Observations by David Robertson, 3/24/23
It’s been another busy week so let’s jump right in.
As always, if you want to follow up on anything in more detail, just let me know at email@example.com.
Draw a Bath, Almost Daily Grant’s, March 20, 2023
Bed Bath, which managed to raise $135 million from the exercise of preferred stock warrants earlier this month, a transaction that analysts at Keybanc deemed to be among the “most unusual financing situations” they have seen in the past two decades, now sports an equity market cap of just $95 million. As recently as August, that figure stood near $2 billion, a remarkable fact considering the purveyor of home furnishing’s 5.165% notes of 2044 changed hands at roughly 30 cents on the dollar at the same time, implying that a complete wipeout of shareholders was likely in the cards.
A recent illustration of ridiculously inefficient markets. In the midst of speculative fervor last summer, BBBY managed to reach a market capitalization of $2B. This happened while fundamentals were weakening and the bond market was indicating the stock was almost surely worthless.
The incident invokes memories of Toys ‘R’ Us that I relayed in 2017. Back then, however, the bond market was caught unaware as well. The fact that the bond market is now pricing in serious trouble for BBBY suggests the bond market is catching up to the facts on the ground. It also suggests stocks are still oblivious.
Amidst all of the bank uncertainty the last couple of weeks, investors became so frightened that they … added record amounts of money to the S&P 500. For whatever reasons, the broader stock market, and by association the large tech companies, are being viewed as bastions of safety amidst roiled markets elsewhere. This just increases the dissonance with the fact that stocks are risk assets.
Relatedly, another interesting observation involves the movement of the volatility index, VIX. After spiking upon the first news of bank problems, VIX jumped a couple more times but settled down quickly. Conversely, the fixed income volatility index, MOVE, is down from its peak but is still very elevated. This behavior recalls the experience of the GFC when fixed income markets provided better signals about underlying problems than equity markets did.
This is a pretty good chronology of malfeasance at Credit Suisse and serves as a useful reminder of the bank’s spotted history. For those bemoaning the loss of a storied institution, I say, “good riddance”. Toxic cultures not only put a strain on good actors and law-abiding folk, but also propagate those harmful tendencies onto future generations. Society is better off without them.
This is a quintessentially human story: Absolute power corrupts absolutely. When organizations become large and powerful and “systemically important”, they lose the competitive pressures that naturally govern behavior. As a result, they get lazy. They find it easier to cheat and to break rules than to create real value.
While Credit Suisse was a poster child of such corruption, it happens to nearly every large organization eventually. As financial conditions continue to tighten, I suspect more and more bad behavior will be revealed … in other banks and beyond.
Trust in market rules is at stake as investors remain in limbo ($)
The net result, then, is that investors are in limbo land. They don’t know whether capital market laws will be a predictable pillar of faith for finance in the future, but they also don’t know whether US and European governments have the desire (or means) to stand behind all banks, and thus act as an alternative pillar of faith. No wonder fear abounds; moral hazard is rife, but in a deeply unpredictable manner.
In general, I like rules. This is not because I’m incredibly persnickety or because I get off on technicalities. I like rules because they work. In most cases they help define rules of engagement such that those engagements can be transacted more efficiently and with less friction. In any kind of social context this is useful.
That said, I am not a fan of all the harping about rule-breaking about Additional Tier 1 capital in the Credit Suisse - UBS deal, such as illustrated from the quote by Gillian Tett above. Although there are clearly legal issues to untangle, focusing on the total loss of AT1 misses the forest for the trees.
The reason rules exist to begin with is to provide order to society - which is a public good. Sometimes, however, there are even greater public goods, such as preventing a global bank run, that come into conflict with certain rules. When this happens, there is no perfect solution. The best we can hope for is that policymakers consider the challenge in context and do the best they can.
Another point is that much of this nitpicking is mistaking the proximate cause for the ultimate cause. I don’t like a precedent being set that allows debt to be wiped out and some equity value salvaged either. However, the agreement to do so was not the big failure here. The big failure(s) were in 2009, 2014, 2021, and 2022, amongst others (see “Banks”) when serious rules were violated but enforcement failed to adequately punish or deter bad behavior. There’s only so much that can be done after the fact.
