It’s coming up on awards season. The Emmys were last week and weirdly, I got a thought bubble about nominees in the Black Swan category, walking the red carpet looking for attention! Think the Masquerade scene from Phantom of the Opera when the Phantom comes prancing down the stairs to harsh the festivities (at least he sang well).
We have some obvious nominees today. But are they the real thing? Will they move markets? We have, with some reason, become inured to the disruptive headlines howling about threats to our way of life. Is there simply too much chaos out there to pick out the things which are really relevant from the noise? Our 24-hour news cycle is hardly helpful, is it? The talking heads, with practiced expressions of concern, seriousness of purpose and faux competence, serve up our daily quantum of fear and distress (Film at 11!). Don’t they seem almost gleeful to report yet another potential disaster? With breathy anxiety, designed to tug at our atavistic fight or flight instincts, they repurpose as news exaggeration, hyperbole, vague allegations, unconfirmed reports and sheer speculation.
The scary part is, of course, that buried and obscured in all that noise might be real news, things that investors and market participants really ought to be paying attention to because they will matter. The trick is sussing out the stuff that matters from the stuff that doesn’t.
So, we really do need to take into account these aspirational swans. One of them could be that figurative dead archduke.
Let’s take a stroll along the red carpet and chat up some of these swans.
Let’s start with our old friend, geopolitical disruption. Certainly, the ongoing horror show in Afghanistan is a thing. This adventure in grotesquery (there was virtually no risk, was there, that any of those helicopter pilots who evacuated the embassy back in August was ever going to land on the embassy roof, right?), it could have been something that moved markets and changed the calculus. But a black swan? Nope, not yet.
Well, then perhaps this sterling expression of American power and resolve might encourage adventurism around the world by the customary bad actors and such adventurism, or even credible threat of such adventurism, could roil markets. No one could have read about that “semi-official” Chinese news outlet publicly musing that the United States’ failure in Afghanistan should tell Taiwan that the jig is up without a frisson of anxiety. But a black swan? Nope, or at least not yet.
Then, of course, there’s the ongoing Covid mess which just refuses to follow the script of a good made-for-television movie. Started well. First, there would be a problem (check). Then our doughty heroes and heroines would engage in hard work and innovation to fix it (mostly check). Then the problem would be resolved. Throw in a car chase and a whiff of romance, roll credits, have a bit of a party and get back to work.
It didn’t happen, or at least it hasn’t happened yet. The plague goes on, the bug is still with us and looks like it might be indefinitely. Look, I’m not going to argue that life has not changed or is not still changing. Small business was and is particularly hard hit, but employment is up, GDP is growing and all the macro indicators are continuing to suggest expansion. There’s more of a feeling of momentum and a return to normalcy right now than something that has triggered fundamental change (check out any college football game this weekend). Doesn’t yet feel like a black swan.
For the moment, continuity wins and catastrophe stays in the Green Room.
How about the ultimate end (or not) of the vast amount of governmental largesse that has been rained on businesses and consumers (err…voters) for this past several years? It’s going to end at some point. Is its expiration a potential black swan?
The combined efforts of the current administration and the last, together with the Fed, moving mountains to avoid any possible threat of an economic downturn caused by a loss of liquidity, has been extraordinary. This has been an entirely unique fiscal and monetary adventure. We are literally off the charts. Here be dragons. The counterfactual is always the handmaiden of rank speculation, but assuming for a moment that all of that intervention, all that fiscal and monetary support had not happened, would we be in the economic wilderness today? We don’t know, but the economy is close to full employment, with moderate (transitory?) inflation and GDP almost fully recovered from the pandemic year. If, arguendo, all that financial support made a difference, what happens when it goes away? Are we back in the wilderness? Will the butcher’s bill come due?
While the occupants of the heights seem, at least publicly, confident that all this largess can be brought in for a soft landing, our track record of engineered soft landings is not, shall we say, sterling. If this Rube Goldberg-like complex of monetary and fiscal stimulus is not perfectly unwound, it’s hard to see how it won’t risk a significant economic disruption.
But it hasn’t happened yet. GFC 2.0 must still wait in the wings.
How about if it doesn’t all end any time soon? Want to talk about real inflation? Stagflation? All this fabulous stimulus and talk of a soft landing from the Covid mess certainly carries with it a significant risk of inflation. While many self-proclaimed experts continue to insist that inflation is transitory (because to admit otherwise is to admit our monetary posture might not be sustainable), there’s certainly evidence out there that it’s not. I get all the arguments about supply disruption, labor issues, material shortages, etc., but I’ll join the Milton Friedman team here and say that we can’t (or shouldn’t) ignore a vast increase in the money supply and a vast increase in liquidity occurring in a market without a concomitant increase in productivity and rapidly growing GDP and be comfortable that inflation is not lurking. Inflation or, God help us, stagflation, will impair value creation, drive up borrowing costs, dry up liquidity, destroy savings and strip any mojo from the economy and ultimately such continued excess itself will lead to a recession when someone finally goes all adult and does something about it (hard to see who that could be at this point).
