a Tiger Cub, meaning that he used to work for Julian Robertson’s OG hedge fund, Tiger Management. As the story goes, Hwang was an equity sales guy for Hyundai Securities, where he won an annual cash prize “for charity” that Robertson used to give to the “person outside the firm who contributed the most to the firm’s success”, which led to a job … LOL. This, of course, was in the heady pre-Reg FD days for golden age hedge funds like Tiger and SAC and Quantum, when the line between legal and illegal inside information was, shall we say, a bit more blurry than it is today, and guys like Hwang thrived.

Julian famously broke up the band as the Nasdaq bubble burst in early 2000, and the Cubs went their separate ways, seeded by Julian and his LPs. Hwang set up Tiger Asia, where he had great returns by following the playbook that had worked so well for him in the mothership, and Hwang became a billionaire in his own right. That playbook, however, which was probably a hot steaming mess of collusion and insider trading even before Reg-FD, was certainly a hot steaming mess after Reg-FD, and once the SEC really started to enforce all this in 2009 with the establishment of a Big Data program to review suspicious hedge fund trades (yes, there are Epsilon Theory notes on Reg-FD enforcement and its impact on alpha generation: here and here), it was only a matter of time before the feds nailed Hwang to the wall. That happened in 2012, when the SEC brought criminal charges for insider trading against Tiger Asia and Hwang personally, charges that Hwang et al pleaded guilty to and paid a $60 million fine to resolve. Hwang was sentenced to one year probation. Again … LOL. Tiger Asia had to be wound down, and like Stevie Cohen did with his similarly implicated (but never criminally convicted) SAC Capital, Hwang turned his hedge fund into a “family office” – Archegos Capital. And like Stevie did with his “family office” (Point 72), within a few years Hwang started taking outside investors and was back in full swing as a hedge fund master of the universe.

Did Hwang learn his lesson and change his tiger stripes? Again … LOL. What Hwang learned was how to avoid getting caught. With the establishment of Archegos Capital, Hwang stopped shorting stocks or taking long positions directly. Instead, he took his positions in the form of total return swaps and similar instruments with Wall Street banks. A total return swap is a contract with a broker/dealer counterparty where you agree to be on the opposite sides of the economic outcomes of a referenced security (or any referenced data flow that can be mapped against a time series of prices, really). In other words, you don’t buy shares of stock in a company directly. You buy a contract with, say, Goldman Sachs that they will owe you money if the stock goes up (or if the company pays out a dividend or makes some other cash distribution, hence the “total return” moniker here) and you will owe them money if the stock goes down. Or vice versa if you’re short. A total return swap is a pure derivative, a distilled bet on something else going up or down in price, a zero sum game played between Big Boys who know the risks and take them with eyes wide open.

In the days and weeks to come, you’ll hear the usual suspects say that swaps and derivatives are the “problem” here. Pfft. The problem is doing business with convicted felons like Bill Hwang. A tiger cub? I prefer the Epsilon Theory lingo. The guy’s a raccoon, pure and simple, and once a raccoon, always a raccoon. They can’t change their stripes, either.

So here’s how it worked. An investment portfolio based on total return swaps had one wonderful quality for the prime brokerage operations of the banks involved here, and two wonderful qualities for a raccoon like Hwang.

For the prime brokers, that wonderful quality was fee and spread income. Under almost any conceivable conditions (hold that thought!), market risk on the swap could be hedged more cheaply than the trading fees, structuring fees and net interest margin that they charged Archegos, yielding a “risk-less” income stream of millions of dollars per year.

For Hwang, the two wonderful qualities were:

  • massive embedded leverage, as these swaps are bought on margin, not cash, meaning that Hwang could receive the full economic outcome of a dollar’s worth of stock for posting, say, 15 cents in cash as collateral, and
  • zero reporting requirements with regulatory authorities, as the only thing that Archegos “owns” are these private derivative contracts with TBTF banks, leaving Hwang free to run the old Tiger Asia playbook without having that pesky SEC tracking his trades.

Again … LOL.

So how did this fraud fall apart?

Well, here’s what did NOT go wrong for Hwang. I don’t think Hwang blew up because positions like Viacom and Discovery went south on him. I don’t think he blew up because he got a margin call, as you and I understand the term. Look at all of the positions that are getting liquidated … this portfolio wasn’t down before it got sold out beneath him. To be sure, the last month or two hasn’t been great for the what-me-worry, infinite-duration stocks that Archegos loved to press. But even if he was doubling down on losses in true degen-style, this isn’t a portfolio that has obviously crapped out. This is a portfolio that needs the sails trimmed, not blown out. No, I think something else triggered the decision by Goldman Sachs et al to exercise whatever liquidation provisions they had in their ISDA (the contract governing their swaps, derivatives and prime brokering) with Archegos. This was a “margin call”, not a margin call.

What can trigger a “margin call”, by which I mean a forced liquidation of positions held at your prime broker even if you’re not in violation of net capital requirements? I can think of two possibilities:

  • Goldman Sachs got wind of Archegos borrowing with other prime brokers by pledging the same collateral they pledged to GS (let’s call it The Producers con), or
  • the general counsel’s office at Goldman and Morgan Stanley both got a letter from the Justice Dept. with some … ummm … pointed questions about the trades they were executing on behalf of or in connection with Archegos.

If I were a betting man (and I am), I’d be prepared to wager a not insubstantial amount of money that both of these for-cause reasons to tear up the ISDA and liquidate the Archegos positions came into play, with the DOJ letter being the spur to the general counsels at GS and MS et al having a phone call and enjoying a “wait, you have how much exposure to Bill?” moment. See, that’s the thing with running The Producers con … you can never let your investors (or lenders) compare notes.

A few minutes later, the head trader at Archegos gets a phone call from Goldman. “It seems that you are in violation of section (18b), subsection (iv) of your ISDA, so we’re going to need $15 billion in cash in the next thirty seconds, otherwise we will begin liquidating your positions with massive, multi-billion dollar block trades. Yes, we’re going to do this just as sloppily as we can. Also, as per section (27), subsection (i) it is our responsibility to notify you that we have received inquiries from statutory regulatory authorities of appropriate jurisdiction in regards to your trading accounts. Have a nice day!” While he’s listening to this, the head trader’s assistant informs him that Morgan Stanley is on hold.

I have no idea if this is how any of the events on Thursday and Friday actually went down. But that’s how I’d write the screenplay.

Who gets left holding the bag here? Well, it sure ain’t Goldman Sachs and whatever other prime brokers did the liquidation on Friday. They got their cash by getting out first. Same as it ever was. The bag-holders are the prime brokers who saw their screens and telephones blowing up unexpectedly on Friday afternoon NYC-time, banks like Nomura and Credit Suisse. Man, I bet that was a miserable weekend in Geneva and Tokyo. Same as it ever was.

But that’s just the first wave of bag-holders. The second wave of bag-holders … well, that’s us.

What do you get when you give a raccoon like Bill Hwang tens of billions of dollars AND invisibility from regulators so that he can run his collusion and insider trading schemes to his heart’s content? You get a rolling series of squeezes and corners. You get a market that is completely disconnected from reality. You get ridiculous Chinese companies pumped and dumped through US listings. You get a Tesla that’s valued at a trillion dollars. You get Gamestop.

I’m not saying that Hwang is responsible for all of this. I think he’s responsible for some of this. And I think there are a lot more Bill Hwangs out there.

Three weeks ago, I wrote this to ET Pro subscribers:

I think that the collapse over the past week of Greensill Capital has a lot of systemic risk embedded within it, particularly as the fraudulent deals between Greensill and its major sponsors – Softbank and Credit Suisse – come to light. And that’s not even considering Greensill’s second tier of sponsors – entities like General Atlantic and the UK government – all of whom are up to their eyeballs in really dicey arrangements.

Is this a Madoff Moment for the unicorn market? Honestly, if you had asked me a few weeks ago, I would have told you that a Madoff Moment was impossible in our narrative-consumed, speak-no-evil market world of 2021. Now I’m not sure. 

Two weeks ago, I wrote this to ET Pro subscribers:

No, the thing that has my spidey-sense tingling is that I think there are lots of other Greensill specialty lenders out there, lots of other Tokio Marine insurance wrappers out there, lots of other Softbank shadow banking facilities out there, lots of other Credit Suisse absolute return funds out there, all geared and levered to global trade and supply chains at precisely the moment when globalization is reversing after three decades-plus of a one-way trade.

Last week, I wrote this to ET Pro subscribers:

Specifically, I think THIS can work: a long/short go-anywhere investment program based on the Narrative Machine IP and a macroeconomic thesis of deglobalization and multipolar geopolitical conflict, supply chain and trade finance stress, and push-inflation pressures within a highly levered global economic system.

There is a tide that is flowing out today, and it’s revealing Lex Greensill and Bill Hwang just as surely as it revealed Jeff Skilling in 2001 and Bernie Madoff in 2008. The big trade around Skilling and Madoff wasn’t directly on their specific scams and frauds, but on what their specific scams and frauds showed us about systemic rot in the financial system. It’s exactly the same with Greensill and Hwang today. The big trade isn’t on some company that Greensill was propping up through “supply-chain lending” or on some company that Hwang was short-squeezing or pumping. The big trade isn’t even on some common denominator sponsor for both Greensill and Hwang like Credit Suisse (although … wow). No, those are one-off, idiosyncratic trades. Interesting prop trades, sure, but limited.

The big trade is figuring out what happens if Credit Suisse is taken out in the street and shot in the head like Bear Stearns.

The big trade is figuring out how deeply the Japanese financial system has been corrupted (Softbank, Tokio Marine, Nomura).

The big trade is figuring out what happens when the squeezes and corners from insane hedge fund and shadow banking leverage come undone.

Sounds like fun!


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Hot and Cold

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We are in a cold war with China.

That is, as we say, not a prediction. It is an observation.

Feel free to disagree with it. But you also ought not to read anything too portentous into the term. Cold wars aren’t declared, after all. Observing their existence is the limit of what we can do.

In any case, what I mean by the term isn’t complicated. Two political belligerents are now engaged in a foreign policy whose objective is to thwart through all means short of firing weapons the expansion of influence, the establishment of additional international military infrastructure and the expression of territorial control over contested lands, sea lanes or airspace by the other.

I suspect that you might have read the below piece (or one like it) reporting on the statement and sanctions from the EU and US concerning China’s treatment of Uyghur Muslims in its western reaches. If you asked yourself, as we often counsel, “Why am I reading this now?”, it was not because western politicians only just discovered to their collective horror the depth of what is happening in Xinjiang.

U.S., allies announce sanctions on China over Uyghur ‘genocide’ [Politico]

About a week before you read that, perhaps you read coverage of the Quad Summit. It was a highly public meeting among its members – India, Australia, Japan and the United States – to begin the process of contesting the scope of the CCP’s sphere of influence within east and southeast Asia.

Quad Summit’s Vaccine Deal Is Biden’s Bold First Move in Asia [Foreign Policy]

A couple weeks before that, it might be that you read about the USS John McCain steaming through the Taiwan Strait for the first time during the Biden presidency (as an aside, I’m not sure which style guide encourages the use of the verb “rule” for what it is that American presidents do, but nuts to that).

U.S. Navy warship sails through Taiwan Strait for first time under Biden’s rule [NBC News]

Maybe you have read weeks of coverage of the Anchorage meetings, or Secretary of State Antony Blinken’s reference to Taiwan as a “country”, or explicit multi-lateral expressions of commitment to the defense of Taiwanese sovereignty.

In his first trip to Asia, Blinken warns China not to use ‘coercion and aggression’ to get its way [CNBC]

This is certainly not surprising to those who already knew that Taiwan is now Arrakis.

Yet while the emerging geopolitical struggle is not being called a cold war just yet, it is being called everything that a cold war is. It is only a matter of time before an influential politician, writer, journalist, executive or publication begins issuing missionary statements framing and phrasing it as a new cold war. Then some U.S. State Department official will say very officially that it is not a new cold war, at which point everyone will know that everyone knows it is a cold war and throw away all pretense.

And that’s when the narrative war will get hot.


The last time we went down this road, the Soviet Union had a lot of propaganda notes they could play domestically. There were, however, only a relative few they could play to any real effect abroad. What we today call whataboutism is in part referential to the art form it became under Soviet propagandists. In short, they discovered that they had a ready response to any criticism of their brutal and arbitrary system of justice, policing and treatment of political prisoners: “Sure, but what about racism in America?”

If that makes you nod your head a little bit, well, that is the point. The most effective propaganda doesn’t lie. It tells a truth and insists that all facts must be framed around that truth. If you aren’t willing to buy into that framing, well, then clearly you just aren’t honest enough to believe the truth they told you.

That is why the narrative war in this case will operate on another level. The CCP – and yes, our own government – doesn’t just have a few of these notes to play. They have the whole damn piano.

