Here’s a transcript of a recent Twitter Spaces conversation about crashing credit markets, runaway inflation, and why we need to fix our current financial system.
Listen to the episode here:
Dylan LeClair: The last 40 years look like a bubble. As this duration component dissolves and the long-term risk-free interest rate rises or rises significantly, the annuities of the 60/40 portfolio will be of that kind. For LDIs (debt-driven investments), where they used their long-term bonds as collateral, that seems likely to be the breaking point.
Maybe it will happen in the US, maybe not. It has a big impact. The questions I would suggest are: I haven’t looked at real credit risk at the corporate land or sovereign level, but what’s really interesting is when you think the central bank is shrinking its balance sheet. As rates continue to rise, when will credit risk be priced in more rapidly than the unwinding of duration we’ve seen so far?
Greg Foss: Great question. The short answer is that no one knows. In reality, new issues reassess the market. And since no new issuance has actually taken place in high-yield land, it can be argued that no repricing has taken place.
If you have a secondary market deal, but it poses a big new problem, let’s take a look at this Twitter example. Twitter is never sold to the secondary market. The $13 billion in debt Elon borrowed will remain in the bank’s portfolio. Because if they had to sell it to the secondary market, the bank itself would lose about $500 million. The yield they proposed — pricing Elon’s debt and locking it in with a commitment — is no longer a market yield, so we need to sell at least 10 points down, which we don’t want. To bear the loss of that market capitalization, they keep it on their balance sheet and ‘hope’ the market will recover. I mean, I’ve seen it before.
In 2007, Citibank CEO Chuck Prince famously said about LBOs (leveraged buyouts) at the time. He’s like, “Well, when the music comes on, I have to get up and dance.” Well, about three months later, the pudgy Prince came to really regret that statement because Citibank had too many unsold papers.
I mean, the secondary market doesn’t have to repricing all kinds of CLOs (collateralized loan obligations) and leveraged products, but it’s going to dribble that way. Dylan, start dribbling like that.
In itself, it’s not a subprime-like crisis. It’s a crisis of confidence. And confidence is a slow bleed against the realization of structured products like the subprime default or the Lehman Brothers situation. Or, sorry, it wasn’t Lehman, it was the Bear Stearns hedge fund that exploded the subprime mortgage debt. That was the canary in the coal mine that started it all. That was the 2007 secondary market price revision. Where are we today? As you said, we are in a situation where the 60/40 portfolio has collapsed. In 2007, the Fed was able to cut interest rates and bonds rose. This was because, if I remember correctly, it was about the same as the current yield. There was room for the Federal Reserve to cut.
It wasn’t trading at 1.25 basis points or even 25 basis points that got the Fed to its current 3.25%. There was room for interest rates to come down to provide a buffer. As we all know, bond prices go up and yields go down. There used to be a cushioning effect there, but now we can’t afford it.
As you said, that 60/40 portfolio: the worst performance in the last 100 years. The NASDAQ fell double digits in the same quarter, and long-term bonds have never fallen double digits. why? The NASDAQ has been around since about 1970 and long-term bonds have never lost double digits in the last 50 years. If I remember correctly, they have depression if it’s traced back.
The point is that the 60/40 portfolio probably experienced its worst drawdown in nearly a century. And Lynn Alden laid this out really well. In terms of capital destruction figures, I think he has evaporated $92 trillion worth of wealth in this cycle of fighting inflation. In the 2008 timeframe, only about $17 trillion of assets had evaporated. We’re talking orders of magnitude bigger. We are talking about a US debt spiral where his 130% government debt to GDP doesn’t leave you much room.