The Dividend Cafe - Contagious Ignorance

Episode Date: April 1, 2021

The actual event that I am discussing may be totally foreign to you, despite the fact that it has dominated the financial news for five or six days. There is a good reason for this if, indeed, it is true for you. The event has proven to be a really weak “news” story in my mind (not for lack of trying), but even apart from the broader news hype, it has further proven to be a weak “financial news” story, and that really, really comes not for lack of trying. This news story begs for us to address the subject of “contagion risk.” After listening to this episode, you will know much more. DividendCafe.com TheBahnsenGroup.com

Welcome to the Dividend Cafe, weekly market commentary focused on dividends in your portfolio and dividends in your understanding of economic life. Hello and welcome to another edition of the Dividend Cafe podcast and video, this time recording here from my little spot at LAX getting ready to jump on a plane. So I will be traveling to New York the rest of today, and then we'll be done for the week because tomorrow is Good Friday. And so the Dividend Cafe is coming to you

on Thursday this week in one of these very rare Friday market holidays. We'll have the long weekend and then be back to normal next week. The topic this week at Dividend Cafe is solely focused around the events of this week that probably for regular people watching regular news, they may not have had to be exposed to it. But for folks that are somewhat gluttons for punishment that watch financial news all week. This was the story. It really began kind of last weekend and picked up, stayed constant throughout the week.

And it was a story of this private, what they're calling a hedge fund, but it wasn't even a hedge fund. It was a private investment firm of a family office that sort of blew up late last week. And to give you kind of the nutshell of the story, I'm going to apply this to you. I'm going to apply this to our clients. I'm going to apply this to other investors. But I'm going to use the story of what happened to this particular private investment firm to kind of draw a broader investment lesson for all of us. And really, if you don't mind, to be as snarky and critical as I can possibly be of the media. Probably some politicians too, but par for the

course. Here's what happened. There was a private family office of a multi-billionaire, former hedge fund manager himself. It's actually an individual I've met with on two different occasions, have known by all reputation, understanding, very well regarded, well liked, very philanthropic individual. It was just levered out of their skis in a couple of different particular companies. It appears that most of the concentration was in two pretty good size American media companies and three or four Chinese Internet companies. So not tiny, small cap, obscure companies, well-known, heavily liquid, in a couple of cases, mega cap companies. But the difference here is they were not just simply overly levered and then the stocks moved down and they kind of blew up, but they were levered through swaps, through what's a form of derivatives where you can get a lot of leverage and you don't have to put a lot of collateral up. And it's not transparent. It's a way of getting around the regulatory requirements of disclosing to the

world what you own. It is a very obscure way of going about doing things. It's hard to explain because if I start going down the vocabulary rabbit hole, I'm going to lose you. I could explain it all. And if any of you want me to unpack it, send an email. I'm very happy to do it in a deeper way. But look, the entire notional exposure of these equity, the entire capital exposure of these equity derivatives worldwide is not even $300 billion soaking wet. There's over $10 trillion of swaps on interest rates and getting close to $3 trillion, it's over $2.5 trillion in currency swaps. So that's real big money. And those are not just levered, naked, highly risky financial transactions. Those are hedging some financial exposure.

And they're very commonly used, and they're very impactful in capital markets for a number of different reasons and a number of different ways. With these equity derivatives, it's a way of getting exposure to a security or a basket of securities. And at the end of the day, with the counterparty, you get to receive kind of either the risk or reward. And along the way, as things move, there's collateral that has to be put up.

And one of these stocks last week moved down a lot. They needed collateral. It wasn't available. Other stocks were moving. So there're brokers who've extended this debt capital to lever the position, start selling them out. Once you start selling out of a position, then you get more downward pressure. And once you get more downward pressure, you get more selling. And that's the negative feedback loop that is levered finance always and forever. So in this particular case, this individual, his family office, this private investment firm, it appears is blown up.

And if indeed the banks that were lending, one is a European bank, pretty well known, one's a Japanese bank, slightly less well known, that have a few billion dollars of exposure apparently each, if they lost money, then that means the losses for the family office were over 100%. It means they lost everything. The only way that lenders can lose money is if all the equity capital is first wiped out. So it's a very sad story for this family. I don't want to take anything away from any employees, partners, stakeholders involved. Could have happened there.

