Prelude to the Next Recession

Fugue's picture
Rank: Almost Human | 6,219

Hey Monkeys,

Almost ten years ago, the Fed, followed by the other central banks of the world, embarked on an unprecedented mission to save the global economy from spectacular implosion with QE. Shortly afterwards, new regulations were instated to improve the health and security of the financial sector (despite the many gripes this forum is bound to have with those efforts). As many have noted in the past decade, I don't think that the effects of these policies were strictly predictable at the time QE was implemented, but these decisions were made nonetheless, as action was urgently needed.

The more I read the news these days, the more I see things that concern me about the macroeconomy. It seems to me that with increasing frequency, we are hearing bad omens in the press about the unintended, but perhaps inevitable effects of crisis-era rescue measures coming home to roost. Just today, the Wall Street Journal published this article about the rapid expansion of direct lending to small cap and mid market enterprises by institutional investors, acting through financial intermediaries such as private equity and hedge funds.

In part, I suspect this pivot to what is essentially shadow banking is a response to the more restrictive capital and lending requirements of Dodd-Frank and Basel. In part, I imagine this pivot is also the natural effect of a private lending sector flush with dollars seeking a haven from bonds that have nowhere to go but down, and equities which are breaking historical highs all the time.

I am not trying to draw strong parallels to '08 with this post - from what I have read, there is no analogue currently for the role played by credit default swaps in the lead up to 08. Further, I do not see a direct analogue for the perverse incentives surrounding synthetic CDO underwriting which plagued the banks in the lead up to 08, two crucial components which allowed that bubble to expand well past the safe point. In other words, I would like to think that the equation doesn't currently involve the degree of principal-agent problems which made the magnitude of '08 possible.

This article, however, draws one parallel that is clear to me. That is, institutional managers (pension funds, insurance companies, etc) are venturing into unfamiliar territory, and relying on investment managers to be their financial sherpa through a murky world of high risk, highly structured junk lending.

What troubles me further is that behind the first layer of "unsophisticated" investors is another, much larger layer of even less sophisticated investors. I'm talking about the public employee unions of this country, and the other beneficial owners of the assets invested by institutional pension funds.

It seems to me that this bull run has the potential to persist past a "safe" point, because (1) the managers are turning to risky credit because they have nowhere else to go for returns, (2) the institutions are turning to the managers because they view their investment expertise as the only way to keep up with unrealistic payout obligations mandated by governmental bodies, and (3) the ultimate investors, the pensioners, are totally unsophisticated - they aren't paying attention to sound investment philosophy, and will only start to make noise when their state pension plan dramatically fails to meet its obligations. When those obligations aren't met, complaints will mount fast.

Keep in mind the grim state of retirement saving in this country. For the record high number of Americans who are asleep at the wheel of their retirement plan, expecting social security and their job pension to cover their living expenses for decades, what are the implications of a failure for these expected payments to materialize?

Further, the pension plans themselves are subject to the pressure of government intervention and legislation. I think it goes without saying that I don't need to sell WSO on the pitfalls of an investment program that is subject to hijacking by congress.

Trouble on the horizon for large public pension plans has been discussed in the press for years. I feel that for those analyzing this question, the issue is more a matter of when, than whether X state will fail to make its retirement fund payment obligations in the next few decades.

When and if they do, what will happen to the system of private capital that is currently propping up the economy? It seems more to me than simply a question of falling equity prices.It seems, from this article, that this system now props up the vital day-to-day financial lifelines of companies - the short term loans and revolving credit facilities necessary to stay operational every day.

Are there any people with industry experience that care to share their thoughts on these issues? The puzzle seems too large to understand on one's own, but I think the pieces are slowly starting to become visible.

Comments (60)

Best Response
Jun 15, 2017

Meaningful tax reform, reducing regulation and revising decades old trade agreements could fuel growth. Sadly, it is more politically appealing to crash this country into the ground than tolerate anyone who isn't PC.

When I'm on the breadline and homeless I'll sure be glad that men can use the women's bathroom. Or that we are sanctioning Russia because the voting public didn't elect the worst democratic candidate possible.

