Ultimately what I’m saying here boils down to this: unceasing market intervention has crushed the forward-looking expected returns for pretty much every asset class out there: rates, credit, HY, equities, equity with overlay/protection strategies (calls too cheap), long/short, macro, relative value, you name it. The Feds have done much more than just peg rates to zero and sit on the yield curve – they have quite literally stripped the investment management industry of most (but not all) alternatives for generating a decent return in the future by convincing the trapezing investment community that there is a safety net. This belief heuristic pulled investment returns into the present by rallying EVERYTHING. This is simple math, but hard to stomach for the investor who’s career is on the line if he’s not “chasing” or “in the game.”
While I remain sympathetic to the left tail of deflation as the probable outcome (the risk is real, but yes the risk has been overpriced by protection buyers for some time now, as Chris Cole points out), I have been thinking a lot lately about something else that’s bugging me about the right tail. I recently went back to my notes from late 2007 and found an old rant that I wrote at Citi where I discussed Bill Ackman’s Pershing Square presentation on shorting MBIA and Ambac. Those were his high conviction shorts on account of their overwhelming exposure to junk mortgages – and as it turns out they were some of the “AAA backstop” to the whole shadow banking system when it came to shoddy mortgage securitizations. Ackman’s view was, even if subprime is only a $100bln problem that is ‘contained,’ the claims that MBIA and AMBAC might have to pay out were so huge relative to capital cushions that they would quickly overwhelm the balance sheet and send these stocks from $80 to zero, quite literally on a razor’s edge (did I mention these were AAA rated!!).
In recalling this recently, it suddenly occurred to me that we are into something comparable but possibly far more serious today. The idea of how pressure in complex systems builds up over time… that complexity and connectivity magnifies contagion mechanisms both seen and unseen… and yet asset prices no longer reflect much worry for future risks … why exactly? Because the Federal Reserve has become the ultimate backstop, just as the fixed income derivatives guys on the trading floor upstairs thought they could rely on Ambac and MBIA. I hate that this seems to head down the goldbug rabbit hole, but where else does this go? The real convexity… the real non-linearity payout today… it’s in betting on the failure of the optical backstop just like it was back then – the thinly capitalized, AAA-rated guys who are purportedly smarter than everyone and happily set up a business where they guarantee immense risks and collect what they think is a sufficient premium that turns out to be laughably insignificant. Today MBIA and AMBAC are no longer in business – by this I mean their “guarantee” is not worth much for any future underwriting. So who took their place, figuratively speaking? Whose balance sheet is the ultimate backstop to reckless financial speculation? Who created Too Big To Fail? Who says “Hey, I have the ultimate liability here, but don’t sweat it cuz the worst case scenario is simply impossible”… do you see where I’m going with this?
