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.