$20T in debt. 15 years of endless war. 100MM Americans out of the work force. China building islands. NK nearing solid state rocket capabilities. Student loan debt soaring. Obamacare collapsing. But let's focus on Russia.

This country is a joke.

Jun 15, 2017

don't you know that this life is a life of sin ... stop cryingg

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Jun 15, 2017

The war is endless because Radical Islam has no end goal.

Our country has lost its values. Political parties are to make it easy for voters to organize, not to serve the financial benefits of the candidates.

Our economy is fucked because our politics are fucked up. Next election looks like it's going to be between the radical idiot on the left and the radical idiot on the right, again. No fix in sight. We just need someone to do what's best for the country--not the poor, or the rich, or the worker, or any of that stupid high and mighty shit. Just fix America.

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Jun 16, 2017

Lol so you're saying its okay for other countries to hack our election because the other candidate was an idiot? I see how we ended in this point in the first place.

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Jun 16, 2017

I see you cannot use simple reasoning.

1) Russia didn't hack our election
2) Weak evidence Russia "hacked" the DNC emails which had no bearing on the election.
3) no evidence Russia had anything to do with the Posesta emails.

Furthermore, the mainstream press, which most Americans get their "information" from gave the podesta emails no airtime.

HRC lost because of the FBI, her being a horrible candidate and Dems turning their back on their blue collar base. Hence why PA, Michigan and Wisconsin went red when they usually go blue.

But keep touting that fantasy.

Jun 16, 2017

@TNA out of curiosity, did you vote Trump in the Repub primaries slash would you have voted Trump in the primaries?

Jun 17, 2017

I'd vote for a bill that would make Trump the eternal leader of this nation. And I have more respect for Putin than any politician in this sack of shit country.

If Russia hacked us, keep it quiet. This country is a joke. Banana republics get hacked. The US does this shit to panama or Nicaragua.

HRC fucking sucked. She was shrill. Dirty AF. And who did republicans run. Man pussy Bush? Please.

Jun 15, 2017

Btw - per the non bank lending.

Govt pushed this lending from banks to non banks under the idea that they aren't structurally important and don't put deposits at risk.

When a company fails at a bank it goes to work out. The company can improve and then get ABL financing or go somewhere else. Non banks don't have work out staffs. They sell or liquidate. And guess who invests in these non bank funds? Pensions. So if they fail, people lose retirement.

CLOs, BDCs and non banks are juicing leverage and covlite deals. There will be a reckoning.

Law of unintended consequences.

Jun 15, 2017

This is exactly what I'm saying. Private capital markets and the entities they do business with are largely opaque by comparison to the entities lending in the leadup to '08. As the article states, the credit is also hugely exposed because it is tied to the fate of individual companies, not huge baskets of securitized assets. Yet there's a huge amount of mom n' pop capital that's deployed through the private capital markets. What happens to all those people (and also the enterprises their capital is supporting) if other macroeconomic factors force a contraction in this credit that has been expanding on the balance sheets of private investors?

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Jun 15, 2017

I was reading the gold sheets and they talked about how these non bank players are untested in a downturn. We shall see how things work out.

Personally, as someone whose spent their entire career in the credit markets, things are getting nuts. I have friends at different places texting me saying "look at this absurdity". With so much money out there and not enough good deals, you have people doing stupid things.

Jun 15, 2017

Pretty sure there will be a market collapse and I think it can be as big as the great depression.

Jun 16, 2017

Unfortunately our economy is far too complex for that to happen. I know that young retail bears and old cynical jaded people think that'll happen, but I've been hearing that drama for 31 years. Bears are a broken clock theory at best.

Jun 15, 2017

Blah blah blah blah blah. The recession will come once interest rates rise to a certain point. What many people don't remember about the crash of 2008 is the interest rate policy (hikes) in 06 and 07.