Hard landing, recession; no landing, inflation, then recession. Are we acting like we’re about to spend time between Scylla and Charybdis? It sure doesn’t seem that way.
How about Mr. Biden’s gigantic combined infrastructure and “human infrastructure” (what a brilliant example of good word-smithing!) plans? Somewhere between $5 and $7 trillion of spending, and half of that or more in increased taxes over the next decade. Does that change the calculus? As I’m writing this, “who knows?” is about a precise an answer as I have heard about whether some or all of this passes and becomes law. Could the passage of some or all of this be the black swan we should be worrying about? Certainly, we’re not acting like it will be the sort of precipitating event which rapidly moves markets. Less a cliff and more of a boiled frog sort of thing? Maybe. But for the moment, along with geopolitical risk, and Covid, federal fiscal policy still seems to be a black swan wannabe.
Well, that’s all the obvious black swan nominees strutting the red carpet gussied up in their apocalyptic finery, but I have another one to consider, a bit stealthier and one that I actually think could, over time, change the calculus. That’s regulatory change. Oh boy.
Mr. Biden’s administration has a discernible progressive tilt these days, which has taken many by surprise since transformational change was not exactly the centerpiece of his return to normalcy campaign. But now? Talk is, of course, cheap, but the talk is pretty belligerent.
More regulation under Mr. Biden has always been in the cards. For heaven’s sake, elections matter and the Democrats are in charge, a party with a congenital anxiety about, and indeed a certain hostility toward Wall Street, banking and finance. Couple that with a high level of confidence in the ability of government to make positive, important change, and you have the makings of a wave of significant regulatory action.
Remember people are policy. Look at the number of bona fide progressives who are taking seats in the administration. It’s pretty straightforward, isn’t it? How about the appointment of Barbara Roper to the SEC, or Lina Khan at FTC, and Mr. Gensler himself at the SEC? There’s Jared Bernstein at the Counsel of Economic Advisors and K. Sabeel Rahman at OIRA. Graham Steele to be Assistant Secretary of Financial Innovations and if Ms. Warren gets her way, Leal Brainard as the next Fed chair. All card-carrying progressives, all with an established track record of progressive views. There are no Robert Rubins or Lawrence Summers warming important seats in this administration.
Mr. Biden, right now, is trying to deliver a $5.5 trillion candy bowl budget of progressive policy goals, but he’s not likely to get everything he and Senators Sanders and Warren, et al, want. This will leave the progressive wing of the Democratic party seriously unhappy. That anger will have to be assuaged. What Mr. Biden will have in the toolbox to make progressives happy is broad and intrusive regulatory change. That’s the bone that must be thrown. (I note in passing that if the candy bowl is paired down with some Democrats’ complicit cooperation, it might be even worse. Nothing motivates the political animal as much as perceived apostates within its own caucus. The fire burns all the hotter for heretics and that will mean the regulatory action will have to be greater to serve an even more deeply annoyed progressive wing.)
When the White House goes looking for ideas for nifty regulatory change, there’s plenty to choose from. Take a look, if you would, at Senator Warren’s many articulated plans from the last presidential election cycle (and she is still at it…see her recent speechifying). Private debt is too high, banks shouldn’t be earning as much fee income, private equity is bad because it causes job losses, Glass Steagall should be restored and commercial banks fire-walled away from investment banking, executive compensation is too high and should be capped, there should be consequences for bank failures and financial disruptions and that means jail time for bankers, banks should understand that they have a societal obligation to provide leverage in some markets and deny it to others. That’s just a start.
And there are still goodies in the Basel IV goody bag and leftovers from Dodd-Frank, we’ll surely see the return of CECL and the full and aggressive implementation of the Fundamental Review of the Trading Book, the Net Stable Funding Ratio Rules and the Liquidity Ratio Rules which will all be used to reign in unfavored lending and investment. Some of the changes to the Volcker Rule adopted over the past four years might be reversed. There’s still more fun to be had with Pillar II. There’s the never resolved question of ratings agency reform and the possibility that the current SEC will embrace some sort of a rotation process among the main agencies, regardless of their competence, credit cultures or views of particular risks. That was one of the great bad ideas from Dodd-Frank but it’s still on the books; it’s still with us. Remember also that there was a notion in Dodd-Frank that perhaps the full panoply of public registration rules should be applied to all 144A transactions. How about that for good fun? Mr. Gensler was chatting up the Committee on Banking, House and Urban Affairs last week about SEC priorities and amongst them was issuer and underwriter disclosure in ABS. He mentioned in passing how enforcement and examinations must be more robust.
More disclosure, more compliance, the need to harvest more data, and more enforcement action. That’s a tax on productivity. Moreover, regulations inevitably increase the level of risk aversion as folks worry that they are not meeting the dictate of their regulatory masters. In such an environment of higher costs and more risk aversion, lending activity will be suppressed and torqued to meet administration goals and objectives.
