LOOKING FOR FLOATING BODIES
Since Chairman Powell’s press conference in early May, it has been clear to us that the Fed is committed to fighting inflation at all costs. Their resolve over the last month and half has only increased and can now be characterized by the metaphor of submarine hunting by dropping larger and larger depth charges into the water in search of enemy subs. The problem with this approach is that besides hitting enemy subs, those depth charges might also kill a host of other living creatures when they go off. We’ll only know when the bodies float to the surface.
Low rates and excess cash have created a fertile environment for risk taking. The term TINA (There Is No Alternative) was coined to describe the attraction of equities in a zero-interest rate world. To be clear, TINA is not a fundamental driver. It is the result of a perverse set of incentives that sows the seeds for asset bubbles. It’s not just equities that are at risk, other asset classes and investment schemes may set off a series events that cascades into equities as it did the Great Financial Crisis.
Hyman Minsky outlined a theory in 1992 titled the “Financial Instability Hypothesis,” arguing that financial bubbles are inevitable. The hypothesis states that during times of growth and easy money, investors increasingly extend themselves in an attempt to capture perceived easy profits, leading to an inherently instable system when underlying conditions change. Minsky went on to describe financial bubbles forming and unwinding in a five-step process:
1. Displacement
Investors latch on to a “new paradigm” that “changes everything”
2. Boom
Excitement over the “new paradigm” leads investors to chase a groundbreaking “opportunity”
3. Euphoria
Everything works, there’s easy money to be made, heroes and icons are born
4. Profit Taking
Fundamental conditions change, the smart money recognizes it and starts to look for the door
5. Panic
High profile failures begin to emerge, and everyone rushes for the exit at the same time as the walls cave in
The most salient example in the recent history highlighting Minsky’s theory in action was the Great Financial Crisis, which was set off by a collapse in subprime debt. As we recount the story, it’s aery how well the story rhymes with some of the tunes we have heard in the last few years. The subprime market was virtually non-existent before the early 2000’s when lenders, spurred by low rates and innovative new products, were able to entice low quality borrowers to invest in assets utilizing a newly adopted tool, Adjustable Rate Mortgages (ARMs), which promised to revolutionize lending. Innovative financial structures were created leading to the swelling of a new segment of Wall Street which operated with bold new lexicon. The products and tools they used were adopted as mainstream along with an alphabet soup of asset backed securities such as CDO and CLOs designed to packaged mortgages. These collections of low-quality debt promised to use algorithms to segment the riskiest pieces, allowing rating agencies to provide blessings and owners to feel safe. Hundreds of billions of dollars of products were created providing ample liquidity to anyone who wanted to buy a home, regardless of credit quality. Lenders were further emboldened because they could insure their asset backed securities with CDS, which acted as insurance and was backed by huge financial institutions, making it seem like an almost risk free transaction. ARMs went from having no market share of the mortgage market to nearly 30% of all mortgages in a period of less than five years. Speculators flooded into the markets as home prices soared and the housing market boomed. Fast-talking bankers dazzled investors and led to the funding of huge pools of capital dedicated to speculators and wooed investors into complicated financial products that nobody understood. As the housing market boomed, inflation crept into the system, prompting the Fed to raise rates to tame animal spirits, in an early sign of fundamental conditions changing.
In December of 2006, Ownit Mortgage Solutions was claimed as the first major victim, filing for bankruptcy. By February, HSBC announced a $10.5 billion charge off and Freddie Mac announced they would no longer purchase subprime loans. By the end of the first quarter of 2007, major financial institutions were increasingly showing up in the headlines, highlighting exposure. Then, New Century Financial, one of the largest subprime lenders at the time, filed for bankruptcy. By June, 2007, the ratings agencies were onto the game in CDOs and began a wave of downgrades. By the end of the second quarter of 2007 Bear Stearns was embroiled in bailing out failing hedges funds and well on its way to sealing its own grave. Over the next quarter there were daily headlines of major financial institutions taking huge write-downs and the Fed was aggressively cutting rates and providing liquidity facilities to try and stave off a disaster. Over the next year numerous large financial institutions, such as Bear Stearns and Lehman Brothers, were claimed as victims of the crisis, the housing market collapsed along with equity prices (which were cut in two-thirds), and the country was plunged into its deepest recession in the modern era.
Nobody knows when the next bubble will burst or financial crisis will show up on our doorstep, but we do know that Minsky was correct: Financial bubbles are inevitable, they tend to form and end in repeatable patterns and are nearly always cultivated by low rates, easy money and a lack of regulatory oversight. In searching for the next bubbles and seeds of financial crises we have to ask ourselves, what problems did TINA create? What new financial products were created that led to a swelling of new money led by icons proclaiming that they were investing in a “new paradigm”?
Early in June, Celsius, one of the largest cypto lenders, managing $12b in assets, announced it would suspend transfers and withdrawals, and the SEC announced it has begun an investigation into the collapse of Terra, which allegedly whipped out over $40b in assets when in collapsed in May. At its peak, the cypto market represented $2.6t in assets spread over 19,000+ currencies. Its asset size is already a fraction of that today, with the majority of crypto currencies down over 50% from their peak. We don’t know if the cypto market by itself is large enough to set off a financial crisis, but we do know some interesting statistics about its demographics and the depth of ownership. The pressing questions then becomes, what else do the people who invest of cypto own and how will their consumption patterns and other assets be impacted by the collapse in prices?
Cypto is just one example of a bubble that has formed in the last several years, as the climate for taking risk was stoked by low rates and easy money. The most ominous danger is in the housing market, where low rates, excess cash and behavior changes related to the pandemic combined to create historic run up in prices, crushing affordability. Although ARMs and subprime are likely no longer a large enough portion of the market to create a crisis, there are other risk factors that could potentially create an unwind in housing prices.
There are two ways that bubbles burst, slowly (orderly) and quickly (disorderly). Just because there is a bubble doesn’t mean there has to be a crisis, but it means there is the risk of one. Our greatest concern right now is that the aggressive positioning of the Fed and their use of indiscriminate tools, which act as depth charges into the economy, will do more than claim small fish.
Fortunately, our risk model picked up signs of the potential severe slowing unfolding in mid-2021, when we began to reduce risk in the portfolio, and has since continued to downgrade market conditions in 2022 arriving at Negative Conditions at the end of April. We have limited risk exposure at this time and expect further volatility in risk assets. From our current positioning we will continue to make adjustments to the portfolio as we expect to transition from an inflationary environment, to a deflationary environment, where the Fed will need to step back from its current campaign. This process could take several quarters to unfold or it could happen quickly in the face of a bubble bursting and an asset crisis being set off. Ultimately, the downturn will eventually end as most do, with a clearing price being established for assets against a positive policy backdrop, and when it does, we believe our current portfolio construction will enable us to be well positioned to allocate to risk assets as they rise.
Caleb Sevian
Chief Investment Officer
Footnote: The Origins of the Financial Crisis, Brookings Institute, Martin Meil Baily, Robert E. Litan and Matthew S. Johnson.