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Jun 15, 2017

What you're saying is elementary, and it's somewhat funny that this is the basis of your insinuation that others misunderstand the true causes of '08. Of course bull runs come to an end when interest rates rise "to a certain point". That's the foundation of macroeconomics and the basis of the federal reserve bank's existence. Thanks for stating the obvious.

What is not obvious, and what I'm asking, is whether the nuances of the current capital markets structure will make the next recession more violent than it should be. One of the reasons '08 was more than just another planned economic contraction, and ended up being the worst recession since the Great Depression, was because perverse incentives, off-balance sheet insuring, and (depending what you're reading) the efforts of players like Magnetar caused the bull market to persist long after a simpler, more rational market would've put the brakes on the market for RMBS and CDOs. A misalignment of incentives, moral hazard, and rampant principal agent problems among counterparties fueled the creation of absolutely shit securities that a "rational" market without moral hazard wouldn't have contemplated.

The question is not whether there will be a recession. The question is whether the recession should've already started, and if so, why that is, and how long we will have to wait for it to begin. And, when it does arrive, how far down the tumble will be.

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Jun 15, 2017
Fugue:

Of course bull runs come to an end when interest rates rise "to a certain point". That's the foundation of macroeconomics and the basis of the federal reserve bank's existence. Thanks for stating the obvious.

In fact, no it isn't.

Neoclassical's (i.e., mainstream economists) do not believe that the FED has any meaningful control over interest rates, with the exception of the over-night rate and potentially other rates on the short-end of the yield curve. They believe that interest rates are set entirely by endogenous variables related to international capital flows, savings conditions and the demand for investment. Therefore, they do not believe that either recessions or expansions are, in anyway, a function of fluctuations in interest rates. They attribute macroeconomic variability to 'real' conditions (i.e., factor productivity - see "Real Business Cycle" theory).

Now Keynesians can attribute business cycles to higher rates via the demand channel. In other words, a policy of higher rates, in the Keynesian world, could restrict aggregate demand and, as a result, investment (Keynesians believe that investment is a derivative of demand and not vice versa). Unfortunately for the Keynesians, aggregate demand peaked right before the recession, as interest rates rose and Keynes really fell out of favor in the 70s.

So no, the proposition that high interest rates lead to recessions is not "the foundation of macroeconomics" as you so laughably assert. And no, that's not the "basis of the federal reserve bank's existence." The basis of the FED is to act as a lender of last resort. It gained open market operations authority during the great depression when, as you may have guessed, Keynesian economics became mainstream. Keynes is no longer mainstream and the idea that business cycles are directly the result of interest rate policy has never been mainstream, though the Austrian's argued for it in the 30s.

But it's okay. I don't expect you to know much about this stuff. After all, you're just some random schmo on WSO.

Fugue:

What is not obvious, and what I'm asking, is whether the nuances of the current capital markets structure will make the next recession more violent than it should be. One of the reasons '08 was more than just another planned economic contraction, and ended up being the worst recession since the Great Depression, was because perverse incentives, off-balance sheet insuring, and (depending what you're reading) the efforts of players like Magnetar caused the bull market to persist long after a simpler, more rational market would've put the brakes on the market for RMBS and CDOs.

I know you think that this sounds impressive, but no economist takes this shit seriously. This is the garbage that talking heads on CNBC and political pundits go on about, but macroeconomists aren't interested in it - and for good reason. Blaming CDOs and RMBs for a recession is like blaming a thermometer for a fever. It's about as useful as blaming "greed." In other words, there is absolutely no relationship, empirical or theoretical, between business cycle volatility and financial innovation. RMBs/CDOs/Swaps increased in prevalence before the 2008 market crash as a result of the financial risk in the system - they did not create it.

Finally, it's not the case that market crashes cause recessions. Recessions cause market crashes. Broader macroeconomic conditions were deteriorating before the financial crash of 2008 (as an example, the collapse of Baltic dry index). Which assets are affected first, and to what degree, depends on historical circumstances, but that isn't fundamental.

What fundamentally causes recessions (inadequate aggregate demand, inadequate supply of money, too much leverage, interest rate policy, etc.) is what's up for debate. The shit you're talking about is really irrelevant, though I get that you think it makes you sound competent.