Finally, ESG bears special mention. Whatever you think about its policy merits, ESG is going to be a can opener for a government trying to encourage investment in some aspects of the economy and discourage it in others. The existing budget identifies a lot of the winners (and by the process of exclusion, losers). The European Union is actually considering risk weighting bank books to serve ESG goals. The prudential pressure to facilitate ESG goals and the pressure on the private fund community is enormous. Weather largely moves from west to east but regulatory enthusiasm seems to move from east to west and what’s happening in Europe is a harbinger of what may happen here. Perhaps you’ll love ESG’s winners. And why not? Mom and apple pie, right? But, the trouble with picking winners is that there will be losers. This focus on ESG will drive capital away from unfavored asset categories and I’m just saying, one of those is likely to be commercial real estate.
So, there are plenty of black swan wannabes out there, all of whom are flapping their little wings on the red carpet, none have taken flight, as evidenced by the fact that most macroeconomic indicators still point upward and certainly both the stock market and the debt markets are quiescent.
Just because we don’t have a winner in the black swan category just yet, does not, however, mean one shouldn’t prepare for when a bona fide black swan will strut down the red carpet. It’s going to happen soon, isn’t it? Come on, you know it is. Given the current state of play, it seems almost inevitable.
There are things that can be done, recognizing that disruptive change is more likely than not in the reasonably near future.
Thinking out loud, the following are all worth considering:
- As a lender, don’t fight the tape. Embrace ESG opportunities. Embrace infrastructure. If the government makes it extraordinarily easy and lucrative to lend in the ESG infrastructure space while militating private risk through public intermediation, it’s time to lend there. Lend where the government leads.
- As the regulatory burden increases, and this is dead nuts certain to occur, it will disproportionately impact the regulated banking community (creating competitive advantages for) the alternate lending set and alternate lenders will provide an increasingly large share of credit to unloved (by the government) market sectors and that means, among other things, commercial real estate (will the non-banks continue to offer LIBOR next year and if so, what does that mean? A competitive advantage?). Continuing to raise money to deploy in the space is a good idea (though hardly an original one).
- Many of our black swans are consistent with continued suppressed coupons. Alternately, if one of those black swans is inflation or stagflation, it’ll be inflation for the wrong reasons. It won’t be demand driven, it will be monetary excess. So even as rates rise, yield requirements will rise faster and we’ll continue to have a gap that needs to be managed between the needs and expectation of the users of capital and the providers of capital. Consequently, either way there will be sustained, ongoing demand for leverage through warehouses of various sorts and leverage through CLOs and CRE CLOs. Also true, in times like this, it’s a very good idea to broaden out your avenues to acquire leverage. You don’t really want to be all in in the repo market or in any other leverage modality. If you have only one warehouse, get another or maybe two. I know they are expensive to put up, but you get very real risk mitigation from having options when the market goes pear shaped. (Goes cattywampus? I’ve always wanted to use that word).
- Well-heeled alternate lenders should grab the opportunity to become lenders in the warehouse space as banks’ ability to be in that market might diminish. A chance to earn modest risk adjusted returns (without the burden of the banks’ risk-based capital charges while waiting for opportunities to deploy cash in more lucrative opportunities). Consider, if you will, what might be called the positive externalities of filling that role in terms of data, access to deal flow, access to follow-on opportunities, etc.
- Consider counter programming the non-preferred market segments. Think about where the administration is likely to push the banks for whom they’ve got significant levels of control and get to the spaces that won’t be preferred. Okay, so that might not be favored by the political set, and maybe it will give you the opportunity to testify to a congressional committee or two, but any sector with barriers to entry and diminished competition is attractive…I’m just saying.
- A new distressed debt cycle is in the cards. Maybe not tomorrow, but it’s coming. Whether we trip into recession immediately, or take a stroll down inflation lane before doing so, the cycle has not been vanquished and a distressed debt opportunity is ahead of us. Certainly, a fair amount of money has already been raised in the space and no one should yet be thinking of giving it back. Personally, what I find really interesting here is the possibility of credit risk transfer trades coming to our shores in a significant way. While CRT transactions have occurred on a sporadic basis, it’s way more common in Europe and I think we’ll see more of it here. Spend some time figuring it out.
- Plug in to what’s going on in the political sphere. Pay attention to who’s filling seats and what they say in speechifying. Always true, but perhaps even more true now, as our business is likely to be increasingly impacted by governmental action. Forewarned is forearmed. While it’s tough sometimes to find enough bandwidth, given the fact we all have day jobs, to spend time watching the political sausage making, it’s surely a time when that investment is worthwhile.
There are plenty of black swan wannabes strutting the red carpet just now and I’m sure, based on the truism that there are always unknown unknowns, there’s probably something else that will scramble into contention on which we have no visibility today. Status quo of the post-Great Recession world will surely be disrupted.
So, stand by, it’s going to be a rough ride, but in volatility lives opportunity.
 Look, for these purposes, let’s put aside fundamental questions of whether enhanced regulation of the banking and financial sector is a societal good thing and just focus on the fact that it will be less than fun for most market participants.