Noam Chomsky: The False Promise of ChatGPT ($)
we know from the science of linguistics and the philosophy of knowledge that they [machine learning programs like ChatGPT] differ profoundly from how humans reason and use language. These differences place significant limitations on what these programs can do, encoding them with ineradicable defects.
The Waluigi Effect (mega-post)
The Waluigi Effect: After you train an LLM to satisfy a desirable property P, then it's easier to elicit the chatbot into satisfying the exact opposite of property P.
AI R Us
What’s even more frightening to me than the ability to systematically train and prompt these artificial human intelligences in a controlled direction to a certain, optimizable output is the ability to systematically train and prompt our biological human intelligences in a controlled direction to a certain, optimizable output.
The voluminous chatter about ChatGPT and its ilk has all the trappings of yet another tech fad. This is understandable in that the technology and some of the capabilities are truly amazing. In all the frenzy to earn the badge of being a “disruptor” though, one would do well to remember that one of the consequences of a “move fast and break things” ethos is that things … break.
The general lesson here is that it helps to understand a technology in order to effectively deploy it. The articles and links above go a long way in establishing some functional bounds around ChatGPT.
For example, because machine learning programs “differ profoundly from how humans reason and use language”, there are “significant limitations on what these programs can do”. In other words, a little bit of thinking and planning can avoid a lot of wasted effort.
Also, and more ominously, LLM AI [large language model artificial intelligence] is “NOT the helpless, harmless assistant … It is the opposite of that”. So, that would be something like an invincible, dangerous lieutenant. Yay! Early adopters who just start trying things may end up being truly disruptive - but in a really bad way.
Bottom line: In order to get the most out of chatbots it will be beneficial to employ them thoughtfully and strategically. Otherwise their “dark side” is more likely to appear.
Short, interesting point here. The pandemic forced many businesses to adapt to an environment of lockdowns and one of the more noticeable adaptations was the rapid roll out of mobile banking. Almost overnight, most basic bank transactions could be done on your phone and that vastly reduced the friction and costs of banking.
At the time, lower frictions were a good thing. When it came to the run on Silicon Valley Bank, low frictions were a bad thing. As one of the masters of volatility and systemic risk, Michael Pettis, points out, reducing frictions beyond a certain threshold actually increases instability. Reorienting taxes could serve to both restore greater financial stability and reduce taxes on producers. Interesting.
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While there has been a great deal of discussion regarding the debate between inflation and deflation the last couple of weeks, most of that discussion has focused on banks and regulatory policy. Russell Clark adds important perspective to the debate by considering politics in a broader geopolitical context.
He focuses on China and the tradeoffs it is making in public policy. In particular, he points out “corporate pain (ie falling profits) is not seen as a good reason to devalue in China”. More specifically, “China happily crushed property developers as they were benefitting relatively few people,” and “they broke up the tech companies as the benefited relatively few people”.
The politics is clear. China is prioritizing labor over capital in its public policy. Due to its size and influence, the inflationary effects will ripple globally. Further, the prospect of deflation in the US implies “some sort of austerity” which, judging by current evidence, is “non-existent”. As a result, global trends are still pointing in the direction of inflation.
Edge of the Edge
The reason inflation is difficult to predict is that it can reflect any combination of four factors: excessive demand for goods and services, constrained supply of goods and services, inadequate demand (lack of confidence) in government liabilities, or excessive supply of government liabilities. Two of those factors are purely psychological.
As a side note on bond yields, I’ve noted that 10-year Treasury yields have rarely persisted below the weighted average of Treasury bill yields (weight 0.50), year-over-year PCE inflation (0.25), and nominal GDP growth (0.25). Presently, that weighted average is about 5.3%, so the current 10-year Treasury yield of 3.4% embeds quite a bit of confidence that the Fed will achieve its inflation target, whether through recession, credit crisis, or other means.
