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LDI: the New Subprime?


While the party created by yesterday's BOE intervention didn't last long (more about that below), I thought I would touch on what triggered the panic on the part of the Bank of England. It was caused by "LDI," or liability-driven investment strategies. This arose because there was no yield to be had thanks to ridiculous central bank policies of NIRP and ZIRP, which were exacerbated by QE. Thus, people who had long-tailed liabilities, whether they be insurance companies or pension funds, had no way to achieve their returns without taking an ungodly amount of risk. And that's what they did, because if you tried to be disciplined and not do the wrong thing, you would have been fired for underperforming.

Today's Special: Central Bank Surprise This is yet another byproduct of the can-kicking that we've seen, and of course in Europe they didn't clean up their banking system like we did. So, there's a reason why Deutsche Bank and Credit Suisse, for instance, have as low equity valuations as they do (Credit Suisse is currently a sub-$4 stock price). At this point we don't know what we don't know and there are going to be lots of problems that we will discover are consequences of the aforementioned central bank policies.

It just blows my mind that so many fools think that central banks can raise rates painlessly when it's been clear for a long time that these policies cannot be abandoned, and they are in essence an addiction. I suspect that narrative will change once the Fed is forced to panic, as it will be, because the pain will be too great.

Too Big to Bail? What's more, as I say, this is all without knowing what we don't know. It could turn out that LDI is this cycle's "subprime" -- but even with subprime, a lot of us knew that there was rot in that particular lending arena. Yet, we didn't find out about the special purpose investment vehicles until pretty late in the game, which were just a way for the banks to hide products and not mark them to market so that their already-leveraged balance sheets, which only had about 3% or 4% equity, were even more levered. Ergo, they were more liable to implode extremely fast (and spread contagion). The one thing we did right in America during the can-kicking of the last 15 years was to have the banking system strengthen its balance sheet, and I think that is one of the reasons why the first round of QE didn't create as much inflation as I expected.

In any case, if there's going to be contagion from LDI and other financial products we don't know about, the systemic problem children are liable to be in Europe, which is not what they need given the economic and energy issues they face, as well as the massive debts and incoherence between the EU and the people in many of the countries, the Italian vote over the weekend being a glaring example. So, Europe is in a world of hurt (as is Japan) and we will see huge stress on the ECB as worries escalate about the potential of the euro to totally fracture into separate currencies. Thus, the dangers continue to escalate, and meanwhile all the Bank of England did was try to play for some time.

Reaching the Pivot Point Today the Lord of the Dark Matter touched on this topic. He didn't have anything to say about any specific dangers, but he shared a great comment about the concept of buying bonds in a levered fashion, which was part of this LDI structure, and which it turns out originated with Bill Gross and Pimco. He goes on to explain:

"…across thirty years, Bill and his colleagues figured out that in the right, experienced hands, with the right risk management, and the right regulatory approval, leverage equaled alpha. It became known and remains known as 'lambda cash.' I want to be very clear: I [have] no concerns about PIMCO. If any firm understands how to manage and stress test the moving parts of a lambda cash program, through various liquidity and market regimes, it is them.

"What I am wondering about is all the people who, knowingly or otherwise, sought to replicate the 'lambda cash' idea: from the gigantic Canadian pension plans (colossal users of total return swaps) to a sleepy UK DB pension fund dreadfully misadvised by some asset consultant (they've been a bit quiet this week), it seems to me a lot of people used derivatives to gain duration exposure, and then sweated their cash in short-duration credit. Nothing wrong with that -- in the right hands -- but as this extraordinary liquidity cycle rolled on across decades to keep up with the play (FOMO), people took on more and more risk."

Don't Buy the Skinny Dip The reason I wanted to illuminate that point is because that's what we're going to find out. Again, going back to the consequences of NIRP and ZIRP, people everywhere took way too much risk (think excess exposure to leverage, LBOs, and venture capital). Thus, as the tide goes out, there is going to be tremendous destruction and that will increase pressure on the Fed to cave. One of these days it should be obvious that these central banks are to blame for creating untold havoc, and are even worse than the governments, which gave no forethought about their mindless pursuit of ESG at the expense of energy security.

With all that out of the way, the market was crushed right off the bat, led lower by the Nasdaq, which fell almost 4% before a modest bounce began. In the afternoon, the market chopped sideways to a little higher, as you can see in the box scores.

Away from stocks, fixed income was hit hard with the front of the curve taking the brunt of it. Green paper was weaker, with the pound rallying to over $1.10. I'm keeping my eye on the pound just as a useful barometer of financial stress. Turning to the metals, they were lower almost all yesterday evening, with gold falling about 1% and silver a bit more than that. However, in New York they started to rally for a change. Then the second-string economic data knocked them for a loop, but they rallied back again to close about flat, with many of the miners green all day.

Take Your DRAM-amine Tonight, Micron will report earnings and I expect it to be a horror show due to the complete debacle in pricing for DRAM. I like to think of my position as short DRAM, long gold -- in essence it's a commodities pair trade. I bring this up because the response to the news might be a good litmus test. There's a fairly decent short position in MU, but it's not epic. I expect that the news ought to send the stock tumbling, but we'll find out.

Positions in stocks mentioned: short MU, long MU puts.