Published April 16, 2021
A couple of investment stories have piqued our interest recently. We wanted to comment on them to perhaps provide some perspective on these events.
We know that cheap money, while generally good for jumpstarting the economy, eventually breeds all kinds of excesses. Often those excesses show up as one-off, seemingly random events which, when taken together, form a picture of a more serious issue. Such was the case in the summer of 2007 as two hedge funds at investment bank Bear Stearns were suddenly shut down. Here is the headline paragraph from the Wall Street Journal in June 2007 describing that event:
“Two big hedge funds at Bear Stearns Cos. were close to being shut down last night as a rescue plan developed over several days fell apart in a drama that could have wide-ranging consequences for Wall Street and investors.”
The cheap money, as measured by the 10-year U.S. Treasury rate, was 3% in 2003, a sharp drop from the near-10% rates of the early 1990s. That round of cheap money fueled a housing boom unlike anything ever seen. The two Bear Stearns hedge funds were entirely invested in securities tied to this housing boom. That they suddenly had to be closed down was a ‘tell’ of the excesses built up in housing finance. One year later, failures related to housing finance would result in the biggest financial crisis since the Great Depression. Note that this Bear Stearns event occurred four years into a slowly ramping interest rate environment; so, four years after the bottom in interest rates.
Today, we have a couple of seemingly similar stories. In the past month, a large fund called Greensill Capital had their bank cut off funding. This led to at least $2B in losses for Credit Suisse bank. That was quickly followed by another almost $5B in losses incurred by Credit Suisse for another problem fund (Archegos Capital) they had loaned money to.
The fall of Archegos Capital followed the usual script for financial blowups: 1) a “friend” of the bank is allowed to become hugely leveraged in pursuit of some investments, 2) those investments encounter trouble, fall substantially in value, causing the bank to, 3) call for a quick repayment of the loans outstanding. That drives a forced sale of the investments at fire sale prices. The bank is left recovering substantially less than the value of the loans.
Much could be said about these two cases of overextended investors betting big on investments gone bad. The point we wish to make is that these are both cases where access to capital is almost infinite for these two investors. That infinite access to capital is a common theme in financial blowups. There are always investors willing to live on the edge, taking enormous risks. Cheap money is rocket fuel to those investors. They can substantially leverage up because risks seem low. Of course, that leverage becomes a veritable monster when asset values start to fall. Banks are able to get money for almost free these days (e.g. they pay almost 0% for deposits and can borrow from the Fed for almost nothing also). If banks can find someone they trust to lend that money to, they are more than willing to open the spigot and let funds freely flow. Banks and investors get a bit drunk, if you will, on this free money. They become looser than they typically might and make bad decisions. Both Greensill and Archegos are case studies in this behavior.
Does this mean we are headed for another financial crisis? Almost everyone would agree we are not. The reason is that these losses, while eye-popping in size, are not “systemic” the way the housing finance crisis was. Because of the financial crisis, banks are required to carry much more capital in reserves – e.g. a much bigger buffer or safety stock of cash. While they may be taking more risks generally, they are not anywhere near as extended, or leveraged, as they were going into the financial crisis. Banks carry almost 50% more capital now than they did going into the Crisis. The Credit Suisse debacle notwithstanding, banks generally are also more cautious in their lending than they were during the housing boom. Then, “zero doc” mortgages became almost commonplace as risks in the financial system were so chopped up and passed off that participants seemed to dramatically underestimate the true risk they were taking. (We refer to zero doc mortgages, broadly, as those where the creditworthiness of the borrower is basically ignored.) Today, getting a loan is not nearly so easy for the average person.
Back to the concept of access to capital. It is this access that makes such a huge difference in the financial success of a person or company. It is the economic lifeblood. Just ask anyone who is unable to get a loan, for whatever reason. Easy, low-cost access to capital allows one to expand and invest, to start a business, buy a home, and on and on. If you are shut out of that flow of capital, or have it minimized to a trickle, you have the deck hugely stacked against you. The two fund managers noted above at Greensill and Archegos, despite their huge and spectacular failures costing billions, will most likely be able to again access millions of dollars in investor capital. Access is extremely valuable.
Investors looked to a heavy slate of quarterly earnings reports this week, to see if the reports would justify stock prices at record high levels. Monday brought a quiet day of little change as investors awaited the first of those reports. Tuesday saw a burst of buying in the Nasdaq’s tech/consumer companies en route to a +1% advance. The halt of J&J’s covid-19 vaccine appeared to have little impact on investors as the healthcare company’s stock only dipped -1% on the news. The Nasdaq gave Tuesday’s rise all back Wednesday as a report from the Fed noted that company’s had been able to raise prices to consumers. High-growth tech company shares have been unduly influenced of late by fears of rising inflation and a corresponding hike in interest rates. The broader market also ticked lower -0.4% as powerhouse bank earnings failed to provide much spark. But Thursday brought a wide swath of good economic news and renewed optimism. A +10% jump in retail sales as consumers spent their stimulus checks, and a sharp drop in unemployment claims, were the featured economic reports. That rise in spending coupled with a strong report from health insurer United Healthcare (UNH) and additional good news from the finance sector supported a +1% gain in stocks. Friday continued the positive spin with a +0.4% rise in the market on good earnings reports from companies as diverse as trucker JB Hunt (JBH), paint maker PPG, metals company Alcoa (AA), a bevy of finance firms, and car maker Mercedes-Benz. In summary, earnings more than lived up to expectations through this first week and stocks continued their grind higher.
A fourth straight weekly advance for stocks left the S&P 500 (SPY) +1.40% higher. The Nasdaq 100 (QQQ) added +1.45%. Smallcap stocks (IWM) continued their 10-week consolidation rising +0.93% to regain a chunk of the prior week’s dip.
Warm wishes and until next week.