In2009, short-seller Bill “Fleck” Fleckenstein pulled the plug, closing his positions and his fund. By successfully predicting Armageddon, he walked away with huge returns that rivaled the protagonists of the cult film The Big Short. The untold story, however, details how some speculators continued to predict further economic collapse, thinking the world was about to end.
But despite the financial system literally breaking in half, the authorities’ combination of bailouts, liquidity injections, and “asset relief” programs restored confidence, and those bearish speculators went bankrupt. It was this extraordinary confidence revival that created the foundations for the longest bull market in history, the idea that you could ignore reality, zombify the economy, and get paid for it. Because why create an improved system free of all existing bad ideas when you can simply restart the profit machine, and convince everyone to play along?
Over the past decade, economic growth has halved while investors have put their faith in the Fed to prop up the economy, producing an absurd range of financial assets and systems created specifically to support them. Instead of savings, capital, and real wealth growing our economy, we have financial engineering: CDOs, CBOs, MBSs, and to back them up, a plethora of alphabet soup “asset relief” programs: CPFF, TALF, PDCF, SMMCF, TALF, MSCLF. You get the idea.
Financial institutions have been revived not via real economic growth but via leveraging debt-financed assets that would instantly go to zero in post-financially insane world. And as leverage has become the de facto funding source that the megabanks, hedge funds, pension funds, and insurance firms use to bankroll these products — generating huge returns for themselves — we’re about to experience the sharpest market crash on record.
To understand why let’s look at how Wall Street creates a CLO: a fancy name for fixed-income securities consisting of roughly 250 senior secured bank loans. Using a waterfall structure, the CLO manager packages loans into “tranches” of varying characteristics. Tranches at the top of the capital structure receive cash first, take losses last, but earn the lowest yield. The lower you go down the chain, the more potential losses and risk you take on, but with higher rates of return. By creating infinitely complex financial products, investors focus on the attractive yields, not the questionable assets hiding under the surface.
Wall Street then markets these CLOs to yield-starved investors who can’t get the same rate of return from U.S treasuries, dividend stocks, or corporate bonds. Let’s say a hedge fund has $200 million to spend, and they decide to buy the equity part of the CLO which has the highest yield but takes most of the losses. But since the Fed has announced it’s committed to bailing out almost anyone, the hedge fund won’t just purchase the CLO tranche outright. Instead, they will go to an investment bank for a billion-dollar loan, leveraging their capital five times.
As the financial system considers CLOs to be “assets”, the hedge fund can use their newly-acquired $1 billion CLO tranche as collateral to purchase even more assets. By exchanging that collateral for cash via money markets such as repo or interbank, the hedge fund can embark on an additional asset binge, using leverage to buy up mortgage-backed securities (MBS), junk bonds, REITs, stocks, and any other supposedly high-yielding assets. That original $200 million investment has turned into a vast portfolio of financial slop, but no one questions their motives or credit history because money is ultra-cheap. This hedge fund now has a leverage ratio of 20:1; their liabilities exceed their net worth by 20 times. What could possibly go wrong?
With the cheapest monetary environment on record, the state creating ever-increasing forms of moral hazard, and the Fed seemingly devising new bailout programs every week, the average leverage a hedge fund takes on has exploded to all-time highs. In fact, if you’re 10 times leveraged that’s considered conservative.
This, however, should come as no surprise as the Fed Put persists. Financial institutions have every incentive to use as little capital to buy up as many assets as possible to a point where this asset binge has made its way into every market: stocks, junk bonds, mortgages, bank loans; you name it. Before we only had a bubble burst in tech in 2001, then in real estate in 2007–2008. The next bubble to burst will be the bubble of everything.
This highly leveraged house of cards was tested by COVID-19. As investors started to sell anything the global lockdown might infect, a deleveraging event in the financial system caused the sharpest market decline in history, eclipsing the record from the 1930s Great Depression. A synchronized cross-market crash that Guggenheim CEO, Scott Minerd, described as “the Great Leverage Unwind”.
But the COVID-19 crash will be nothing in comparison to the next market crash. The historic rise in the Fed’s balance sheet illustrates how much money was needed to paint over the pandemic-induced cracks using — yes you guessed it — more leverage. The quality of assets has reached rock bottom while the leverage needed to finance their survival has increased to all-time highs. So when the next crash occurs, leverage on top of leverage on top of more leverage will have to be wiped out by the system to restore “stability”. It will be thrice as fast and thrice as sharp. It will be known as the Great Deleveraging: Part 2.
When the inevitable crash occurs, however, the Fed will again step in. But this time they’ll announce the outright purchase of stocks — which they can already achieve by lending money to primary dealer banks who then buy stocks on their behalf. The Fed will do this not because it has any effect on the system but because it will revive risk appetite enough to become self-fulfilling. They may even throw in a few more “asset relief” programs just for theatre — the SMR (Stock Market Relief) program has a nice ring to it. The Fed lies when it says stimulus stimulates the economy. Officials know it only encourages the big financial institutions to lend to firms that are on the verge of bankruptcy.
The amount of damage the Great Deleveraging: Part 2 inflicts on the system depends on what the Fed says and does. But judging by the market’s post-pandemic response, it’s almost a certainty — to the dismay of the sound money advocates, the Fed’s critics, the bears, the poor, and the young — that the financial behemoths will miraculously but blatantly save the biggest Ponzi scheme in modern history, and that we’ll continue to climb the wall of worry for months or years, maybe even decades, to come.