In a new global financial crisis, where are the dead bodies buried?
The position is reminiscent of 2000 when the dotcom bubble deflated and also 2008. On both occasions, private funds did not fully recognise or report impairments...
This article continues from where Is a full-blown global banking meltdown in the offing? left off.
While the current focus is on the banking sector, emerging financial and economic stresses may reveal other exposures. This may include risky investments, the shadow banking system, structured products, trading and the bank-sovereign debt doom loop especially in Europe.
Recent years have seen increased investment in venture capital ("VC") and early/late-stage start-ups. While some of this may turn out to be sensible, a significant part financed two people in a garage on the basis of a skimpy PowerPoint deck as febrile FOMO (fear of missing out) obsessed investors chased the next new thing.
Abundant capital became its own strategy. Low-interest rates, abundant liquidity combined with superior, privileged information and deal access, advantageous tax treatment and generous regulations encouraged investment. It stimulated the entry of 'VC tourists' or, as the National Venture Capital Association terms them, 'non-traditional capital' -- mutual funds, hedge funds, sovereign wealth funds etc. These new investors predictably drove up deal sizes and values while simultaneously devaluing expertise, due diligence and common sense.
The apparently unlimited supply of cheap capital led to an explosion of firms with little or no possibility of creating a long-term viable, sustainable, self-financing operation. Fraud becomes a cost of doing business. The objective was to spend other people’s money to acquire customers to either on-sell onto the next fool or, more unlikely, emerge the victor in a desperate and expensive winner-takes-all race.
These unprofitable start-ups require near-continuous investment. Promoters and seed investors were reluctant to raise sufficient funding to cover needs till the business was even moderately operational or cash-generating. They feared giving up their stakes at too low a valuation. Relying on direct experience of 'uber-ised' transport or 'Deliveroo-ed' take-away sustenance, firms assumed the permanent availability of on-demand funding.
Some ventures have sufficient liquidity on hand to continue operations for some time but few have sufficient money to allow the business to reach a self-financing stage. At best, many ventures will need to return to the funding market at some stage, generally within 18-24 months, or close.
The need for funding coincides with a decrease in the amount of new money available. New inflows into private equity have declined by around two-thirds from the 2021 level of around $600 billion. Start-up investments worldwide fell by a third in 2022. The number of funding mega-rounds (fund raisings of $100 million or more) fell by 71 percent. New unicorns (private firms valued at $1 billion plus) fell by 86 percent. It remains to be seen whether VC tourists, who have been amongst the largest losers, return.
Most private investments are liquified to realise returns and generate cash, by trade sales or IPOs. With these markets now closed for an unknown period, the ability of investors to free up funds for new investments is constrained.
There is the additional problem of valuations. Between 2021 and 2022, the valuations of private start-ups tumbled by 56 percent. The average value of recently listed tech stocks in America dropped by 63 percent.
In 2022, Klarna, a Swedish buy-now-pay-later (also known as point-of-sale (POS) instalment loans) firm, suffered a 87 percent slide in value in one year. In March 2023, payment processing firm Stripe raised more than $6.5 billion implying a valuation which was $50 billion, some 47 percent below its 2021 peak. The cases are not isolated.
Lower valuations affect fund-raising options, especially as founders and existing investors would be reluctant to recognise large losses on existing positions. The coincidence of losses on investments and capital calls may lead to a general liquidity contraction for investors, requiring them to undertake forced sales. The position is not confined to the US but also exists in Europe and emerging markets.
A mitigating factor is a record amount of undeployed capital held by managers ($300 billion) and sovereign investors (undisclosed but believed to be, at least, comparable). However, new investments will need to meet stricter criteria with a focus on profitability, cash flows, strategic sectors, and longer holding periods.
Since the global financial crisis, higher risk or more complex lending or trading moved into the opaque and less regulated shadow banking system -- non-bank financial institutions which include insurance companies, pension funds, mutual or hedge funds, family offices and speciality financiers. The Bank of International Settlements estimates its size at $227 trillion as at 2021, almost half the size of the global financial sector up from 42 percent in 2008.
Traditional banks are deeply embedded in the shadow banking sector through trading relationships, custody and clearing. Some are minority investors in these off-balance-sheet vehicles as well as arrangers of capital. Banks also provide leverage, often using derivative products or other off-balance sheet structures. Alternatively, they provide direct funding – 'lending to the lender' -- frequently backed by collateral. As the collapse of hedge fund Archegos illustrated, the extent to which it eliminates risk is debatable.
2008 highlighted how the shadow banking sector can transmit financial stress. More recently, the September 2022 dislocation in the UK government bond market triggered by liability driven investing ("LDI") strategies of British defined benefit pension plan illustrates the potential for contagion.
Rapidly growing private markets, part of the shadow banking complex, invest in unlisted equity and debt, infrastructure and real-estate assets. Much of these investments are in more risky transactions driven by higher return targets and often expensive funding.
Deterioration of markets would drive losses and dry up liquidity from this source. One fear is the significant gap between private investment values and equivalent public equivalents. In 2022, public markets fell 15 to 20 percent, the valuations of private start-ups decreased by 56 percent and the average value of recently listed tech stocks in America dropped by 63 percent. During the same period, the enterprise value of private equity investments, on average, remained flat to rose slightly.
Private investment valuations rely on net present value models for fixed-income like businesses (real estate, infrastructure, commodity) and mapping to equivalent public listed stocks for equity assets. The latter reflects the fact that this is the relevant benchmark for any eventual sale. There is now a significant gap between private investment values and equivalent public equivalents. Termed 'volatility laundering', this is achieved by generous assumptions, internal sales or funding (raising conflict of interest issues), reliance on illiquidity or opaque models or deferring revaluations.