The China dispute is embedded in our most highly charged political narratives. This cold war will be fought in the hot war of narratives about ‘China flu’ and the ‘Wuhan coronavirus.’ It will be fought in the narrative of those terms as inherently racist. It will be fought in narratives about the ‘Biden’s family’s corruption by the CCP’ and ‘the crusade by the political right to create a corruption narrative.’ It will be fought in narratives about a news media that downplayed the betrayals of the world by the WHO and CCP in order to pin COVID-19 squarely on the Trump administration. It will be fought in narratives about a political movement that tried to distract from its own policy failures to pin COVID-19 squarely on Beijing. It will be fought in narratives of de-globalization, reshoring and ‘proximity sourcing.’ It will be fought in narratives of Chinese dominance over Bitcoin mining and whether that jeopardizes narratives of decentralization.

If you’re like me or most Americans, you will probably think somewhere between half and all of those narratives are nonsense. It doesn’t matter. In narrative world, any one of those narratives can be weaponized into targeted and divisive propaganda.

The China dispute is embedded in our most highly charged cultural narratives. This cold war will be fought in the hot war of narratives about how ‘the NBA showed in the Daryl Morey situation that all they care about is sales in China’, and about how ‘the backlash against LeBron James’s support of Beijing over Morey is another sign of American casual stay-in-your-lane racism.’ It will be fought in narratives about American board rooms, C-Suites and ESG offices that couldn’t care less about profiting from the CCP’s abuses of Uyghur Muslims as long as companies say Correct Things about the social and environmental causes that really matter. It will be fought in narratives about companies that don’t care about those causes so long as they say Correct Things about the patriotic implications of opposing CCP influence.

If you’re like me or most Americans, you will probably think those narratives are even more nonsensical than the political versions. It doesn’t matter. In narrative world, any one of those narratives can be weaponized into targeted and divisive propaganda.

The China dispute is embedded in our most highly charged social narratives. We are only days removed from the brutal murder of eight spa workers, most of whom were Asian-American women. We are in a period in which Asian-Americans of various national origins are experiencing an increase in targeted acts of violence and aggression. In just the past week, a Vietnamese-American friend of mine in Brooklyn was followed for several blocks in his own neighborhood by someone shouting racial slurs at him (incorrect racial slurs, too, which I suppose makes it racist in several ways at once). Do you think this very real thing that is happening isn’t going to be pulled into the hot war of narratives? Do you think that the prevailing counternarrative – that the US media went out of its way to frame this emerging racism exclusively as part of Trumpian White Supremacy while ignoring its unnerving prevalence in several other communities – is not going to be pulled into the narrative war, too?

So yes, lots of adjacent narratives out there, ready to be directed toward whatever purpose. What’s the point?

The point is that most of us are under the impression that a protracted conflict with China – even a cold war-style geopolitical struggle – will increase national unity. This is the old saw about politicians looking for an external enemy to unite around, and it is usually true, even if we usually mean it cynically.

Not this time.

Our conflict with China is deeply embedded in every fault line of our existing internal divisions. I fear that a cold war with China will lead to a hot war in narrative world that makes the widening gyre of our politics veer further away from a center that can hold. I think that’s true in financial, economic, political, social and cultural markets alike.

We can’t do much to stop it. We CAN prepare how we will identify and respond to it in our consumption of news and social media, and more importantly, in our relationships and interactions with others.

Clear Eyes. Full Hearts.



32+

The Darnold Dilemma

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Patrick Mahomes and Sam Darnold

I think Jay Powell and the Fed have locked themselves into a two to three year commitment to treating inflationary pressures as “transitory”, just like an NFL GM and organization lock themselves into supporting a “franchise” quarterback they draft in the first round. Once selected, and so long as they believe it is possible that their draft pick is, in fact, a franchise quarterback, it is impossible for the organization to express ANY doubts about the wisdom of the pick. Why? Because once doubt is expressed, the quarterback is finished with that organization. He can’t lead the team. He’s damaged goods. He loses all trade value. The fans howl for blood. More likely than not, the GM loses his job, too. So for two to three years – the minimum time it takes to know whether or not your #1 draft pick is truly a franchise quarterback – every public statement AND every public policy (draft picks, free agent signings) that an NFL organization makes will be 100% in support of their draft pick.

This is exactly where the Fed is with their stance on inflation. Every public statement and every public policy for the next two to three years MUST be 100% in support of their inflation-is-transitory #1 draft pick. Hey, maybe they made a great pick. Maybe inflation-is-transitory is the monetary policy equivalent of Patrick Mahomes!

Or maybe it’s Sam Darnold.

The simple truth is that the Fed doesn’t know. And neither do I. Like any NFL fan, I like to pretend that I know better than the GM and … honestly … I really do think that my instincts here are better. But, hey, maybe I’m wrong and Jay Powell is right about the transitory nature of inflationary pressures over the next two to three years.

But here’s what I DO know:

I know that for the next two to three years, the Fed can’t change its forward guidance or monetary policy to reflect any doubts it might have about the “is inflation transitory?” question.

And knowing THAT … well, knowing that gives me two to three years to make investment decisions without fear that the Fed will undercut me with a policy shift.

For the past 12 years, the primary risk to all discretionary investment, from the most vanilla US equity mutual fund to the most fly-close-to-the-sun global macro hedge fund, has been Fed risk. It’s been the cold hard fact that all of our time, all of our smarts, all of our research and knowledge and edge … all of it can be swamped in the time it takes for Bernanke and Yellen and Powell and crew to announce a new dot plot or liquidity injection or support facility. Whatever it takes, right? Not anymore.

I think the Fed is boxed in from a policy and (more importantly) a communications/forward guidance perspective, over a long enough time horizon for a discretionary alpha-oriented investment program to work. And that’s pretty exciting to me, a discretionary alpha-oriented investor.

Specifically, I think THIS can work: a long/short go-anywhere investment program based on the Narrative Machine IP and a macroeconomic thesis of deglobalization and multipolar geopolitical conflict, supply chain and trade finance stress, and push-inflation pressures within a highly levered global economic system.

I really do.


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A Conversation with Howard Marks

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Brent Donnelly is a senior risk-taker and FX market maker at HSBC New York and has been trading foreign exchange since 1995. He is the author of The Art of Currency Trading (Wiley, 2019) and his latest book, Alpha Trader, hits the shelves in Q2 2021.

You can contact Brent at [email protected] and on Twitter at @donnelly_brent.

As with all of our guest contributors, Brent’s post may not represent the views of Epsilon Theory or Second Foundation Partners, and should not be construed as advice to purchase or sell any security.


McLaren P1 supercar
This is not Howard Marks’ car. Or is it?

Today, I’m writing about Howard Marks’ most recent memo, which you can find here: Oaktree Capital – Something of Value.

Major bonus: I sent my note to Mr. Marks as a courtesy in case he had any feedback (because he is a legend and I’m scared of authority figures). He was kind enough to get back to me. He didn’t just reply with a one-line email, he gave me almost an hour of his time. So herein, I combine the original piece I wrote with my notes from a 60-minute phone call with Howard Marks. Enjoy!


Howard Marks has been a great investor and one of the best finance writers in the business for decades. He has been writing must-read investor letters since I was in high school. His latest memo “Something of Value” contains much insight, particularly about why traditional value investing is likely permanently impaired as a strategy and why Growth vs. Value is a false dichotomy.

The Marks letter spans 18 pages so my piece today will scratch the surface. If you have time, go read the memo from Howard Marks first, then come back.

Here is my quick review + summary + partial rebuttal + phone interview excerpts. Just so it’s clear: the indented quotes are from the memo and the left justified, larger font quotes are from our phone call.


Howard Marks on value and efficient markets

With unlimited computing power widely available to most investors in the world, stocks that are cheap on simple metrics like price/earnings etc. are probably cheap for a reason. Unlike pre-internet, when you had to scour annual reports in a library to find company metrics, everyone now has access to detailed company financials. If you want to be a value investor, more imagination is required than simply running a P/E or P/S screener on Yahoo! and buying whatever pops out.

In ye olden days, it was hard to get timely and accurate corporate information and so simply buying cheap things worked because not everyone knew what was cheap. There is no reason to think that should work going forward.

Here is the key quote from Marks’ note:

In the past, bargains could be available for the picking, based on readily observable data and basic analysis. Today it seems foolish to think that such things could be found with any level of frequency. If something about a company can be easily read in an annual report, or readily discovered by a mathematically competent analyst or computer, it stands to reason that, in most cases, this should already be appreciated by the marketplace and incorporated in the prices of the company’s securities. That’s the essence of the Efficient Markets Hypothesis.

Thus, in the world we live in today, investing on the basis of rote formulas and readily available fundamental, quantitative metrics should not be particularly profitable. (This is not necessarily true during market downturns and panics, when selling pressure can cause prices to decouple from fundamentals).

That last sentence is the key—and it should also be stated in reverse. That is: growth can also outperform value during manias and bubbles as buying pressure can cause prices to decouple from fundamentals.

Essentially what this all comes down to is that markets are mostly efficient but efficiency breaks down at times due to behavioral factors. Markets defy EMH and decouple most aggressively from fundamentals during manias and crashes. Despite the wide availability of home computers and financial data, for example, value still outperformed from 2000 to 2007 as the NASDAQ bubble unwound and mean reversion following the dotcom mania (and crash) eventually brought things back into balance.

Value and growth cycle back and forth… Each time value underperforms (like now), prognosticators find a new explanation for why that might be permanent, not cyclical. If anything, though, what stands out to me is that the ratio of the growth and value indices looks to oscillate fairly consistently around 1.00.

Growth vs. Value performance vs. percent of Americans that own a computer
Growth vs. Value performance vs. percent of Americans that own a computer

I initially read the memo as a bit of an assertion that “value is dead”, but that’s not right. Marks explained to me on the phone that that is not what he meant.

“Market inefficiency is mostly cyclical now. In the past it was structural.”

What he meant was that structural inefficiencies that once existed are gone and will never come back. Pre-internet, there was alpha sitting around all over the place. Anyone with a calculator, a basic understanding of DCF, and a strong work ethic could scoop up that alpha because markets were structurally inefficient. Now, markets are structurally efficient and veer into inefficiency only during cyclical periods of extreme emotion. You either need to use a behavioral approach, or you need to understand the companies, industries, and technologies way better than anyone else. That level of understanding requires a much deeper knowledge than one can glean by scrolling through publicly-available data.


Howard Marks on growth

The memo avoids declaring a new paradigm to justify current record-high valuations … but it definitely feels like it wants to declare a new paradigm! For example:

It’s also worth noting with regard to truly dominant companies that are able to achieve rapid, durable and highly profitable growth that it is very, very hard to overprice them based on near-term multiples. The basic equations of finance were not built to handle high-double-digit growth as far as the eye can see, making the valuation of rapid growers a complicated matter.

The last line is definitely debatable and the entire paragraph is kinda debatable, but not quite the language you see from #truebelievers in presentations for various NEWECONOMYDISRUPTORS™ ETFs. “The shares of frictionless businesses are reasonable to own at any price, multiple, or valuation because super long duration assets have nearly infinite cash flows!”  While this sort of 1999ish statement has now made its way into the mainstream narrative, Mr. Marks stops just short of making it.

The idea that some companies have infinite cash flows discounted at a near-zero interest rate means valuation no longer matters for some companies is the same numerator mistake everyone made in 2000 (near-infinite growth of the World Wide Web… For, like, ever!). To be clear, a) the denominator story now is different from 1999 and b) Mr. Marks never says valuation doesn’t matter, but he gives more than a passing nod in that direction as he suggests there may be a few companies out there right now where almost any valuation could be seen as reasonable. One other note: just because US government yields are at 1.5% or companies can borrow at low rates, that doesn’t mean company WACCs are 1.5%. Take a look at the WACC for a few of your favorite companies. It’s not zero and it’s not even close!

Anyway, I found Marks’ arguments against value more compelling than his arguments in favor of growth, but the whole memo got me thinking.

One big message I took from the memo is that investors should not get married to one style. Trade and invest flexibly using the logic of what style makes sense at any given moment in the regime you find yourself. That does not mean you have to chase the current fashion, it just means you should think for yourself and be flexible. Don’t rigidly declare yourself a value investor or a growth person.

Another takeaway for me is that even the smartest people in the world (like Howard Marks) risk overweighting recent information. This is not a criticism of Mr. Marks, just a hard-to-avoid fact for all human beings. Recent news, information and performance are easier to remember than prior (or future!) performance. I could also be wrong and there is something truly new and different about today’s crop of tech companies. I’m open to that possibility, but I also doubt it. There have always been companies perceived to be dominant and expected to achieve rapid, durable growth as far as the eye can see. As Marks says:

John Templeton warned about the risk that’s created when people say, “It’s different this time,” but he also allowed that 20 percent of the time they’re right. Given the rising impact of technology in the 21st century, I’d bet that percentage is a lot higher today.

Personally, my guess is that the number is still well below 50%. On the phone, I tried to press Mr. Marks on this topic because it’s the most interesting aspect of the letter. When a “value guy” who correctly identified 1999 as a bubble in real time and sidestepped it nods to the idea it might be different this time … that’s interesting!

When I pressed him on the phone he said:

“Yes, you could say I’m struggling with a partial conversion.”

“Drill down and be open-minded.”

