I’m rarely, if ever, the smartest guy in the room. My math and science aptitude is even more impaired than California Governor Gavin Newsom’s reading comprehension abilities. I know that one plus one equals two, but venture much beyond that and you’d be asking me to explain quantum physics.
To get by in life, I’ve been forced to develop a heightened sense of common sense, much like a blind person develops sharper hearing or smell. Over the years, I’ve learned to tune out media noise and consensus thinking and instead identify people much smarter than me who have a track record of knowing what they’re talking about.
I call it the Starkman Instinct, and it served me well before the 2008 market crash.
Among my PR clients that year was a prominent securities arbitration attorney who was already doing a booming business representing wealthy investors whose brokers and money managers had placed them into complex securities marketed as safe and sound but were tanking at alarming rates. Among the investments my client expected to get torched were subprime mortgage funds, which had fueled the housing boom in the preceding years.
In June 2007, the Bear Stearns High-Grade Structured Credit Fund required a $1.6 billion bailout from Bear Stearns to meet margin calls while it attempted to liquidate positions tied to subprime mortgages. The following month, investors were told the fund had lost most of its value. Its sister fund, the Bear Stearns High-Grade Structured Credit Enhanced Leveraged Fund, lost virtually all its investor capital.
Months before those funds imploded, Federal Reserve Chair Ben Bernanke told Congress, “At this juncture, however, the impact on the broader economy and financial markets of the problems in the subprime market seems likely to be contained.” After the Bear Stearns funds collapsed, Treasury Secretary Hank Paulson reassured markets, stating, “I see the underlying economy as being very healthy,” suggesting the subprime fallout was largely insulated from the broader financial system.
While Paulson was assuring markets that all was well, I read a small item in Barron’s quoting a veteran market strategist who had correctly warned about the 1987 crash. I no longer remember his name, but I remember his message. What had triggered the collapse of the Bear Stearns funds was systemic. Another market implosion, he warned, was coming.
His view mirrored the warning from my securities arbitration client.
I called my real estate broker and told her to sell my co-op as quickly as possible. She insisted I was mistaken about a looming real estate collapse, but I held firm. She found a buyer, but as the closing approached, we were not sure they would show up.
The New York City real estate market was already seizing up. Buyers were walking away from signed contracts and forfeiting their deposits. I was blessed; my buyers closed on our deal.
I’ve lost touch with my securities arbitration client, but it’s a safe bet that suing brokerage firms and money managers for stuffing wealthy clients into risky investments they barely understood is once again a growth industry.
Susan Antilla, a veteran investigative journalist and one of the country’s sharpest observers of Wall Street regulation and arbitration, recently detailed how retail investors are getting mauled in so-called alternative investments they never fully grasped.
Antilla cites a survey by the Financial Industry Regulatory Authority of 2,861 investors. They were asked whether they would invest in a product that promised a “guaranteed, risk-free 25% annual return every year for the next five years.” Half said yes.
Half!
Little wonder that many on Wall Street privately refer to retail investors as “dumb money,” although in official marketing parlance they are beneficiaries of “democratization.”
Among the products aggressively sold to retail investors in recent years are Business Development Companies, or BDCs. The pitch sounds comforting. These vehicles make loans to medium-sized companies that either cannot access the public bond markets or prefer to avoid the scrutiny and covenants that come with traditional bank financing. The loans carry attractive yields and are supposedly secured higher up in the capital structure.
What could possibly go wrong?
BDCs have evolved into a massive private-credit machine that operates outside traditional banking regulation and the public market’s pricing discipline. Instead of bonds that trade daily and are priced in the open market, BDCs hold loans that are valued internally by the firms that originate and package them. Liquidity, investors are told, is available through periodic “tenders.”
Translation: you can sell your shares when the fund allows you to.
Legions of doctors, dentists, and other high-income professionals piled in, many believing these instruments were essentially high-yield bonds with a little extra spice. They weren’t.