The position is reminiscent of 2000 when the dotcom bubble deflated and also 2008. On both occasions, private funds did not fully recognise or report impairments and were able to take advantage of liquidity fuelled recoveries. It is not clear whether the same will occur this time.
An unpleasant revaluation shock in private markets and large write-downs are not impossible.
Structured products, especially securitised debt, which were prominent in 2008, are a familiar area of concern.
Collateralised Loan Obligations ("CLOs") are packages of mainly low-rated debt used in private equity. The vehicles use different forms of credit enhancement and rating models to structure high-quality debt. They also entail explicit and often subtle embedded leverage. If the credit cycle turns, then higher default rates will result in cash losses to holders of risky lower-rated tranches. While higher-rated securitisation tranches may not suffer actual losses, downgrades and mark-to-market losses are likely. Where used as collateral for borrowing, margin calls may require sales which would realise these losses.
Non-government-backed mortgage-backed securities, commercial real estate and auto-loan securitisations may be affected by declines in asset values and defaults.
Investors own large volumes of bank hybrid capital securities, which regulators can force to be written down or converted into equity at their option. Under the terms of the UBS merger, Swiss Franc 16 billion ($17.3 billion) of Credit Suisse's Additional Tier 1 ("AT1") capital bonds were written off in their entirety. Around Swiss Franc 1 billion ($1.1 billion) of other capital was also written off.
Retail and private banking clients globally, especially wealth management investors in Asia, hold significant quantities of complex, highly-engineered derivative-based products. Bought in search of yield during the prolonged period of low rates without a full understanding of the structure and review of the detailed documentation, potential losses could be significant.
After the Credit Suisse AT1 write-offs, the Financial Times published a primer of the structure which might have been useful to investors especially prior to purchase.
Higher volatility will generate trading losses. Abnormally large daily moves in equities, currencies and interest rates have become normal. Bond market volatility, in particular, is at its highest level in over 30 years. In a single week, US 2-year and 10-year yields fell 0.74 percent and 0.26 percent per annum respectively, the largest changes since 1987.
Several investment banks, hedge funds and trading firms have reported losses. Common causes include bets on interest rates, erratic price movements and illiquidity which activated stop losses on positions. Quantitative investment strategies, reliant on market trends and historical data analysis, have been especially affected.
The extensive use of derivatives to provide exposure to prices and leverage (especially via the ubiquitous carry trade where low-cost funding is used to purchase higher-returning investments) may prove another source of instability. At a minimum, higher volatility across all asset classes will create increased margin requirements triggering cash needs.
A true stress test to the central counterparty ("CCP") system designed to reduce credit risk on derivative transactions is possible. Any malfunction would cause a major disruption for financial markets.
The risk of unexpected trading losses and disorderly and uncontrolled liquidation cannot be discounted.
The European Central Bank's ("ECB") has hidden the Euro-zone sovereign debt doom loop by its aggressive support of government debt of weaker Euro-zone members or, as in the case of Greece, an unrealistic restructuring.
Government debt is high and rising - France (113 percent of GDP), Greece (193 percent), Italy (151 percent), Portugal (127 percent) and Spain (118 percent). Budget positions are deteriorating due to slowing growth and spending on cost-of-living subsidies, especially to ameliorate the effect of energy expenses.
- Rating downgrades of a country result in falls in the value of government bonds held by banks who face calls for additional collateral draining liquidity from markets.
- The deterioration in a sovereign’s credit quality increases the amount of capital that banks must hold on certain transactions, not only with the sovereign but entities in that jurisdiction.
- Banks are forced to hedge this risk, usually by purchasing credit insurance on the sovereign or shorting government bonds exacerbating losses. Alternatively, they can use proxies, shorting equity indices, major stocks or the currency spreading losses and volatility into other asset markets. Correlation between major asset classes becomes unstable, especially in a risk-on risk-off trading environment.
- The increasing financial risk, higher funding costs and reduced market access of banks adversely affected by losses on government bond investments and the reduced ability of the government to provide emergency support sets off a chain reaction of actual losses in the inter-bank markets, requiring further hedging, compounding the spiral. Loss of trading liquidity, uniform rules, similar risk models and herding behaviour, where participants have similar positions and strategies, can prove additional accelerants.
Individual Euro-zone nations' lack of independent monetary policy, fiscal capacity, currency flexibility and ability to monetise away debt would re-emerge as policy constraints. Any new debt crisis will expose simmering divisions between debt and inflation-phobic creditor and debtor nations.
John Kenneth Galbraith in The Great Crash, 1929 described 'bezzle' -- theft where there is an often lengthy period of time between the crime and its discovery. The person robbed continues to feel richer since he does not know as yet of his loss. Bezzle, which increases under benign conditions, is only exposed by changes in the environment. Over the last decade, investors have been 'bezzle-d' by investments offering high returns which did not adequately compensate for the real risk that only emerges much later. If a major financial crisis develops, losses on these bezzle-based investments will impoverish investors.
For the moment, financial markets are holding. But as one analyst of the 1929 crash observed: "Everyone was prepared to hold their ground, but the ground gave way."
Satyajit Das is a former banker and author of numerous works on derivatives and several general titles: Traders, Guns & Money: Knowns and Unknowns in the Dazzling World of Derivatives (2006 and 2010), Extreme Money: The Masters of the Universe and the Cult of Risk (2011), A Banquet of Consequences RELOADED (2021) and Fortune’s Fool: Australia’s Choices (2022). His columns have appeared in the Financial Times, Bloomberg,WSJ Marketwatch, The Guardian, The Independent,Nikkei Asia and other publications.
This is part of the web-only series of columns on newindianexpress.com.
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