It is surprising how often the precursor of a major crisis is the collapse of some nondescript firm or fund, with LTCM and Enron prime examples of fallouts that triggered a tidal wave across markets.
As Warren Buffett said, “when you combine ignorance and leverage, you get some pretty interesting results”. The sudden surge in inflation following the pandemic rebound has led central banks to aggressively start to raise interest rates, introduce quantitative tightening and cause significant dislocation in many asset markets. Although it would be comforting to think that the leverage shake-out is finished, it’s likely that there are a few more surprises in store.
There is no doubt that gearing can be a powerful tool in wealth creation. Debt allows an investor to gain a much larger economic interest in an asset and scale returns. Often, interest and other costs of gearing may be deductible and used to lower taxable income legitimately. Investors often use borrowing against a stable portfolio to unlock additional funds and diversify their holdings.
However, investors have been caught off guard by the sudden lift in borrowing costs and the tightening of liquidity, particularly those who have borrowed heavily to invest in houses, infrastructure, commercial real estate and equities. Often leverage becomes excessive in boom times and the deleveraging cycle as asset prices depreciate can be very unpredictable and painful.
In May last year, the US Federal Reserve warned that the measures of hedge fund leverage “may not be capturing important risks” after the $US36 billion collapse of Archegos Capital, a little-known family office that had multiple credit lines across several Wall Street firms. It is surprising how often the precursor of a major risk-off crisis is the collapse of some nondescript firm or fund, with LTCM and Enron being prime examples of collapses that triggered a tidal wave across markets.
Often, the true scale of leverage in the system becomes apparent only as liquidity in markets dries up. The negative network effect cascades across firms and markets like a row of dominoes. Despite the constant attempts of regulators to increase disclosure and transparency, financial market engineers continue producing derivatives and products to dodge reporting requirements. In the Archegos case, it was the excessive use of equity total return swaps that evaded the regulator’s attention. Even the buy-now-pay-later sector which has extended “credit” to customers for more than eight years is only now being brought into the credit regulatory framework.
The rising inflation prints combined with deteriorating consumer confidence indicators is a dangerous recipe. While investors are hoping they have seen the worst of the equity market drawdown and shaken out any nasty leverage surprises lurking beneath the surface, it does feel like there is more to come. Anticipating where the problem will originate is always a challenge.
In Australia, homeowners take on extraordinary levels of debt to enter the property market. Thankfully, they are not required to mark to market their loan to value ratio. House prices have started to fall, and many new borrowers could easily find themselves in a negative equity situation. If they can continue to pay the rising mortgage costs, they cannot be forced to sell their homes and realise a loss.
Other gearing products are less forgiving. Sophisticated investors often take out margin loans on bonds, shares, and managed funds – the unwinding of these in the first half of the year has been particularly painful. In the six months to June, the level of margin debt in the US alone fell by almost $US320 billion.
The concern, of course, is what is happening in the opaque corners of the financial system. The shadow banking system has changed significantly since the global financial crisis, as traditional banks have withdrawn from riskier markets and family offices and specialist funds have filled the void, particularly in corporate debt, property, and crypto financing. As asset prices decline and loan covenants get breached, the lack of liquidity in secondary trading becomes a negative rather than the marketing positive that was used to raise investor funds in the first place.
In crypto lending, we have seen the “surprise” collapses of Celsius Network, Babel Finance and Vauld. Property-related debt across the globe is at record levels and the most indebted company in the world, China’s Evergrande, is struggling to meet its obligations. The recent spate of high-profile property developer collapses in Australia could be the proverbial canary in the coal mine warning for our own private credit markets.
The links between financial market participants can often dissipate the impact of an isolated problem. But when there is broader asset class damage caused by macro liquidity reductions, the links just cascade the problem. Private investors, looking for bargain opportunities in distressed markets, are going to need to be a little more patient.