They were private loans to leveraged companies, often backed by private equity firms, in structures that depend on continued refinancing, steady earnings growth, and cooperative credit markets.
Unlike the years leading up to the 2008 financial crisis, when the credit rating agencies played Sgt. Schultz and saw nothing, heard nothing, and rated everything investment grade, today even they are displaying flickers of discomfort.
Fitch’s outlook for the BDC sector is “deteriorating.”
That flicker has become sharper with Blue Owl Capital, one of the largest private-credit players in the country, recently disclosing it sold $1.4 billion in loans to return capital to investors in certain older funds and ending quarterly redemptions in one of them.
One of the buyers was an insurance affiliate tied to Blue Owl, alongside pension funds — not exactly the kind of broad, open-market price discovery retail investors imagine when they hear the word “liquidity.”
Blue Owl believed the loan sales would reassure markets. Instead, its shares slid, along with those of other private-asset managers. Some retail investors panicked. One Ohio investor quoted in the Wall Street Journal said, “The last thing you want to hear as an investor is that the door is closing.”
Blue Owl executives held a conference call with the money managers who distributed the firm’s funds and assured them all was well. The loans were only sold at 99.7 cents on the dollar.
Blue Owl is not a fringe operation. It sits at the center of the private-asset ecosystem, alongside private-equity giants Apollo, Blackstone, KKR, and Ares. Shares of many of those firms are down more than 30 percent from their recent highs, even before any meaningful wave of credit losses has materialized.
Private-equity firms buy companies, often using significant leverage. That debt increasingly comes not from traditional banks but from private-credit funds. Those funds, in turn, are frequently housed inside vehicles like BDCs, some of which are marketed directly to retail investors seeking income.
Put simply, the dentist in Boca Raton who believes he owns a conservative income product may, in fact, be helping finance a leveraged buyout executed by a private-equity firm whose stock is already down 30 percent.
Here’s the kicker: Bain & Co. recently noted that private-equity deals that once worked with five percent annual earnings growth now require 10 to 12 percent to generate acceptable returns.
It’s heartening that I’m not alone in my concern. Among those sounding the alarm is Jamie Dimon, CEO of JPMorgan Chase, America’s largest bank.
“Unfortunately, we did see this in ’05, ’06, ’07, almost the same thing,” Dimon said at the firm’s annual investor day in New York this week. “The rising tide lifting all boats, everyone was making a lot of money, people leveraging to the hilt. The sky was the limit.”
Dimon added: “My own view is people are getting a little comfortable that this is real — these high asset prices and high volumes and that we won’t have any kind of problem whatsoever. So we’re quite cautious about that.”
“All of our main competitors are back,” he continued. “It’s good for the world, et cetera. I don’t know how long it’s going to be great for everybody. I see a couple of people doing some dumb things.”
The systemic danger in BDCs and private debt is not that hedge fund titans get bruised. It is that affluent Americans are among the most exposed. They are the consumers still buying new homes, GM’s high-priced trucks and SUVs, luxury vacations and discretionary goods that much of the country can no longer afford. If their balance sheets sneeze, the broader economy catches a cold.
To be sure, Dimon has been warning about elevated asset prices for years. Last October, he likened a string of bad loans at JPMorgan and other banks to cockroaches.
“I shouldn’t say this, but when you see one cockroach, there’s probably more,” Dimon said. “Everyone should be forewarned on this one.”
Dimon pocketed $43 million in compensation last year, and JPMorgan’s board, which Dimon chairs, authorized $50 billion in stock buybacks.
That may comfort investors.
But in April 2007, just weeks before two Bear Stearns hedge funds imploded and the first tremors of the financial crisis became undeniable, JPMorgan authorized a massive $10 billion stock repurchase program.
Buybacks are not proof of impending collapse, but neither are they proof that everything is fine.
As Dimon himself acknowledged, cockroaches rarely travel alone.