His defense of a more open-minded position on “highly-valued” tech is rooted in the idea that you cannot make blanket statements about entire industries without having an intimate knowledge of the firms themselves. The quip he used was:

“All generalizations are flawed, except this one.”

So his feeling is that now, given the enormous growth rates and very low interest rate environment, you need to keep an open mind and understand each individual company, industry and technology. This clearly doesn’t square with the 1999 experience. Even the very best companies in 1999 were terrible investments. For example, if you bought Amazon in 1999 or 2000, you were underwater for 10+ years!

Sure it’s like 1999, but it’s not 1999, it’s 2021

Mr. Marks says we are experiencing something similar to the Internet Bubble in some ways but 2021 is vastly different in other ways. Rates are low and the Fed is not hiking. Some assets are overvalued and in a bubble, but some are not. To make blanket statements like: “stocks are too high” or “tech is overvalued” is not the right approach. He believes you need to drill down and make more granular assessments, whether it’s crypto, tech or old economy stocks.

He did make it abundantly clear that he still believes that valuation always matters. He spent about 10 minutes emphasizing and reiterating that he does not currently believe and will never, ever believe that valuation does not matter.

“Value vs. growth is a false dichotomy.”

Marks said his grandmother used to joke: “What do you like better: summer or the country?” Value vs. growth is not a spectrum, it’s two sides of the same coin.

“It’s not what you buy, it’s what you paid.”

He said: “I’m going to sell you my car, do you want to buy it?” I mumbled for a second and he clarified: “The question makes no sense.” Every asset you buy is a combination of the intrinsic worth of the asset and the price you pay. Looking at one or the other in isolation is dumb. People define “value” as cheap, but they are often talking about price, not worth.

… “carrying low valuation parameters” is far from synonymous with “underpriced” ….

Traditional capital-V Value Investing is all about numbers: ratios, book value, cash flow, price-to-earnings, etc… Meanwhile, Growth Investing is all about the company: Tell me the story, what a great product, DISRUPTION!, huge moat, revenue growth, innovators!, viral founder, and so on. Again, this is a false dichotomy. Good investors should be looking at both, not one set of variables in isolation from the other.

I don’t believe the famous value investors who so influenced the field intended for there to be such a sharp delineation between value investing, with its focus on the present day, low price and predictability, and growth investing, with its emphasis on rapidly growing companies, even when selling at high valuations.  Nor is the distinction essential, natural or helpful, especially in the complex world in which we find ourselves today.  

“A high P/E stock can still be cheap.”

Real value investing is not about buying cheap things. It’s about buying assets for less than they are worth and waiting for the market to agree with your judgment. This might mean buying a stock at 70X earnings when it’s worth 250X earnings. Or it might mean a stock at 0.8X earnings is expensive because it’s going bankrupt. Good investors understand and study the relationship between price and intrinsic value and do not buy assets based on value metrics or growth stories in isolation.

Even famous so-called value investors like Ben Graham and Warren Buffett made as much or more money in growth as they did in value. I did not know that! Super interesting.

Graham went on to achieve enviable investment performance although, funnily enough, he would later admit that he earned more on one long-term investment in a growth company, GEICO, than in all his other investments combined.

Buffett, the patron saint of value investors, also practiced cigar butt investing with great success in the first decades of his career, until his partner, Charlie Munger, convinced him to broaden his definition of “value” and shift his focus to “great businesses at fair prices,” in particular because doing so would enable him to deploy much more capital at high returns.

This led Buffett to invest in growing companies – such as Coca-Cola, GEICO and the Washington Post – that he could purchase at valuations that were not particularly low in the absolute, but that he found attractive given his understanding of their competitive advantages and future earnings potential.  While Buffett has long understood that a company’s prospects are an enormous component of its value, his general avoidance of technology stocks throughout his career may have unintentionally caused most value investors to boycott those stocks.  Intriguingly, Buffett allows that his recent investment in Apple has been one of his most successful.

“Don’t place arbitrary or artificial constraints on your portfolio. It’s not about being best at a particular game, it’s about choosing the game you can win.”

Unless you are forced by mandate, don’t corner yourself into a particular style. Just like in trading I say it’s best not to be a breakout trader or a mean reversion guy or anything similar… In investing, it’s best not to pigeon-hole yourself as a value guy or a growth woman etc. Intellectual flexibility and adaptation lead to long-term outperformance, not the expert application of a single investing style.

This is relevant right now with regard to the bullish ESG story. ESG investing might be the best thing to do ethically, but from an investment point of view it’s hard to imagine the thing that everyone in the upper echelons of finance loves (and is actively and publicly signaling it loves) will outperform the things that everyone thinks are icky. I mean, Philip Morris is one of the best-performing stocks of all time, and a big part of this is because for much of its existence, people would not touch it.

 “No asset is so good that it can’t be overpriced.”

Marks started at Citicorp in 1968, in the midst of the Nifty Fifty bubble [1] and that experience (like my 1999 experience) puts him always on alert for bubbles. Here’s a quick excerpt from a 2018 Wharton piece:

Marks recalled that when he took a summer job in Citibank’s investment research department in 1968, investors were crazy for the “Nifty Fifty” — 50 large-cap, blue-chip growth stocks in America that included IBM, Xerox and Coca-Cola. He said they were selling for “astronomical” prices of 80 to 90 times earnings. That compares with the average price-to-earnings (P/E) ratio for the S&P 500 in the post-war period of about 16 times earnings.

Enthusiasm for “growth stock investing” carried investors to the ridiculous conclusion that for the stocks of the fastest-growing companies, no price is too high. That was just before the “nifty-fifty” stocks of America’s best companies lost up to 90% of their value in 1973-74.

Formative experiences shape behavior for decades. Everyone forms strong bonds to salient early-life experiences, whether those experiences involve investing or life outside finance. If you grew up in the Great Depression, you reuse aluminum foil. If you grew up in the 70s, you scrimp on gas.[2] If you came of age in 1999, you might find the smell of highly-valued tech particularly pungent. As a general rule, these sorts of bias are bad.

Marks noted in our conversation that this predilection for bubble detection can be both a blessing and a curse. While it might save you from going all-in levered long at the most egregious moments of euphoric overvaluation, it can also lead you to be too cynical. It can lead to gigantic missed opportunities.

While the idea that some companies can be good investments at what appear to be sky-high valuations didn’t resonate much with me because I feel the same thing was said in 1999, it did resonate with me big time when Marks said his partial conversion on the 2020 disruption economy is in some measure motivated by this realization:

“I was too skeptical in the past. Skepticism can lead to knee-jerk dismissiveness.”

When he said those words, my brain lit up a bit because I have suffered from the same bias of excess dismissiveness many times. Healthy skepticism is great. Reflexive cynicism and dismissiveness is bad. Marks’ comment hit home for me and the conversation may have influenced my less skeptical view of NFTs a few weeks later (see AM/FX: The metaverse contains infinite Pop-Tart® cats). If I was wrong about the iPhone and I was wrong about bitcoin (and Twitter… Who’s ever going to use that???)… Maybe next time I should be more open minded? And perhaps less wrong?

The risk, of course, is you end up on the other end of the spectrum—that’s not good either!


Reflexive cynicHighly skepticalHealthy skepticRational optimistUnrealistically
optimistic / gullible
Pollyanna

I have been too far left on this spectrum, and so has Howard Marks


While I want to be less knee-jerk dismissive overall, my observation right now is that there is a large swath of the investment community wearing the Growth Investor blinkers and that has put them too far to the right on the spectrum from cynic to unrealistic optimism and beyond.

These investors see booming top line growth and economic disruption and low rates as far as the eye can see but ignore the other side of the equation. They see a McLaren P1 and think: “Wow, I want that!” and then pay Howard Marks $22 million for it when it’s really worth more like $2 million.

Marks is worth around $2B, so I am assuming this is the car he drives. I could be wrong.

Meanwhile, value investors are looking for 1992 Toyota Tercels they can buy for $800 and resell for $2,000. The right philosophy is to look at all the cars and see which ones you can get for less than fair value.

McLaren P1 - good value at $450k / overpriced at $22m

Easier said than done in the stock market, obviously, but I think it’s a good framework.

In ten years, I bet we will look back at many of the outsized investment winners of 2020 and see them as flukes. Separating skill from luck is notoriously difficult in finance. Evaluating the performance of any strategy or fund manager by how it, he or she performed in 2020 could be the epitome of Taleb’s fooled by randomness. I think “persistent investing skill” and “performance in 2020” are more likely to be inversely than positively correlated.

Many fund managers who delivered stellar performance in 2008 left investors disappointed in 2009. It is the aggregate performance of managers and strategies over multiple years that matters, not 2020 outcomes.

Anyway, a lot to chew on here. I thank Howard Marks for the memo and for being so generous with his thoughts and his time. There is no reason he needed to spend an hour talking to me on the phone, and I sincerely appreciate that he did.

Finally, Mr. Marks suggested I check out this 1962 Warren Buffett interview, just for fun. It is fun!


[1] A year or so before man landed on the moon and 18 months before the letters “LO” were transmitted over the ARPANET in what is widely viewed as the birth of the internet.

[2]> See: Malmendier and Shen, Scarred consumption (2021) https://voxeu.org/article/scarred-consumption and Severen and Benthem, Formative Experiences and the Price of Gasoline (2019) https://www.nber.org/papers/w26091


Brent Donnelly is a senior risk-taker and FX market maker at HSBC New York and has been trading foreign exchange since 1995. He is the author of The Art of Currency Trading (Wiley, 2019) and his latest book, Alpha Trader, hits the shelves in Q2 2021.

You can contact Brent at [email protected] and on Twitter at @donnelly_brent.


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22+

Spidey-Sense

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The more I look at this Greensill collapse (last week’s ET Pro note, A Madoff Moment, also The Best Way to Rob a Bank), the more it has my spidey-sense tingling.

Not because Greensill itself is big enough to cause a systemic shock, and not even because I expect in my heart of hearts that Lex Greensill is going to roll over on Softbank or Credit Suisse or General Atlantic or Tokio Marine, any one of which is definitely big enough to spark a systemic shock. Sure, it could happen. And I definitely think there are some bad emails at Credit Suisse that will come to light, but if anyone knows how to cover up yet another flubbed covert op, it’s Credit Suisse.

No, the thing that has my spidey-sense tingling is that I think there are lots of other Greensill specialty lenders out there, lots of other Tokio Marine insurance wrappers out there, lots of other Softbank shadow banking facilities out there, lots of other Credit Suisse absolute return funds out there, all geared and levered to global trade and supply chains at precisely the moment when globalization is reversing after three decades-plus of a one-way trade.

I mean, look at these purchasing manager survey results on both supply chain breakdowns and supply-driven inflation:

And then I pulled these charts up today. I’m going to present them pretty much without comment.

First up, from Japan, a 20-year chart of Tokio Marine’s 5-yr CDS spreads. They’ve been 22 bps wide since 2014.

Next, from Australia, a 17-year chart of Macquarie Group’s 5-yr CDS spreads, now 27 bps wide.

From the Netherlands, here’s a 20-year chart of ING’s 5-yr CDS spreads, now 21 bps wide.

And finally, from the US, here’s a 20-year stock chart of John Deere, a company wonderfully geared to steel prices and foreign sales of its farm equipment. LOL.

To be clear, I’m not saying that these companies are complicit in some Greensill-like fraud or that they are uniquely levered to a 30-year globalization trade. But not saying that is exactly my point! These were just some of my faves from my hedge fund back in the good old days of 2008, now 13 years later with charts that are just as complacent and what-me-worry as they were back then. I think there are dozens and dozens of companies out there just like this, with billions of dollars of trading liquidity in the aggregate, all of which are … ummm … REALLY interesting to me as we hit an inflection point in a thirty-year globalization trade and a forty-year deflation trade at the same time that the Lex Greensills and Masayoshi Sons of the world have had 13 years to build their scams to the breaking point.

So I’m trying to figure out what to do. Managing a series of trades like this in a set of securities like this against a backdrop of catalysts like this … this is how I am wired as an investor. This is why my spidey-sense is tingling like crazy, in ways I haven’t felt since Q4 of 2007. I can’t believe I’m saying this, but it’s making me think about getting back in the saddle as a long/short portfolio manager, marrying my spidey-sense with the advances we’re had over the past three years in building the Narrative Machine. I dunno. We’ll see.

All I know for sure is that I’ll be building out this investment thesis in real time here in ET Pro. The game is afoot!


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ET Podcast #7 – Inflation Investing

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The Epsilon Theory podcast is free for everyone to access. You can grab the mp3 file below, or you can subscribe at:

Spotify: https://open.spotify.com/show/3ZXOnreiGGiUtuGHzbin6d

Apple: https://podcasts.apple.com/us/podcast/epsilon-theory-podcast/id1107682538



We’re going to Pack-source a slate of investment strategies for an inflationary world.

Here are five tentpoles to organize and support that effort, five sets of questions we must answer.

What should we think about …

1) US Treasuries?

2) US Housing Market?

3) Narrative of Central Bank Omnipotence?

4) Fiscal Policies and Inflation Expectations?

5) Real Assets and Abstracted Securities?