But the idea that this has been presented all week as a systemic or contagious risk to other investors is so preposterous and so weird, given what the market itself was doing on the day of this alleged meltdown. The Dow was up 450 points. on the day of this alleged meltdown, the Dow was up 450 points. Then the follow-up day, after I spend the weekend getting pop-ups and stories and traders, literally, I'm reading this word for word. Traders will be glued to their screen Sunday night, anticipation of meltdown and market and blah, blah, blah. Market was up 100 points Monday. All right, down a few points Tuesday, Wednesday. Right now, as I'm recording, futures are up early Thursday morning.

So you have markets up through this period. There's clearly not even a tiny bit of contagion risk going on. And the media does its very best to make this whole commotion out of it. So I think, first and foremost, I just want to remind my clients that the media is not your friend. Their business model is clickbait. Their business model is hype, is generating a lot of noise, either euphorically or gloomy, panicky noise that is good for attention getting and not relevant to the fundamental realities of investors. Secondly, I want to point out that the vast majority of events that are presented as a big

deal are not contagious. It is sad for someone to lose a bunch of capital. And it is secondly sad for their lenders to lose capital. But those were transactions that grown adults bore the reward potential and the risk potential of. And by the way, not just grown adults, billionaire grown adults, highly sophisticated. So these people could lose a bunch of money that has nothing to do with you. It has nothing to do with what would be called a contagion risk. Well, I'm not saying contagion risk doesn't exist, though. It didn't exist here. And I think most of the time that we talk about it, it doesn't exist. But we all know from the financial crisis of 08 that the events of one actor spilled to another actor that spilled to another, once

counterparties start having capital erosion, it can lead to other events. I think the potential for that in the European moment, 2010 through 2012, we didn't really know what bank exposure was to Greek debt. And if Greek debt went down and what would happen to Italian debt? And if Italian debt went down, what would happen to Wall Street firms? And if Wall Street firms went? So, okay, that's a legitimate domino conversation. You're talking about a few billion dollars of a private family office money. And by the way, I understand a few billion dollars is a lot of money to us. The line I use in Dividend Cafe this week is it's a lot of money for our family budget. OK.

In global financial markets, a few billion dollars. It's not like it's couch money. It's not even lint. It just literally is a rounding error in the grand scheme of things, unlike the trillions of dollars that ended up being contagiously impacted through the financial crisis. So what I want to leave you with is this idea. There is such a thing as contagion A, which is real contagion risk. Financial crisis 08 is always going to be the kind of easy understanding of that concept and that reality that played out.

Contagion B is noise, is volatility, is a couple days of wondering what's going on, a little uncertainty. Spreads can widen out in credit markets. There could be forced selling and risk parity hedge funds, these types of things. We've had moments like that. We'll have more moments. The media loves those moments.

They can be scary. I don't want to downplay it, but my point is contagion B is only a risk to you when you choose to make it a risk to you, when you choose to play into the noise by deciding to do either panic buying, which can be pretty silly, or worse, panic selling. This case is either contagion A or B. It's contagion nothing. This was a nothing burger of a story for us, for global financial markets. But in terms of other events that are never going to happen, I would suggest that it's our job to identify what's a real contagion B event, meaning noise, meaning a few days, meaning volatility, and not something that has a

fundamental impact to the earnings capacity of the companies we own, a fundamental impact to the credit worthiness of the debt instruments we own. That's what we care about is both equity and debt investors. And I think that getting this right is gonna save investors from a world of trouble and getting a little reminder of these lessons will go a long way towards the outcomes

we all want as investors. Outcomes that do not include blowing up a few billion dollars in a few days. All right, I'm going to leave it there. We'll jump on this plane and look forward to come back to you next week, but not until you first all enjoy your Easter weekend in front of you.

Thank you so much for listening and watching as always the Dividend Cafe. or advisors LLC. This is not an offer to buy or sell securities. No investment process is free risk. There is no guarantee that the investment process or investment opportunities referenced herein will be profitable. Past performance is not indicative of current or future performance and is not a guarantee. The investment opportunities referenced herein may not be suitable for all investors. All data and information referenced herein are from sources believed to be reliable. Any opinions, news, research, analyses, prices, or other information Thank you. of the data and other information, or for statements or errors contained in or omissions from the obtained data and information referenced herein. The data and information are provided as of the date referenced. Such data and information are subject to change without notice. This document was created for informational purposes only. The opinions expressed are solely those of the

Bonson Group and do not represent those of Hightower Advisors LLC or any of its affiliates. Hightower Advisors do not provide tax or legal advice. This material was not intended or written to be used or presented to any entity as tax advice or tax information. Tax laws vary based on the client's individual circumstances and can change at any time without notice. Clients are urged to consult their tax or legal advisor for any related questions.