Fugue:

The question is whether the recession should've already started, and if so, why that is,

No because interest rates are still low.

Fugue:

and how long we will have to wait for it to begin.

Once they rise to about 5 - 6%. Maybe lower this time.

Fugue:

And, when it does arrive, how far down the tumble will be

Not sure. Probably bad though.

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Jun 16, 2017

Yeah and people are quick to forget that retail never, ever, ever has accurately predicted shiiiit. Broken clock theory at best! We will never have a bear market again in our lifetime. Buy high and sell higher.

Jun 15, 2017

Higher leverage is just a direct consequence of monetary policy, no? The Fed's goal is encourage the search of higher yields in assets perceived to be more risky during times of weak economic activity. So, as we move further towards the goal of full employment and moderate inflation, the economy will have a recession, but crisis level is when the 70% economic driver gets crunched, which is consumption, not savings.

Jun 15, 2017

Sure, but have you considered that the people who currently fuel consumption are about to retire, and that many of their pensions are invested in the markets I'm talking about? And that aside from their investments in these markets and their social security, almost half of them have literally nothing saved, and much of the remaining half have almost nothing saved?

I.e., when you have no savings other than your house and your pension plan, and then your pension plan takes a hit, what effect do you think that has?

It means people buying less lavish retirement home packages.

It means people eating cat food rather than going out to restaurants.

It means less consumption.

Which means a recession.

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Jun 15, 2017

The reason I don't think savings will drag consumption down in that way is because pension funds are a diversified asset. So whether that fund is 2%, 5%, or 10% PE, there's a cushion before consumption gets hit.

As well as there's the 'dry powder' stat of some $800B of PE funds to be invested. But you're right that there's potential for the economy to start heating up too fast again like in the runup to 2008 if the Fed gets too complacent. While interest rate policy might've been effective at helping the market find a boost, we are at risk of it sitting too low for too long.

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Jun 16, 2017

Recession is over! Don't people get that? Bubble popped in 2015/2016. Let the biggest bull run of our lifetime ensue. Buy the dips...what dips? Buy high and sell higher.

Jul 11, 2017
Ativan:

Recession is over! Don't people get that? Bubble popped in 2015/2016. Let the biggest bull run of our lifetime ensue. Buy the dips...what dips? Buy high and sell higher.

I love the persistence here, got a good chuckle out of it. I can't tell if you really agree with this or are the WSO analogue of D&P trolls on stocktwits. Still, you do have a different POV and I wonder if there's more to come?

Jun 16, 2017

Where do you invest your capital in a time like this? Would love to hear ideas

Jun 16, 2017

im 24 I don't invest yet because there hasn't been a recession. my computer traders spy weekly options for me, flipping house money.

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Jun 16, 2017

this morning june 23 242 calls 1.02 to 1.17 first trade. up 58% this week. keep scalping it based on models.

Jun 16, 2017

In the same boat +1 SB. Can't wait for a nice selloff (as long as it isn't too big and then I lose my job haha!). That Amzn deal is so tempting though

Jun 16, 2017

You're 24 and you missed the 2015, 2016, and 2017 dips? Market crashed 3x in one year and was halted 3x in one year (that's rare). MASSIVE equity buying at the lows (literally close your eyes and buy anything and make money).

FYI: 2015/2016 recession ended. Bubble already burst. Or you can wait until 2022/2024 area to buy again.

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Jun 16, 2017

You don't invest your capital in times like this. You store your dry powder and wait for the rest of the world to regain its sense of skepticism. The, once prices have come down, you buy in at a bargain.

Of course, you should maintain a dollar cost average program alongside your dry powder. Can't neglect that aspect of your portfolio.

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Jun 17, 2017

Yeah sure whatever... just remember that 2134 was a GIFT (the first ATH in 2016). Remember that nothing is ever too high to buy. Always remember that.

Jun 16, 2017

These threads suck because you guys always try to point at an exotic product and say that's the harbinger.

QE is the only thing that matters. Period.