ET Podcast #7 – Inflation Investing

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14+

The Best Way to Rob a Bank

94+


The best way to rob a bank is to own a bank.

I think that the collapse over the past week of Greensill Capital has a lot of systemic risk embedded within it, particularly as the fraudulent deals between Greensill and its major sponsors – Softbank and Credit Suisse – come to light. And that’s not even considering Greensill’s second tier of sponsors – entities like General Atlantic and the UK government – all of whom are up to their eyeballs in really dicey arrangements.

Yeah, that’s Lex Greensill at Buckingham Palace in 2019, receiving a CBE (Commander of the Order of the British Empire) from Prince Charles for … wait for it … “services to the British economy”. LOL.

And yeah, that’s former UK prime minister David Cameron, positively beaming in this photo that his publicist chose for the 2018 announcement that he would be joining his good friend Lex Greensill as a “special adviser” to the company, keen to assist with the company’s mission to “democratize” supply-chain finance and “transform construction finance with Big Data and AI”. I mean, that’s what the white paper says, so it’s gotta be true.

Today, David Cameron is waking up to headlines like this in the UK press:

Hope all those free rides on Lex’s personal fleet of four private jets (all bought by Greensill Capital’s German banking subsidiary and leased back to Lex, btw) were worth it, David.

Is this a Madoff Moment for the unicorn market? Honestly, if you had asked me a few weeks ago, I would have told you that a Madoff Moment was impossible in our narrative-consumed, speak-no-evil market world of 2021. Now I’m not sure. We’ll see, but I think this has legs.

By all rights, Greensill – the eponymously named investment bank started by former Citigroup and Morgan Stanley banker Lex Greensill in 2011 – should have been shot between the eyes in 2019. That’s when their “supply-chain finance” loans, in this case to the steel and energy companies of the UK’s “Savior of Steel”, Sanjeev Gupta, blew up Swiss asset manager GAM’s $11 billion flagship fund, the Absolute Return Bond Fund (ARBF).

It’s a story as old as capital markets … Greensill lent Gupta a lot of money, Greensill wined and dined and private jetted ARBF portfolio manager Tim Haywood, and so naturally Haywood bought as much of the Greensill-originated loans as humanly possible, topping out at 12% of ARBF NAV. LOL. The loans, of course, were not as they seem, Gupta’s companies were nowhere near as solid as they were represented, and GAM ended up firing Haywood and seeing their stock price crater. Lots of people lost lots of money … end of the road for Greensill, right? Nope.

Enter Masayoshi Son, CEO of Softbank, who ended up putting $1.5 billion into Greensill in 2019 through Softbank and then another $1.5 billion into Greensill through the Vision Fund, becoming Greensill’s largest investor and diluting the prior largest investor – General Atlantic – from a 15% to a 7% position. And then the fun begins.

Since that 2019 rescue, Greensill has lent billions of dollars to Softbank and General Atlantic affiliates (mostly Softbank, but GA looks plenty stinky here), loans that were then bought by Credit Suisse funds and laundered by Greensill’s German bank subsidiary. Now when I say ‘laundered’, I don’t mean that metaphorically. The German banking and markets regulator, BaFin, has suspended Greensill’s banking license and referred the case for criminal prosecution.

Here’s an example of how the scam worked. Again, it’s a story as old as capital markets. In early 2020, Greensill lent Softbank portfolio company Katerra $435 million. The company ran into … errr … operational difficulties, and Softbank ponied up $200 million in additional capital last December. For its part, Greensill wrote off the $435 million loan in exchange for … again, wait for it … 5% of common equity. LOL. The $9 billion valuation for Katerra (I am not making this up) was determined by Softbank, of course, and so the Greensill German bank subsidiary reported on its balance sheet that all was well. A $435 million senior loan, secured by trade receivables, was exchanged for a 5% equity position in a bankrupt company, with no loss reported. Seems fair!

As always, the best way to rob a bank is to own a bank.

Second best way is to find a really big bank to buy up all the crap loans you originate, and that’s where Credit Suisse comes in. After the GAM debacle in early 2019, there was zero question that the loans Greensill had been selling to Credit Suisse for years were just as stinky as the loans they had sold to GAM. And yet Credit Suisse did … nothing. Actually, that’s not fair. They purchased MORE of the securitized loans from Greensill than ever before. They marketed their funds HARDER than ever before.

I’m sure it’s just a coincidence that Softbank put $500 million into the Credit Suisse funds after their 2019 Greensill investment.

I’m sure it’s just a coincidence that Credit Suisse was the lead advisor to Greensill when they raised hundreds of millions in new capital at a valuation of $7 billion all of … [checks notes] … four months ago.

I’m sure it’s just a coincidence that Credit Suisse and Greensill found a Japanese friend-of-Softbank insurer, Tokio Marine, willing to put a wrapper around the Greensill loans so that Credit Suisse could market these Greensill lending facilities as … one more time, wait for it … a safe-as-houses money-market fund.

Money quote from an investor in this $10 billion Credit Suisse fund family, per the FT:

“You thought you were in an arm’s length arrangement where all your fellow investors had a pure financial interest,” he said. “Imagine you then found that, in fact, some of your co-investors were funding themselves.”

Yep, imagine that. Like I say, it’s a story as old as capital markets. Here’s a fun fact. Did you know that Credit Suisse has paid more than $9 billion since 2009 in legal penalties and settlements?

But then the house of cards came tumbling down. Something spooked Tokio Marine (they’re now putting the blame on a “rogue underwriter”), and once the insurance wrapper came off, Credit Suisse professed shock … shock, I tell you! … as they suspended redemptions from the funds (LOL) and announced a hard-hitting internal investigation into how it was possible that this could have happened. I’m sure they’ll find a “rogue portfolio manager”. And then Credit Suisse dropped a dime to the German bank regulators, BaFin, who after the Wirecard debacle were apparently only too eager to show that they weren’t totally corrupt and incompetent.

So here we are. The ECB is now asking whether or not the situation is “contained”.

Will it be contained? Will all this be swept under the rug? Probably. Apollo is apparently going to buy the shell of the Greensill trading platform for less than $100 million (down from $7 billion a few months ago), and bury this as deep into the bowels of the Earth as it is possible to be buried. Pretty much all of the Greensill directors have resigned and claimed the Sgt. Schultz / Hogan’s Heroes defense (“I see nothing! I know nothing!”), including Lex’s brother (I guess Elon is not the only one who likes to keep board seats in the family). So I am certain that we will hear this week from the ECB and other bank regulators that the situation IS, in fact, contained.

And I’m also certain we’ll be treated to another barf bag Softbank earnings deck this quarter, where Masayoshi Son waves his hands with extra vigor to explain away the Greensill “investment”. Here are some of my personal faves from last year’s virtuoso performance in narrative construction after the Wework debacle. Again, I am not making this up.



Then again … maybe Lex Greensill is feeling a wee bit abandoned by his erstwhile friends at Softbank or General Atlantic or the UK government. Maybe Gupta’s GFG steel business or some of these Softbank/Vision Fund companies can’t find short-term financing to replace their sweetheart deals at Greensill, and lots of people lose their jobs. Maybe there’s a bad email at Credit Suisse. There’s always a bad email.

So maybe this won’t be swept under the rug after all. And if it’s not …

This is the first Big Fraud I’ve seen in 13 years with the sheer heft and star power to ripple through markets in a systemic way. Not since Madoff.


94+

A Freaky Circle

21+

Source: Thor Ragnarok

A quick but important note: We don’t have a dog in this fight. But we are conflicted. We have subscribers at almost all of the firms being mentioned. Our principals have done business with many of them. We’ve been clients of some, too. We like most of them. On both sides. We also don’t really care what any of them think. Make of it what you will, but clear eyes, even with us.


THOR: How did you…

KORG: Yeah, no. This whole thing is a circle. But not a real circle, more like a freaky circle.

THOR: This doesn’t make any sense.

KORG: No, nothing makes sense here.

Thor: Ragnarok (2017)

The whole of Thor: Ragnarok is pretty outstanding, as far as action-comedy films go. But the prison scene is almost certainly my favorite.

The premise is absurd. Thor – the guy in the picture above who isn’t a walking rock, if superhero movies aren’t your thing – is trying to escape a room that is plainly a circular hallway by dashing forward. It is a silly thing to do in the first place. Most circles boast that pesky feature whereby moving forward in one direction always brings you back to where you started. This room, however, is further designed so that running in one direction on the circle apparently doesn’t permit you to run all the way around the circle. You are, perhaps randomly or perhaps predictably (the audience never learns, exactly), transported back to where you began.

Why go through the trouble of creating a freaky circle whose magical affectation simply recreates the most basic identifying feature of a garden-variety circle, that is, that trying to go forward will only bring you back to where you started? As Korg and Thor both observe, the whole gag doesn’t make any sense.

All of which is why it’s perfect. And why it’s a perfect meta-joke. The freaky circle makes sense neither as a prison element nor a plot element. Making it both, however, makes it work for both. You, the audience, now feel a bit of the “Wait, what? Why?” confusion that Thor felt. Brilliant. Absurd.

But for all its absurdity, doesn’t it also feel a little bit familiar?

After all, the usual shenanigans of our financial world bear the same garden variety features that they ever did: too-big-to-fail gain privatization and illiquidity/loss socialization. A half dozen institutions discovering how to leach value via transactions and flow on every novel method to “democratize investments“. The rest of the nominal agents of the investment and corporate world leveraging the prudent man rule to capture as much value from principals as possible before the music stops, all under the guise of “yay, alignment.”

Nothing new under the sun and all that.

And yet somehow the ways in which each of these garden variety features manifest has been made so impenetrable, so arcane, so purposefully complex that we’re left to wonder why they even bothered with the layers of artifice in the first place.

In other words, it’s freaky circles as far as the eye can see.

But I think that you, Korg, Thor and I got something wrong. It does make sense if we think less about what it means for us and more about what it means for the designer of the room. And there is only one possible reason why the designer of the circular prison – or, say, the construction finance lender who was transforming their industry using AI and Big Data – would create a Rube Goldberg device that caused us to end up in exactly the same place we were going to end up anyway.

They do it because it is helpful to them that it doesn’t make any sense to us.


We wrote about it briefly before – but I just keep coming back to this Dyal – Owl Rock SPAC tie-up.

I’m still not sure what to make of it.

As we explained in that prior piece, Dyal is a private equity manager that, through funds it raises from the capital of big institutional asset pools (think pensions and university endowments), buys stakes in the management companies and general partners of other asset managers. It has a particular expertise buying stakes in private equity and credit shops.

Here’s what we wrote about the “Blue Owl” deal in December:

The TLDR is this: one of Dyal’s funds bought a minority stake in one of the biggest private credit shops in 2018. Their funds bought a minority stake in a big direct lending / BDC sponsor firm earlier this year. The latter (HPS) formed the sponsor to a SPAC (Altimar) that has made a proposal that would merge the former (Owl Rock) with Dyal (the GP), its minority private equity investor.

Russian Nesting Deals, Epsilon Theory, December 3, 2020

This was weird enough on its own. But if there’s a strong signal for “you’re on to something” here at Epsilon Theory, it is when publishing something brings a paucity of attention in our comment section and social media – but a lot of direct attention from people in the industry. And this one did exactly that.

Sure enough, within a matter of weeks, we read of not one but two lawsuits from portfolio companies the Dyal funds had bought stakes in – Sixth Street Partners and Golub Capital – seeking injunctions against the proposed merger/IPO with the SPAC sponsored by the Dyal affiliate.

If this is not your world, know that these are not tiny shops. This isn’t a single-store franchise in Des Moines standing up to corporate. Once upon a time, Sixth Street may have been your usual spin-out-half-of-a-Goldman-desk-in-2009-and-see-what-happens story, but the erstwhile special sits team that formed this company has built something really big and really successful. Different backstory for the Golub team, but same end-game. This is a huge private credit shop.

While we’re at it, you could say the same thing for Dyal. Their ideas for how to exploit the underserved market need for liquidity for the owners of asset manager GPs germinated well after those of Petershill (Goldman) and roughly around the same time as those of Blackstone. Who are Goldman and Blackstone? Yeah, in this niche, that’s the universal Jeopardy question to the answer, “The two firms you absolutely would not want to compete against if building a new investment industry-focused private equity business from scratch.” Even so, Dyal still built a leadership-level position. Theirs is a ridiculous achievement. They’re absolutely enormous. Good for them.

Same for Owl Rock. The placard on this particular door hasn’t been around very long, but anyone who doesn’t know Doug Ostrover doesn’t know anything about this corner of our industry.

And so, because these are all legitimate Big Boys, and because these firms in question are already in partnerships with one another that must work, the internecine lawsuits themselves are a Big Deal.

The basic contention of both Sixth Street and Golub is that (1) they have a consent right to the transfer of ownership in their companies and (2) there are demonstrable breaches and/or reasons to believe that breaches of confidential information would be inevitable and endemic to the contemplated post-merger business model of Blue Owl – the contemplated Dyal/Owl Rock entity. In other words, Sixth Street and Golub think they get to vote on the deal, and they think there’s no way that Dyal, their financial sponsor – which as Blue Owl will now be a direct competitor in the credit space – can credibly say they can or will abide by confidentiality requirements about their activities.