The first paragraph is a nice, intuitive, and practical framework for evaluating inflation. Yes, it’s partly a function of supply and demand for goods and services. But it’s also partly a function of supply and demand for government liabilities. This element is too often overlooked. Importantly, “Two of those factors are purely psychological”. As a result of the psychological drivers, inflation is very hard to model; it depends on intangible factors like trust, beliefs, and expectations.
The second paragraph shows very clearly and mechanically that “the current 10-year Treasury yield of 3.4% embeds quite a bit of confidence that the Fed will achieve its inflation target”. Further, there is good reason to believe inflation expectations are normally backward-looking. This suggests one of the biggest potential mispricings in the market right now is the probability of higher future inflation. Just like the rapid rise in 10-year US Treasury rates from the fall of 2021 to end of 2022 blindsided a lot of investors and crushed a lot of portfolios, I think inflation expectations are likely to do the same.
The FOMC concluded its meeting on Wed and revealed another 25 bps rate increase. This met the baseline expectation as did most of the language in the press release and following press conference.
One thing that stood out was the wide differential between the Fed’s expectations for future rate cuts and those of the market. Powell indicated, “Rate cuts are not in our base case,” and this assessment was backed up by the new “dot plot” for rates. The main message from the Fed is that banks are alright and the Fed needs to press on in its fight with inflation.
This raises a couple of issues. One is the nearly 100 bps differential between Fed and market expectations for rates is large and unsustainable. Either the Fed caves and loses credibility, or it does hold rates and that starts getting discounted in asset prices. Seems like a big bet. Another issue is Powell indicated the tightening of bank credit will also have the effect of tightening financial conditions. True enough. Insofar as that is the case, specific targets for the Fed funds rate kind of miss the bigger picture anyway.
What will come out of the banking crisis? There are lots of takes and one of the more balanced ones is from Bob Elliott. As he shows, although lending is likely to get tighter at small banks, the reduction in mortgage rates has a disproportionately large effect. Big picture, for the time being, is things are basically OK.
Stimpyz chimes in with another important perspective. His point is this whole bank episode is not over yet. There are strings attached. Until we know exactly what those strings are, we won’t be able to fully assess the impact. So, the direction of mortgage rates and the appearance of additional bank regulation will be things to watch for before the full impact can be determined.
Another important element of the investment landscape that has not received much attention is that of counterparty risk. Remember, one of the big problems in the GFC was the uncertainty caused by not knowing whether the counterparty of your trades would be able to honor them or not. AIG was ground zero.
Russell Clark raised the issue as it regard autocallables. Apparently the big French banks are ground zero here and the problems are becoming increasingly apparent.
The structuring of autocallables is dominated by French banks, in particular Soc Gen, BNP and Credit Agricole … These three French banks have all seen their CoCo bonds fall in recent days, and hence yields rise. All three now have yields of near 12%.
Structured products have very real counterparty risk. That is they are like a corporate bond. If the structuring bank goes bust, they will rank well below deposits.
This means investors in French bank-sponsored autocallables are getting a lower yield on these products than they would by investing in the banks’ CoCo bonds. In other words, they are getting lower yields by taking on greater risk. This is obviously an unsustainable situation. It also obviously not just contained to autocallables but applies to virtually every structured product out there. Let the games begin!
Much like with the US healthcare system, investors are more attuned to acute problems than chronic ones. With the bank problems considered “solved”, investors were happy to get past the inconvenience and get on with their business.
This cavalier, transactional attitude is likely to prove costly. The bank runs that appeared were not anomalous instances to be quickly dispensed with. Rather, they were the manifestation du jour of deeper, long running problems that will take years and years to fully resolve.
This isn’t to say investors should re-panic about bank runs. It is to say this isn’t over. It’s not nearly over. There will be more panic episodes. There will be more regulatory interventions. The main thing for long-term investors to keep in mind is to stay safe while these problems bubble up to the surface and need to get dealt with. It will be a while.
In the meantime, investors will be better off looking for signals in fixed income markets than in equity markets.
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