The economy that lives by QE, dies by QE.

Jun 16, 2017

No, you suck, buddy.

If you read my initial post, you would understand that I agree with you - that (1) of course the contours of the macroeconomy are severely distorted thanks to the effect of QE on bond markets and, subsequently, equity markets, and (2) that the credit system has also now become distorted because dodd frank has tied the hands of traditional lenders and the private funds crowded out of the markets due to (1) are filling the shoes of the banks.

The exotic product is not the harbinger, and I never said as much. In fact, what I actually said is that there is no analogue for the exotic product in today's economy - covlite loans, CLOs, and revolver facilities are not new or exotic in the way that CDS/CDOs were. I do, however, think that while QE/Dodd-Frank distortions are sufficient evidence to suspect an impending recession, the magnitude **of the recession and **identifying those who bear the brunt of it are only predictable insofar as you look at the particulars of what is happening in the economy right now.

It is no coincidence that direct lending from private funds has increased by multiples since the recession, even eclipsing the pre-recession highs of comparable lending. It isn't just another irrelevant detail to be waived away while patting yourself on the back for understanding the inverse relationship between bond rates and prices. If you understood my arguments, you would understand that I view this phenomenon as an extension of the effects of QE.

I bring up 2008 because it is a helpful, albeit different example. I'm not saying the implosion of LEH and Bear were prima facie the result of their foray into CDO underwriting - but I am saying that prior to the collapse, you would not have been able to predict what was to come without understanding the centrality of these financial innovations to the economy, and understanding the proximate counterparties that stood to lose in the event of those innovations taking losses.

Similarly, if you want to predict how this recession will pan out, you must understand the significance of an economy where corporate lending by banks has been supplanted by corporate lending from first and second vintage funds that have not weathered a downturn, do not engage in workouts in the event of adverse credit events, and expose pensioners, rather than shareholders, to the brunt of financial losses.

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Jun 16, 2017

I wasn't calling you out. No need to be defensive.

Next crisis is a currency/sovereign debt (in my humble opinion).

Unlikely to look like '08.

We already know what these morons in the Eccles building are going to do when the next recession hits.

You'll hear the printing presses from Mars.

Take a guess at what happens to markets when gasp investors realize that liquidity injections (aka money printing) doesn't create growth.

Jun 16, 2017

100% agree. QE for life. Feddy will never let us down.

Jun 16, 2017

Calls closed at 1.36. This market ain't going down till they algo drop it again overnight 500+ points summer 2015 style .

Jun 16, 2017

if anyone here actually knew dick they'd be rich enough to not squabble on these forums.

If the glove don't fit, you must acquit!

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Jun 16, 2017

Hahaha, no no no quite the opposite, people who have more money than they know what to do with are exceptionally bored and they would squabble on these forums :)

Jun 21, 2017
WalMartShopper:

if anyone here actually knew dick they'd be rich enough to not squabble on these forums.

That's the goal. I find myself coming back here when I'm scratching my head trying to figure something out, not because I don't have a dive in Bonaire with my name on it. I look at the hysterics on this thread and wonder if my mother's circle of old biddy friends all opened accounts here so they could fret about the printing presses, illuminati, and how HRC is still ruining the country....holy cow. But who cares. In 50 years, no one here will give a crap about an argument they started/won/lost or didn't even understand.

More to the point, I'm just trying to figure out the timing of the upcoming bear trap. Any takers on venturing a timeline

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Jun 16, 2017

Yeah there's always drama on the news. The most uneducated generation, watching the news to get their economic information, etc. News loves fear, that's how they sell ratings and click bait drama. Truth is, the biggest bull run of our lifetime has started. Were you around for the massive crash of 2016? Did you BTFD? US stock market was halted 3x in one year, that's rare. Bubble already burst. Give it awhile - we just got out of our second recession.

Jun 16, 2017

Well, taking your argument and following it further out into the future...money is fake then, right? Economy fake, etc. Full faith and credit clause. BTFD...buy every dip.

Jun 19, 2017
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Jun 21, 2017
Jul 11, 2017