I have no idea if the former claim is true.

Most private equity investments take place through a series of limited partnership vehicles. It is certainly quite common for a private equity partnership to require consent to transfer an interest from one limited partner (LP) to another. The same is true for most direct private equity investments in companies. Likewise, a change in control of the management company with an advisory agreement with a fund will usually trigger a consent or proxy process among the fund’s limited partners. Securities laws governing investment advisers require it, in fact, although since the client is technically the fund and not its limited partners, there IS an aggressive posture a private equity manager might take that runs an end-around on LPs. They rarely do so, and usually proceed with the usual LP consents. After all, if the purpose of the change in control is to create equity value for the private equity manager, there’s no quicker way for a company reliant on raising new funds to destroy that value than to piss off their big LPs. In this case, the LPs are being asked to consent, so that’s not really the question.

The question is whether a change in control of the management company to your usual private equity limited partnership would trigger an affirmative consent right for the underlying investments of that partnership. That would be really unusual. Then again, what Dyal is doing involves a level of partnership that is really unusual in private equity, and they are, in a sense, potentially in the same business as the companies they acquire. It is entirely reasonable that the purchase or operating agreements might contemplate such a consent right, and entirely reasonable that they might not, but without reading the actual, unredacted documents it is impossible to know.

As to the second claim? Look, you do a deal like this because you want a public market for your interests. Maybe because you want more independence and upside that currently belongs to your parent. Maybe because you know that when it comes to scale in this industry, more is almost always better. The reason you have to tell limited partners in the funds you manage that you are doing a deal (since one does not really tell one’s clients “duh, because I want cash for my super-illiquid equity interest some day, you dummy”) is because of “resources” and “access to deal flow.” All of which makes it sort of awkward when you also have to say to portfolio companies and courts, “We will prevent any sharing of information that would constitute competition with our own portfolio companies.”

Sort of like telling your clients “We will never use flour” and then issuing a press release that says, “We are excited to launch our new bread-making business.” They aren’t literally contradictory, but I mean, c’mon. Some lawyers are gonna make the tiresome expression “robust controls” do a hell of a lot of work in the next few months.

So maybe they get some kind of injunction and maybe they don’t. In any case, no matter how strongly you might feel about it, my gut feeling is that no one’s gonna stop a deal over the latter claim. Courts and regulators have created such a powerful narrative around “yay, robust controls!” that even if one party is literally telling their own LPs that doing things the controls would make really, really hard is the justification for doing the deal, our collective willingness to believe that information will not be shared in Bad Ways knows no bounds.

As for the former claim – which, again, may or may not have merit – Dyal has made their position abundantly clear:

Sixth Street is attempting to assert the existence of a consent right that we believe simply does not exist. We appreciate the broad support from investors, partner managers, and other key stakeholders. The strategic combination is tracking towards a close in the first half of this year.

Statement by David Wells, Outside PR for Blue Owl, as quoted in Institutional Investor

That may be true, too! The funny thing about it, though, is that at least some of this “broad support” appears to be a wee bit engineered. I know it would have been better to make a “manufactured consent” reference, but if you’re jonesing for Chomsky, you’re reading the wrong Epsilon Theory co-founder.

What do I mean by “a wee bit engineered?”

Well, the parties that the PR guy is presumably referring to (other than other portfolio companies) are, namely, the limited partners of the various Dyal and Owl Rock funds, the voting shareholders of the Altimar SPAC and the shareholders of the various Owl Rock-sponsored BDCs. In other words, a lot the people who do get to vote on the deal. OK, the people who get to vote on advisory contracts that are conditions to close the deal. Same difference.

Thing is, a number of the largest limited partners in the Dyal and Owl Rock funds and a couple of the largest shareholders in the Owl Rock-sponsored BDCs who have the effective right to consent to the transaction are also companies who own a piece of an Owl Rock management company holding entity. Little perk of being willing to seed private BDCs with a 9-digit wire transfer. In other words, there appear to be a range of institutions who may not necessarily be aligned with other LPs and shareholders.

In most cases, those institutions probably have an unencumbered right to vote, but even if they decided because of affiliation concerns or conflicts not to do so or to do so at a capped level, a non-abstention non-vote (i.e. where you just sit on the ballot) is still helpful to one leg of the 1940 Act’s proxy rules. And if even that weren’t true, it remains true that narratives of “unfairness” or “imprudence” begin with the big, credible institutions – or they do not begin at all. Because the fiduciary rule is built around this concept, the implied consent of the largest, most credible institutional players not only removes the risk of assent, but may even create risk to dissent.

Who are those institutions? For the most part, really sharp, well-run places with good folks running them. Like the State of New Jersey.

Source: New Jersey Division of Investments, December 2020 Monthly Director’s Report

And Rhode Island.

And maybe Oregon. Truth be told, I’m not sure if Oregon took Owl Rock up on the management company stake or not, although it seems to me they certainly would have been eligible for it at a $150 million commitment to ORCC III. Fun fact: they announced that commitment at the same time they announced a $125 million allocation to a Sixth Street European specialty lending fund. Small world.

Probably South Carolina, too, although if so, perhaps they’ve made the decision to merge that management company interest into the line item reporting their LP commitment on CAFRs. There are plenty of sharp allocators down there, so it seems like a reasonable assumption.

In short, Asset Manager A is merging with Asset Manager B, into whose equity securities Asset Manager A has already caused its own clients to invest, and to whom Asset Manager A has caused others of its own clients to lend money to, and is doing so through the acquisition by a SPAC sponsored by Asset Manager C, into whose equity securities Asset Manager A has also caused its own clients to invest, meaning that clients of Asset Manager A who had intended for their capital to be deployed on an arms-length basis are now effectively becoming both creditors and equity owners of Asset Manager A by merits of their enlistment of them as a vendor, and effectively both paying and receiving transaction fees and expenses to and from Asset Manager C, respectively. And this is able to happen, at least in small part, because Asset Manager B has granted equity ownership that would gain value in a transaction involving Asset Manager B to very large investors in their products who accordingly have a significant say in the outcome of a vote involving a transaction involving Asset Manager B.

Or, in the immortal words of Ray Stevens:


Source: Some YouTube Video of the Ray Stevens classic “I’m My Own Grandpa”

Alternatively, if you are a small LP or BDC investor who is wondering what is going on here, and you weren’t large or important enough to merit getting a seed deal, let me translate the message to you:


Oh no! Anyway Blank Template - Imgflip

But here’s the real conundrum:

I’m pretty sure there’s not anything illegal going on here.

Unless there’s a real cause embedded in the agreements among these parties, I’m not sure there’s anything tortious going on here.

Hell, I’m not even sure there’s anything wrong going on here.

When Owl Rock gave all those big pensions and endowments effective GP ownership for their seed investments, what they were doing wasn’t unusual. It certainly wasn’t illegal. It was an entirely rational response to the power of a large block of capital with an appetite for risk. It is a power (because of my seat, not relatively unimportant me) I have some experience wielding. In my prior life, we squeezed external manager fees into oblivion because we could and because we felt that we should. We bought a stake in Bridgewater for Texas Teachers, an opportunity that came to us because we were a huge, strategic, long-term limited partner. An opportunity you probably didn’t get to see.

We got to negotiate better structures than the deals you probably got, not because we were smarter or more charming, but because we were representatives of a $100 billion+ pool of assets. We also selected a hedge fund seeding / incubation partner whose offering included potentially getting us GP stakes in various funds in the same way all these big pools of capital did. I’m a big fan of the guys at Reservoir we ended up hiring to do exactly that.

There is nothing inherently nefarious about offering those deals. And nothing inherently nefarious about accepting them. Maybe you disagree. Fine, in which case I am nefarious, because I not only accepted these deals, I demanded them as a representative of an asset owner.

Nor is there anything inherently nefarious about the big institutions who will participate in the Altimar PIPEs that will grease the gears of this whole construction, or whatever benefits were offered to them in exchange for their support. Yes, even though it’s Koch and whatever other bogeyman some might be tempted to summon to make all this seem blatantly evil, which it isn’t.

Still, if you are a smaller institutional limited partner in some of these funds wondering why you’re being jawboned about why “this is going to give us access to so much more in-house expertise!” and why “these lawsuits are no big deal!” and why “this isn’t a distraction, we are still aligned with you!”, so vote vote vote, I hear you.

And if you were a retail investor in the public BDC because you liked the yield and felt like your interests were served by the mutual self-interest of other equity owners, but then discovered that maybe some owners were more equal than others, and that maybe the goal of the adviser affiliate hired by the BDC wasn’t just to maximize the returns of the BDC but of the adviser, and that maybe you’d like to express that with your vote, and that maybe you’d like to join with other BDC investors in doing that since clearly they’re in the same shoes with you and…oh.

I hear you, too.

If I were a ‘partner manager’ with business overlaps, I would probably be hopping mad, and that’s without even being party to any of the ‘partnership’ discussions. And yet, if I were a limited partner in one of the funds managed by the advisors in question, I would probably still vote yes on my proxy for the new advisory contract. First, because the GPs in question are really good at what they do and, in some cases, just about the only game in town. A no vote isn’t going to get me those cheap co-investment rights on the next fund, and that probably matters more to my stakeholders than whether some not insignificant conflicts are being appropriately managed – or even that it is possible to manage them. Second, because the problem here, at least in my opinion, isn’t that the people here are bad or that they’re doing extremely bad things for investors.

The problem is that investors in 2021 are sold on a meme of markets in which equity owners and limited partners are “protected” by the mutual self-interest of other equity owners and limited partners (and boards, LOL) without taking into account that nested ownership structures allow powerful institutions to create incentive structures which manufacture…er…compliance for enough of the “important” participants to eliminate the effective agency of small institutions and individuals.

The problem is that we have decided to vest immense power into narratives about “incentives” and “alignment” and the ability to have “robust controls”, when we know that each of those things is fragile to any change in assumptions about the underlying aims of the principals and agents involved. Here’s a rule of thumb for you: they want a clear path to liquidity, and everything else is just pretty words.

The place this game leads us toward is a circular prison. Those who were sold on the “democratizing power” of vehicles like BDCs and SPACs that give “access to asset classes previously only open to big institutions” will realize that, as with every other investment, the sponsors will take their cut, and the big asset pools will take their cut, and the GPs that end up having lent money to themselves with their clients’ money will take their cut, and at the end of the day, what you get is whatever they couldn’t claim.

Same as it ever was.

The only difference is that the artifice through which all of this is achieved is far more obtuse, far more engineered, far more designed for the purpose of allowing those parties to do those things without opposition. I’m not saying that the Blue Owl transaction is unique. Quite the contrary. I am saying it is par for the course in outcome, except that its very structure is designed to distract or abstract from the manifold conflicts embedded in it to make that outcome more likely. It is a freaky circle, a thing which ends up at the same place but accelerates and ensures its outcome.

And makes us wonder what the hell is actually going on.

I DON’T know what that outcome will be for Dyal limited partners. I DON’T know what it will be for Owl Rock limited partners or shareholders in its various BDCs. I DON’T know what it will be for Dyal portfolio companies. These are really good investment firms with really smart people. If anyone can make a weird-ass, convoluted deal work, it’s them.

What I DO know is that everything we are telling limited partners and shareholders about the democratization and alignment of their interests across markets, not just for this particular deal, is complete nonsense.

If you know how to parse those two truths, please let me know.

21+

A Madoff Moment?

0


I’ve started writing a note on this for general publication later this week, but wanted to share with you first. I think that the collapse over the past week of Greensill Capital has a lot of systemic risk embedded within it, particularly as the fraudulent deals between Greensill and its major sponsors – Softbank and Credit Suisse – come to light. And that’s not even considering Greensill’s second tier of sponsors – entities like General Atlantic and the UK government – all of whom are up to their eyeballs in really dicey arrangements.

Is this a Madoff Moment for the unicorn market? Honestly, if you had asked me a few weeks ago, I would have told you that a Madoff Moment was impossible in our narrative-consumed, speak-no-evil market world of 2021. Now I’m not sure. We’ll see, but I think this could be a shock just as big as Madoff.

By all rights, Greensill – the eponymously named investment bank started by former Morgan Stanley and Citi banker Lex Greensill in 2011 – should have been shot between the eyes in 2019. That’s when their “supply-chain finance” loans, in this case to the steel and energy companies of the UK’s “Savior of Steel”, Sanjeev Gupta, blew up Swiss asset manager GAM’s $11 billion flagship fund, the Absolute Return Bond Fund (ARBF).

It’s a story as old as capital markets … Greensill lent Gupta a lot of money, both Gupta and Greensill wined and dined and private jetted ARBF portfolio manager Tim Haywood, and so naturally Haywood bought as much of the Greensill-originated loans as humanly possible, topping out at 12% of ARBF NAV. LOL. The loans, of course, were not as they seem, Gupta’s companies were nowhere near as solid as they were represented, and GAM ended up firing Haywood and seeing their stock price crater. The GAM CEO got fired, lots of people lost lots of money … end of the road for Greensill, right? Nope.

Enter Masayoshi Son, CEO of Softbank, who ended up putting $1.5 billion into Greensill in 2019 through Softbank and then another $1.5 billion into Greensill through the Vision Fund, becoming Greensill’s largest investor and diluting the prior largest investor – General Atlantic – from a 15% to a 7% position. And then the fun begins.

Since that 2019 rescue, Greensill has lent billions of dollars to Softbank and General Atlantic affiliates (mostly Softbank, but GA looks plenty stinky here), loans that were then bought by Credit Suisse funds and laundered by Greensill’s German bank subsidiary. Now when I say ‘laundered’, I don’t mean that metaphorically. The German banking and markets regulator, BaFin, has suspended Greensill’s banking license and referred the case for criminal prosecution.

Here’s an example of how the scam worked. Again, it’s a story as old as capital markets … in early 2020, Greensill lent Softbank portfolio company Katerra $435 million. The company ran into … errr … operational difficulties, and Softbank ponied up $200 million in additional capital last December. For its part, Greensill wrote off the $435 million loan in exchange for … wait for it … 5% of common equity. LOL. The $9 billion valuation for Katerra (I am not making this up) was determined by Softbank, of course, and so the Greensill German bank subsidiary reported on its balance sheet that all was well. A $435 million senior secured loan was exchanged for a 5% equity position in a bankrupt company, with no loss reported. Seems fair!

As always, the best way to rob a bank is to own a bank.

Second best way is to find a really big bank to buy up all the crap loans you originate, and that’s where Credit Suisse comes in. After the GAM debacle in early 2019, there was zero question that the loans Greensill had been selling to Credit Suisse since 2017 were just as stinky as the loans they had sold to GAM. And yet Credit Suisse did … nothing. Actually, that’s not fair. They purchased MORE of the securitized loans from Greensill than ever before. They marketed their funds HARDER than ever before. I’m sure it’s just a coincidence that Softbank put $500 million into the Credit Suisse funds after their Greensill investment. I’m sure it’s just a coincidence that Credit Suisse and Greensill found a Japanese friend-of-Softbank insurer, Tokio Marine, willing to put a wrapper around the Greensill loans so that Credit Suisse could market these funds as … wait for it … safe-as-houses money-market equivalents.

Money quote from an investor in this $10 billion Credit Suisse fund family, per the FT:

“You thought you were in an arm’s length arrangement where all your fellow investors had a pure financial interest,” he said. “Imagine you then found that, in fact, some of your co-investors were funding themselves.”

Yep, imagine that. Like I say, it’s a story as old as capital markets.

And then the house of cards came tumbling down. Something spooked Tokio Marine (they’re now putting the blame on a “rogue underwriter”), and once the insurance wrapper came off, Credit Suisse professed shock … shock, I tell you! … as they suspended redemptions from the funds (LOL) and announced a hard-hitting internal investigation into how it was possible that this could have happened. I’m sure they’ll find a rogue portfolio manager. And then Credit Suisse dropped a dime to the German bank regulators, BaFin, who after the Wirecard debacle were apparently only too eager to show that they weren’t totally corrupt and incompetent.

So here we are. The ECB is now asking whether or not the situation is “contained”. Apollo is apparently going to buy the shell of the Greensill trading platform for less than $100 million (valuation was >$4 billion last year), and bury this as deep into the bowels of the Earth as it is possible to be buried. Pretty much all of the Greensill directors have resigned, including Lex’s brother (I guess Elon is not the only one who like to keep board seats in the family). And I am certain that we will hear from the ECB and other bank regulators tomorrow that the situation IS, in fact, contained.

Unless Lex Greensill flips on Masayoshi Son at Softbank or Bill Ford at General Atlantic or ex-UK Prime Minister David Cameron. Unless the beneficiary Softbank companies can’t find short-term financing. Unless there’s a bad email at Credit Suisse.

Will all this be swept under the rug? Maybe. But then again, maybe not. In any event, this is the first Big Fraud I’ve seen in 13 years with the sheer heft and star power to ripple through markets in a systemic way. Not since Madoff.


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The Fed’s Kryptonite

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This piece is written by a third party because we think highly of the author and their perspective. It may not represent the views of Epsilon Theory or Second Foundation Partners, and should not be construed as advice to purchase or sell any security.



Overview

Last November in Blue Wave I wrote:

“The coming stimulus isn’t a panacea! It means massive deficits will persist. They will require higher taxes and incredible amounts of US Treasury issuance. Higher TAXES and rising LONG-YIELDS (all else equal) are the price for stimulus. The former drags on growth and earnings while the latter will require a Fed response that occupies its balance sheet. If the Fed does not act, higher yields will derail risk assets, just as they did at the end of 2018.”

For months, I’ve written that equity market participants have been ignoring the possible tradeoffs that come with massive stimulus: higher taxes and higher yields. I have strongly suggested that stimulus won’t place the economy back on some exceptional pre-pandemic growth trajectory. Sustainable growth comes from innovation and productivity gains – not from stimulus checks. Moreover, I have argued that the Fed’s ability to stimulate (asset prices or the economy) has been limited because rates and yields are already so close to zero. For some time, I have reasoned the risk of a rise in yields has been asymmetrically high.[1] Now that I believe the risk of non-transitory inflation is elevated without the durable and sustainable growth to justify it (a change in view), the Fed is confronted with an even thornier problem. In stark contrast to my view, the popular meme has suggested fiscal policy wouldn’t have any negative impacts, and equities would continue to rise on the multiple expansion that low rates would assure.[2]

Yesterday, as the 10-year yield hit 1.6%, equities sold off. How much higher might yields go? Something as seemingly straightforward as the impact of inflation on bond yields is the subject of debate in academic circles. Thank goodness I’m not an academic; I care about what makes sense rather than about defending any particular school of thought. The first order effect of inflation on yields (‘reflation’) has merit, but it has its limits. Based upon Fisher’s real rate of interest framework, and despite the obvious shortcomings of his Quantity Theory of Money (QTM), this idea is generally accepted.[3] However, one must consider other factors. Ultimately, the analysis of yields must center on market participants’ expectations for the Fed’s reaction to both inflation and Treasury supply. Said differently, term premia depend largely on uncertainty around the future path of rate policy. For now at least, it appears the current pace of Fed purchases isn’t keeping yields in check. Under current circumstances, inflation is the Fed’s kryptonite.


Discussion

Let’s discuss three forces that may move Treasury yields; they are interdependent. First, there’s inflation. Next, there’s Treasury supply. Third, there’s the Fed reaction function, which ultimately plays the most crucial role. What about the idea taught in college neoclassical economics class that the interest rate is the clearing price for money at which savings equals investment?[4] This kind of market determined interest rate equilibrium exists only in a reserve constrained regime (i.e. –gold standard), in which the monetary policy authority does not set the price (i.e. – interest rate). Today, the Fed serves as a monopolistic price setter of interest rates. By deciding how it conducts OMOs (open market operations; i.e. – the scope and duration of Treasury purchases), the Fed influences bond prices and sets interest rates. Quantitative easing is a form of OMO that acts directly on long yields, whereas traditional OMOs (in a system with fewer reserves) acted on short-duration Treasuries.[5] Consider this: theoretically, if there were no Treasury issuance, the Fed could simply create reserves and use those reverses to directly fund Treasury deficits.[6] It could do so without Treasury issuance and without creating reserves to buy those Treasuries. However, Treasury issuance and the Fed’s operations around it are the principle determinant of yields across the curve. QE was a game changer.[7]

Inflation is the only wildcard that might interfere with its game plan. As I discussed in my most recent paper Inflation Perspiration, I’m now concerned about inflation for the first time since the GFC ended. Fed communications that it intends to tolerate inflation above target under its new average inflation targeting framework will only go so far. It’s rarely had to deal with fiscal policy stimulus well in excess of what is necessary to close the output gap. Exacerbating this dynamic are still challenged supply chains. We are seeing this in semiconductors. Commodities, too, are screaming inflation, as the fiscal stimulus and supply chain disruptions are global in scope. The Fed might want to have a conversation with the executive branch to indicate that a policy mistake could lead to inflation that forces a hike or leads to higher market yields about which the Fed decides to do nothing. Markets do that: they correct for interventions by acting in unforeseen ways. In this case, the reflexivity is occurring in yields. In coming days, it will be interesting to see whether or not the belly of the curve begins to flatten. The belly tends to move first, and if 5-year yields begin to pick up relative to 10s, then it may indicate that expectations about the probability of a hike are increasing. If 5-10 continues to steepen, it could indicate that the rise in 10-year yields is more about fears about supply.[8] Either way, long-duration yields and term premia reflect uncertainty around the path of future rate policy.

Bond Yields: Inflation

Let’s first consider inflation and how it might work to impact Treasury yields by first order effect through inflation (Fisher). Consider this identity:

i = r* + E(π) where i = nominal rate, r* = the real rate, and E(π) = expected inflation.

One needn’t accept QTM, for this framework to be useful. By this definition, an inflation expectation is built into nominal yields, but it’s important to recognize that this expectation may be adopted over time as inflation becomes self-reinforcing. Arguably, yields represent the opportunity cost associated with 1) choosing saving versus consuming or 2) choosing one form of savings versus another.[9] What is the market mechanism by which yields adjust to inflation? When some economic actors perceive durable or storable goods as being more expensive in the future, their preference may shift from saving (in the form of Treasuries) to buying those goods now. That is to say, the fixed income from the Treasuries will buy less of the same refrigerator later. For this reason, they might sell Treasuries, convert them to cash, and use the cash to buy a fridge. As these expectations are adopted, more market participants sell their Treasuries, this will result in successively lower prices for Treasuries (higher yields) until the yield is eventually high enough that it meets the market expectation for inflation. A new market consensus about future inflation brings yields to a new equilibrium (all else equal and with no government intervention).[10] This is but one dynamic.

The owner of Treasuries foreseeing inflation may also decide, rather than change his/her preference to consume rather than save, to change the form of savings. Logically, s/he may wish to own an asset whose stream of cash flows (unlike Treasury bond) changes with inflation. Perhaps commercial real estate with short term leases or LIBOR based loans might fit that bill. Even when reframed as Keynes might, the reason for this change in ‘liquidity preference’ is because that person wants to transform the Treasury into cash and (quickly) redeploy the cash into an asset that benefits from inflation. No matter how it’s cast, it seems plausible that yields may rise with inflation because the cash flow from Treasury ownership is less valuable in real terms.[11] In this way, inflation, disinflation and deflation may still exert some power over yields. In turn, as yields rise as part of this dynamic, this may tighten financial conditions enough to reflexively control demand-driven inflation without Fed intervention.[12] Perhaps, the Fed will allow that now.

Bond Yields: Reaction Functions

There’s a second order effect of inflation: it causes the Fed to react – creating uncertainty around the future path of rates and yields. It’s likely even more important than inflation’s first order impact, as the Fed has an arsenal of tools designed to manage rates and yields (including unlimited reserve creation as part of QE). Thus, what rising long-yields and greater term premia are saying is that the bond market expects inflation to prompt the Fed to raise rates. Mathematically, yields over ‘n’-periods are given by the geometric average of the short rates that prevailed in each period. Thus, if the expectation is for persistently low short-rates, long-yields should be anchored to that expectation.

There’s another way to think about this through bond market dynamics. If bond investors are confident the Fed won’t hike, they will buy the long-end and sell short the short-end to fund the purchase. In turn, this carry trade arb knocks down long yields towards funds. The more certain market participants are that Fed funds in anchored, the less term premium remains after the arb occurs. The risk to the carry trade always comes from a change in the cost of funding (short rates). This arbitrage is a form of duration transformation, and so is QE. When the Fed ‘quantitatively eases,’ it takes the following steps: 1) it creates excess reserves (i.e. – issues FRNs or cash); 2) it creates a reserve liability on its balance sheet; and 3) it buys Treasuries with the excess reserves. All of this effectively funds short (issues FRNs) to buy long and transforms the duration of longer-duration Treasuries into that of cash (i.e. – none). The Fed’s willingness to do this ‘arb’ is only constrained by its own expectations about inflation!

For this reason and others, the Treasury yield curve likely does not steepen as much as we’ve seen it historically. We usually see 3-month 10-year spread above 300 basis points at its widest. We’ll be lucky to see it above 200 basis points this cycle. It certainly can’t bull steepen anymore with funds at zero. The bear steepening will be self-moderating because the market and economy can’t take a move much above 2% on the 10-year, as the regression in Figure 1 shows. Lastly, were the steepening to persist for too long on persistent inflation, the Fed might be forced to hike, but it would be more likely that higher long-yields would do the Fed’s work for it. Bond volatility hit its low last September and again in March. Exhibit 2 of the Appendix may provide some context for just how much bond volatility the Fed is willing to tolerate. It seems like the MOVE index could go back to the 90, which is the regression prediction.

Bond Yields: Taper Tantrums

The Fed reaction function is also important when it comes to absorbing Treasury supply.[13] ‘Taper tantrums’ are yet another way to characterize what happens when there’s uncertainty about the path for future policy. This is what market participants generally talk about when they speak of the ‘taper tantrums’ during periods like 2013 and 2018.[14] In 2018, yields rose to 3.25% at the end of the year. It wasn’t Fed policy in reaction to inflation that did it, it was the Fed’s attempt to normalize its balance sheet. It perceived inflation was persistent enough for it to begin selling its Treasuries just prior to maturity. PCE had been above 2% since July 2018, so the Fed maintained its confidence about taper in its December meeting. A taper tantrum followed this stubborn communication around the trajectory of policy. Equities sold off, and yields reflexively fell in response to this risk off. This led to an early 2019 inversion of the U.S Treasury yield curve. Because financial markets and the banking system, upon which the economy relies, don’t function well with an inverted curve, the Fed does not tolerate it for long.

Figure 1 shows the downtrend in 10-year yields since 1994 (RH; orange). That downtrend is banded by a regression at 1SD (yellow) and 2SD (red). The regression suggests that about a month to 6-months after an extreme (2SDs) in yields, equity market corrections occur.  We observed this in early 2000, mid-2007 and 2018. In turn, a yield curve inversion often follows, and the Fed is often forced to cut. That cut normally results in a bull steepening. It’s also interesting to observe that yields typically fall after the initial and extreme move above trend only to rebound to just above the trend prediction (blue dotted), just as they did in 2001 and 2008. Yields appear to be doing something similar now. In those instances, equity selloffs persisted. Here’s where the reflexivity comes in again: if equities sell off further, they may do some of the Fed’s work for it. Capital may flow back into Treasuries from equities and may drive 10-year yieldsdown – perhaps, even enough that the Fed does not need to increase the pace of bond purchases. The difference now is that yields are already so close to zero in the ZIRP (zero interest rate policy) world.

Convexity hedging is another reaction function, which is often discussed when yields begin to rise quickly. This one is market based. At times it’s overblown, but in light of how active the mortgage market has been at such low rates, it’s worth discussion here. Unlike most bonds, mortgages demonstrate negative convexity. Convexity is the rate of change in duration when prices change. When rates fall, mortgages tend to be prepaid and refinanced. This shortens portfolio duration (negative convexity). As rates rise, and holders of mortgage securities see the duration of their portfolios increase, they sell Treasuries to shorten the duration of their portfolios. Exacerbating the dynamic now are low bond yields; convexity is higher when interest rates are lower. Thus, smaller moves in yields mean a bigger change in portfolio durations and require more Treasury sales. At times, this activity may exacerbate moves in the Treasury market. The Fed plays a role here, too, as it owns ~35% of the MBS market and it does not hedge.

Bond Yields: Equities

I have often rebutted the argument that low rates and yields mean higher P/Es as a matter of logic. They don’t, and higher yields because of inflation without durable growth are unwelcome in equity markets. First, low yields do not drive multiples higher. Only lower yields can do that. Near the S&P’s recent high, the 10-year yield was at 61bps. Last I check ed, Fed funds have been near zero for quite some time. Second, P/Es (once converted to equity yield) can’t be compared to Treasury yields until after adjusting for inflation. Only when real yield moves lower is inflation good for equities relative to Treasuries. Currently, real yields are creeping higher. Third, an assessment of P/Es requires not just a comparison to real rates, it also depends on what market participants require as an equity risk premium (ERP), which moves with expectations for earnings.[15] Surprisingly, required real ERP for equity investors has been increasing since 1990. As it has since July, Exhibit 1 of the Appendix shows that ERP (red) looks quite expensive. It is currently about 1.5SD rich to the regression prediction line (lower ERP indicates less premium and, thus, more expensive).

Not all equities will be impacted alike if inflation presents more persistently than most believe. Mature large, cap technology companies whose revenues streams from the cloud and subscription software services and whose cash flows are more like bonds than equities may be impacted more than growth technology names. Likewise CRE REITs whose portfolios have sticker, long-term leases and utilities won’t fair as well in an inflationary environment. Cyclical commodity and energy companies could benefit, albeit, eventually inflation makes life difficult if costs can’t be passed through to customers. Small caps, in particular, remain recklessly overvalued as retail flows have inflated their values.


Conclusion

The economy and markets are highly sensitive to interest rates and yields. The equity market’s reaction to 10-year yields at just over 3% in 2018 seems to provide some anecdotal evidence of this. The Fed will try to avoid persistently higher yields at all cost; normally QE would enable the Fed to fund short to buy long and keep bond yields under control. However, inflation complicates its motives. Profligate fiscal policy, unlike monetary policy, can be quite effective at prompting an inflationary overheat if the stimulus significantly enough exceeds the amount of the output gap. The first two rounds of stimulus have largely filled that gap. With annualized fourth quarter 2019 GDP at $21.75 trillion versus annualized fourth quarter 2020 GDP at $21.49 trillion, down 1.2% year-over-year, there is a good chance that another $1.9 trillion in fiscal spending will put year-over year GDP growth up between 6% and 7%. Moreover, the release of 50% of pent up savings (currently 13% of disposable income) could release another $250 billion into the economy.

Inflation caused by demolition of the output gap could be exacerbated by supply chains that are just now starting to heal from a supply-side shock. In semiconductors, the cause of the current shortage is a mixture of factors: demand spikes for consumer electronic products like laptops due to the pandemic-driven WFH trend, slowdowns in chip production also caused by the pandemic, bottlenecks due to an outsource of chip production to firms like Taiwan Semiconductor Manufacturing Company (TSMC), and lingering effects from the trade war. These shortages alongside a rally in commodity prices (supported by global stimulus especially in China), could make inflation more persistent as supply chains take time to heal. The Fed is in a tough spot. Where’s Lois Lane when you need her?


Appendix

Exhibit 1: ‘Real’ Equity Risk Premium (blue) Shows Equities Are > 1SD Rich versus Trend

Exhibit 2: BofA MOVE Index versus the VIX

Disclaimer

AlphaOmega Advisors, LLC (AOA) does not conduct “investment research” as defined in the FCA Conduct of Business Sourcebook (COBS) section 12 nor does AOA provide “advice about securities” as defined in the Regulation of Investment Advisors by the U.S. SEC. AOA is not regulated by the SEC or by the FCA or by any other regulatory body. Nothing in this email or any attachment to it shall be deemed to constitute financial or other professional advice, and under no circumstances shall AOA be liable for any direct or indirect losses, costs or expenses that results from the content of this email or any attachment to it. AOA has an internal policy designed to minimize the risk of receiving or misusing confidential or potentially material non-public information. The views and conclusions expressed here may be changed without notice. AOA, its partners and employees make no representation about the completeness or accuracy of the data, calculations, information or opinions included in or attached to this email, is based on information received or developed by AOA as of the date hereof, and AOA shall be under no obligation to provide any notice if such data, calculations, information or opinions expressed in this email or any attachment to it changes. Any such research may not be copied, redistributed, or reproduced in part or whole without AOA’s express written permission. The prices of securities referred to in any research is based on pricing as of the date the research was conducted, may rise or fall at any time thereafter, and past performance and forecasts should not be treated as a reliable indicator of future performance or results. This email and any attachment to it is not directed to you if AOA is barred from doing so in your jurisdiction. This email and any attachment to it is for informational purposes only and does not constitute an offer or solicitation to buy or sell securities or to enter into any investment transaction or use any investment service. AOA is not affiliated with any U.S. or foreign broker dealer. AOA or its principals may own securities discussed herein.


Notes

[1] Please see Check In: To Infinity and Beyond, August 17th, 2020 and see Exhibit 2 of the Appendix.

[2] I have continuously asserted that low rates alone do not lead to multiple expansion; only lower rates can do that and only assuming that risk premia stay constant. So close to the zero bound, traditional policy is stuck.

[3] As Eric Tymoigne of the Levy Institute argues: “Changes in interest rates do not reflect changes in the opportunity cost induced by inflation in the present/future consumption arbitrage, they reflect changes in uncertainty that affect the stock equilibrium between liquid and illiquid assets.” As it turns out, this statement is far less profound than it first appears because, as he later states, “[the] condition of indifference [due to expectations for changes in interact rates] may include the concerns about inflation via the introduction of an inflation premium in nominal rates, but these concerns are included in the broader concerns of liquidity and solvency.”

[4] This identity holds in a closed economy.

[5] The plethora of system reserves necessitated a shift to the use of IOER as the Fed’s principal tool to manage to the funds target rate.

[6] Of course, this isn’t the way the system works!

[7] QE also helps the Fed signal its commitment to its policy to keep rates anchored.

[8] The two are not mutually exclusive as long-yields are the geometric average of short-yields.

[9] Keynesians disagree on what I take to be a technicality.

[10] This of course, assumes that different market participants have different expectations for inflation. I don’t see this as a fallacy of composition, as this is often the way markets work as they move in and out of equilibria, which are something of an academic fiction and if they do exist are usually short-lived, as George Soros argues in his Alchemy of Finance.

[11] As I will point out, it is the comparison of real 10-year yield to earnings yield that may make equities less attractive relative to bonds as inflation rises – but only if real yields are rising, too. There are also other factors to consider.

[12] On the other hand, some believe that most inflation comes from supply shortages that tighter financial conditions will only exacerbate by constraining supply further (i.e. – limiting the availability of loans that might be used to increase capacity). This is the flip side of the argument I’ve been making that low rates create overcapacity that keeps inflation low.

[13] This could also be looked at as constraining the supply to non-Fed buyers.

[14] Risk-asset markets rallied significantly because the Fed was focused on lowering yields on MBS, and that QE program purchased mostly MBS securities. This program had palpable economic impact through lower borrowing costs for homes. Recall that this program was announced in September 2012, and while focused on MBS, it also helped keep longer-dated yields down – that is, until the Fed announced a taper in June 2013. The 10-year yield rose quickly in expectation of taper and the Fed was ultimately forced (in September 2013) announce no taper would occur and the 10-year yield fell again throughout 2014.

[15] ERPf =E/Pf – (Y – E(π)) where E/Pf is the forward earnings yield, Y is the nominal yield, and E(π) is expected inflation.


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A Change in the Water

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Every morning, we take the previous day’s financial news – all of it – and run it through the Narrative Machine to see if any interesting clusters pop out as a topic for us to write about in one of these quick Zeitgeist notes. And when I say clusters, I literally mean clusters – the building blocks of a graphical representation of linguistic connectivity.

But when I say clusters, what I really mean is patterns. I really mean changes in the narrative structure.

We’re not doing this to learn new facts. We’re not really interested in the specifics of what people are saying. We are very interested, though, in how people are saying it. We’re looking for changes in how we talk about what is important in markets and investing.

We’re looking for changes in the water in which we swim.

That water is changing today. It’s changing a lot.

Increasingly, the common knowledge of our investment world – what everyone knows that everyone knows – is that inflation is a problem and you should be focused on it.

For example, today in a popular financial news media aggregator, RealClearMarkets.com, of the 21 articles highlighted on their frontpage aggregator, 6 of them were about inflation … is it here? is it coming? what does it mean for your portfolio? does Bitcoin fix this? etc. etc.

Again, I have zero interest in the specifics or the facts or the message or the sentiment of these selected articles (even though one of them was yesterday’s Epsilon Theory note). What interests me a lot, though, is the CHOICE made by the editors and algorithms of RealClearMarkets.com to select these articles over all of the other financial news stories available to them. What interests me a lot is the recursive ENGAGEMENT that these articles and their shared linguistic structures trigger in readers, such that they will look for more articles on this topic, which means that more articles on this topic will be written. This is how common knowledge happens. This is how the water in which we swim changes.

Now, you might personally believe that inflation is NOT a big deal or a big concern. That’s fair. Reasonable people can disagree on this. You might also look at the consensus about inflation in this metric or that metric and similarly conclude that inflation is NOT a big deal or a big concern. Also fair.

Fair. But it doesn’t matter. At least not for making money. Neither what you personally believe (what Keynes called 1st-level decision making in the famous game theory example he called the Newspaper Beauty Contest) nor what everyone apparently believes (the consensus, or what Keynes called 2nd-level decision making) will make your investment decisions work out successfully for you.

The thing that moves markets – the thing that will make your investment decisions work out successfully for you – is what everybody believes that everybody believes.

It’s 3rd-level decision making. It’s common knowledge.

This has been the core message of Epsilon Theory from the start. This IS the Manifesto. Over the past eight years, we’ve published more than 1,000 notes on Epsilon Theory, and every single one of them starts here.

The Epsilon Theory Manifesto

Our times require an investment and risk management perspective that is fluent in econometrics but is equally grounded in game theory, history, and behavioral analysis. Epsilon Theory is my attempt to lay the foundation for such a perspective.

Today we’re building an active community of investors and citizens who see the world through the clear eyes of narrative and common knowledge. And more importantly, treat each other with full hearts. Clear eyes, full hearts, can’t lose!

I think that the Epsilon Theory Pack can work together to understand what’s really happening with inflation in both real-world and narrative-world, and then figure out effective investment strategies to deal with it.

If you want to read more about what we’re doing and why we’re doing it, here you go:

The Opposite of 2008

In 2008, the US housing market – together with a Fed that thought the subprime crisis was “contained” – delivered the mother of all deflationary shocks to the global economy.

In 2021, the US housing market – together with a Fed that thinks inflationary pressures are “transitory” – risks delivering the mother of all inflationary shocks.

And if you’re interested in digging even deeper to find out how the Narrative Machine can help with your investment decisions, please consider ET Professional. If you send an email to [email protected] we’d be happy to share some of our research and monthly narrative Monitors to see if it’s a useful research service for you. It’s not inexpensive ($2,950/yr), but the license covers a small investment team and, in the immortal words of Don Barzini, we are not Communists!



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The Opposite of 2008

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In late 2007 I started counting the For Sale signs on the 20 minute drive to work through the neighborhoods of Weston and Westport, CT. I’m not exactly sure why it made my risk antenna start quivering in the first place … honestly, I just like to count things – anything – when I’m doing a repetitive task. Coming into 2008 there were a mid-teen number of For Sale signs on my regular route, up from high single-digits in 2007. By May of 2008 there were 35+ For Sale signs.

If there’s a better real-world signal of financial system distress than everyone who takes Metro North from Westport to Grand Central trying to sell their homes all at the same time and finding no buyers … I don’t know what that signal is. The insane amount of housing supply in Wall Street bedroom communities in early 2008 was a crucial datapoint in my figuring out the systemic risks and market ramifications of the Great Financial Crisis.

Last week, for the first time in years, I made the old drive to count the number of For Sale signs. Know how many there were?

Zero.

And then on Friday I saw this article from the NY TimesWhere Have All the Houses Gone? – with these two graphics:

I mean … my god.

Here’s where I am right now as I try to piece together what the Opposite of 2008 means for markets and real-world.

1) Home price appreciation will not show up in official inflation stats. In fact, given that a) rents are flat to declining, and b) the Fed uses “rent equivalents” as their modeled proxy for housing inputs to cost of living calculations, it’s entirely possible that soaring home prices will end up being a negative contribution to official inflation statistics. This is, of course, absolutely insane, but it’s why we will continue to hear Jay Powell talk about “transitory” inflation that the Fed “just doesn’t see”.

2) Cash-out mortgage refis and HELOCs are going to explode. On Friday, I saw that Rocket Mortgage reported on their quarterly call that refi applications were coming in at their fastest rate ever. As the kids would say, I’m old enough to remember the tailwind that home equity withdrawals provided for … everything … in 2005-2007. This will also “surprise” the Fed.

3) Middle class (ie, home-owning) blue collar labor mobility is dead. If you need to move to find a new job, you’re a renter. You’re not going to be able to buy a home in your new metro area. That really doesn’t matter for white collar labor mobility, because you can work remotely. You don’t have to move to find a new job if you’re a white collar worker. Or if you want to put this in terms of demographics rather than class, this is great for boomers and awful for millennials and Gen Z’ers who want to buy a house and start a family.

4) As for markets … I think it is impossible for the Fed NOT to fall way behind the curve here. I think it is impossible for the Fed NOT to be caught flat-footed here. I think it is impossible for the Fed NOT to underreact for months and then find themselves in a position where they must overreact just to avoid a serious melt-up in real-world prices and pockets of market-world. Could a Covid variant surge tap the deflationary brakes on all this? Absolutely. But let’s hope that doesn’t happen! And even if it does happen, that’s only going to constrict housing supply still more, which is the real driver of these inflationary pressures.

Bottom line …


I am increasingly thinking that both a Covid-recovery world AND a perma-Covid world are inflationary worlds, the former from a demand shock and the latter from a supply shock to the biggest and most important single asset market in the world – the US housing market.


It’s just like 2008, except … the opposite.

In 2008, the US housing market – together with a Fed that thought the subprime crisis was “contained” – delivered the mother of all deflationary shocks to the global economy.

In 2021, the US housing market – together with a Fed that thinks inflationary pressures are “transitory” – risks delivering the mother of all inflationary shocks.

It’s the only question that long-term investors MUST get right. You don’t have to get it right immediately. You don’t have to track and turn with every small movement of its path. But you MUST get this question roughly right: Am I in an inflationary world or a deflationary world?

And yes, there’s an ET note on this. Because the Fourth Horseman is inflation.

Things Fall Apart – Markets

The Fed, China and Italy are the Three Horsemen of the Investment Semi-Apocalypse. They’re major market risks, but you’ll survive.

There’s a Fourth Horseman. And it will change EVERYTHING about investing

From that note, here’s what I think preparing your portfolio for an intrinsically inflationary world requires:

  • Your long-dated government bonds will no longer be an effective diversifier, and should be a tactical rather than a core holding. They’ll just be a drag. I bet they’re a big portion of your portfolio today.
  • Highly abstracted market securities will be very disappointing. Even somewhat abstracted securities (ETFs) won’t work nearly as well as they have. You’ll need to get closer to real-world cash flows, and that goes against every bit of financial “innovation” over the past ten years.
  • Real assets will matter a lot, but in a modern context. Meaning that I’d rather have a fractional ownership share in intellectual property with powerful licensing potential than farm land.
  • The top three considerations of fundamental analysis in an inflationary world: pricing power, pricing power, and pricing power. I could keep writing that for the top ten considerations. No one analyzes companies for pricing power any more.
  • When everyone has nominal revenue growth, business models based on profitless revenue growth won’t get the same valuation multiple. At all. More generally, every business model that looks so enticing in a world of nominal growth scarcity will suddenly look like poop.
  • Part and parcel of a global inflation regime change will be social policies like Universal Basic Income. I have no idea how policies like that will impact the investment world. But they will.
  • Most importantly, the Narrative of Central Bank Omnipotence will be shaken … maybe broken. Central Banks will still be the most powerful force in markets, able to unleash trillions of dollars in purchases. But the common knowledge will change. The ability to jawbone markets will diminish. We will miss that. Because the alternative is a market world where NO ONE is in charge, where NO ONE is in control. And that will be scary as hell after 10+ years of total dependence.

That’s what I wrote in 2018, and I still believe all that today. But here’s the thing …

Just as in 2008, a lot of the ramifications of this insane shift in available housing supply will only reveal themselves over time. We won’t be able to predict all of the market-world and real-world shocks, we will only be able to expect them. We will only be able to observe and respond to them.

This is the Three-Body Problem.

The Three-Body Problem

What if I told you that the dominant strategies for human investing are, without exception, algorithms and derivatives? I don’t mean computer-driven investing, I mean good old-fashioned human investing … stock-picking and the like. And what if I told you that these algorithms and derivatives might all be broken today?

There is no predicting what will happen in markets. There is no closed-form solution for figuring out an investment strategy that will thrive in a transition from a deflationary world to an inflationary world. There is only observation and response. Sorry.

And there’s no way that any one of us – no matter how open and aware we are to the changes that may be coming down the pike – can observe and respond to everything that is important to observe and respond to. But together? Aided by new tools and technologies that we call the Narrative Machine? Yeah, I think that can work.

I think that the Epsilon Theory Pack can work together to collect information on what’s really happening in both real-world and market-world, and then figure out effective strategies to deal with it.

I don’t want to crowd-source an investment strategy for a shift from a deflationary world to an inflationary world. I want to Pack-source it. 



Over the past two months, we’ve set up an online platform for paid Epsilon Theory subscribers that we call the ET Forum. It’s like Clubhouse, except that it’s, you know, actually our clubhouse, a safe space for thousands of ET-subscribing, full-hearted citizens and investors to share their efforts to see the world in a more clear-eyed way.

The ground rule for the ET Forum is the golden rule – treat everyone as you would wish to be treated. You are welcome to talk about markets, but please don’t be a raccoon. You are welcome to talk about politics, but please don’t be a rhinoceros. Anonymity is fine, although we hope (and believe) that you will make some strong friendships here. I know that I have!

As I write this note, there are hundreds of Pack members on the ET Forum actively researching how to observe and respond to a shift from a deflationary to an inflationary world, ranging from lawyers looking at changing trends in personal bankruptcy filings to realtors looking at changing trends in real estate transactions to investment analysts researching everything from gold miner capital allocation decisions to construction equipment rental utilization rates. Actually, that last one is mine, and if anyone has data on JLG aerial lift platform backlogs (i.e., is the McConnellsburg, PA parking lot filled with scissor lifts or totally empty, and what color are they painted?) I am all ears.

We call ourselves the Epsilon Theory Pack, because The Long Now is going to get a lot worse before it gets any better, and there is strength in numbers. Watch from a distance if you like, but when you’re ready … join us

Clear eyes, full hearts, can’t lose.


50+

Subprime is Contained

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This is my favorite photo of Ben Bernanke. It’s his last day as Fed Chair, and he’s leaving his office at the Federal Reserve Building in DC for the last time, pressing the elevator button as the doors close smoothly shut. There’s something about his expression and quiet smile here that’s just … everything … even though this is some months before his formal announcement that it would be unseemly for him to go work with any of the banks he regulated and so he’d be joining <<checks notes>> Citadel in an exclusive engagement as a “special advisor”.

I wonder if they got this photo in one take, or if they had to take multiple shots? Anyhoo, I digress.

I was thinking about Bernanke because of what he said multiple times in 2007, that subprime mortgage delinquencies, while “troubling”, would be “largely contained”, and that the Fed “sees no serious broader spillover to banks or thrift institutions from the problems in the subprime market.” It’s a famous line, of course. Infamous, I suppose.

I think what Jay Powell is currently saying about inflation and it being “transitory” may turn out to be equally infamous, and that Powell’s failure to react to soon enough to an inflationary storm may be as damaging as Bernanke’s failure to react soon enough to a deflationary storm. But that’s just my opinion. What is not my opinion, however, is that the financial media and our dominant narratives about the Fed are similarly focused on the timing of the Fed’s first tightening move.

Let me repeat that for emphasis: the narrative around the Fed is no longer IF the Fed will tighten, but WHEN the Fed will tighten.

After flirting with a narrative regime change for a couple of months, our Central Bank Narrative Monitor has now decidedly flipped from an Inflation-Focused regime to an outright Hawkish regime.

That’s not good for markets. The narrative tailwind we have measured and written about since April 1 is now a narrative headwind.

To be clear, we don’t see this as a strong headwind … yet. All of the narrative archetypes we measure around both central banks and security analysis are very weakly expressed these days, so this Hawkish narrative is just the most muscular of a puny lot. What that means in practice is that there is no common knowledge or even rough consensus on when the Fed will tighten. There is still plenty of room for Powell and crew to jawbone this into a happy place, to “soothe the market” as the Wall Street Journal likes to say. Seriously, it’s their go-to phrase now whenever they write about Powell. Did he “soothe the market” or not? Again, I digress.

If you think that market-world fundamentally changed over the past week or two, you are absolutely correct. The market narrative has shifted significantly, as every macro event will now be judged against a backdrop of “does that increase or decrease the chances of market-negative action by the Fed” as opposed to the decade-long dominant backdrop of “does that increase or decrease the chances of market-supportive action by the Fed”.

Put in a slightly different way, the best that the market is hoping for from the Fed today is that they won’t disappoint us too badly. There’s no stimulus to be had, no liquidity program to be administered. A Hawkish narrative regime means that we’re expecting bad news from the Fed sooner or later, and a weakly expressed Hawkish regime only means that there’s no agreement on whether that bad news will come sooner or later or much later, or whether failure to deliver the bad news sooner or later or much later is a good thing or a bad thing.

There’s lots of room in narrative-space today for Powell to “soothe the market” about inflation and bond yields.

You know, just like Bernanke soothed the market about subprime and mortgage-backed securities.


[Next day follow-up]

My Twitter friend Jeff Macke (yes, that Jeff Macke of the infamous CNBC meltdown 10 years ago … really impressive how he’s gotten his life back on track), posted these screenshots yesterday under the heading “These aren’t confident reactions to positive news.” So right.

Neither Target nor Zoom had a bad earnings call afterhours on Monday. No, no. They had good earnings calls after the close on Monday, with both stocks moving sharply higher in afterhours trading. These were no-questions-asked, beat-and-raise earnings announcements.

And then Tuesday morning pre-open you had some ‘yes, but’ sell-side analyst reports. And then Tuesday you got this … debacle.

I’m posting this as a follow-up to Monday’s note – “Subprime is Contained” – because this is a micro version of the macro environment I was talking about in that note … when the narrative hits an inflection point, when it goes from holding water to spilling water, when it goes from expecting a market-positive future to expecting a market-negative future … then mere good news is no longer enough to make the price go up! It’s got to be dramatically and surprisingly good news. There can’t be a whiff of ‘yes, but’ in the news flow, or you get demolished.

Woof. We’ve all been there with a stock we’re long, where you listen to the earnings announcement and it’s all good and the analysts are asking their “congrats on the quarter” questions and management is upbeat about guidance and the stock is trading up after hours on some decent volume and you’re just positive you’re going to make some serious coin tomorrow and then … WHAM.

Unfortunately I think that’s what is in store for us on a portfolio level and a macro level in the weeks and months ahead.


 

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