My Top 10 Wall St. Saves

"As long as the state exists there is no freedom. When there is freedom there will be no state." V. Lenin 

The deadly coronavirus is a severe health crisis that will be hopefully resolved in the near future with the help of vaccines and sensible public health policy. Once again the US Federal Reserve Bank (the Fed) cavalry has ridden to the rescue and 'saved' the financial markets from a doomsday scenario. However, the influence of the Fed in capital markets and the subsequent ‘hangover’ will possibly take several decades to unwind and we must live with the unexpected consequences.

The side-effects of the unprecedented levels of Central Bank intervention are multi-faceted and undesirable. They include inefficient markets, bad allocation of capital, perpetuation of crazy bubbles and ‘enrichissement’ of the ‘in-crowd’. Most of my financial career there has been a long and increasingly tortuous path of Fed interference and adventurism in capital markets which inexplicably rises exponentially in scale with each crisis.

To have an idea of this encroachment and impact on free markets we need to ‘rewind’ slightly and play my often myopic and highly biased version of market history.

Once "Greed was Good"

Back in the early 1980s the world was in convalescence from a large bought of inflation from the 1970s oil crises and US interest rates were above an eye watering 10%. I don’t really remember the oil shocks since I was too young but I remember the 1970s summers being hot and seemingly extending forever (probably a childhood illusion) but on the TV adults spoke ominously of industrial strikes and trash in the streets.

In the 80s, pop music arguably improved, interest rates fell and stock markets soared in a chaotic free-wheeling market. The high yield bond market was invented by Michael Milken (who later went to jail for pushing the envelope a bit too far), Gordon Gekko appeared in pin-stripes with a brick sized mobile phone in the movie “Wall Street” and “greed was good”.

In the UK, Margaret Thatcher was loved or hated for her social and economic policies but was a fervent supporter of free markets. Perhaps her ideology was too extreme if you were a coal miner or union member but an economic boom ensued. The property market went crazy, entrepreneurship became trendy, more restaurants opened up and flashy money appeared. I even remember seeing an entire transporter full of Ferrari Testarosas driving past my school. Bizarrely, comedian Harry Enfield improbably reached number 4 in the singles chart with the song "Loadsamoney".

Her privatisation program, although you might dislike cramped franchise run commuter trains and buying electricity off the EDF (an inspiring attempt to hide ‘Electricite de France’ from the Brits) was overall a short-term success. In contrast many European countries still have not bitten the bullet and have highly unionised, state run inefficient, bureaucracies constantly demanding tax-payer funded bail-outs (I am thinking France and Italy which mainly defy all the laws of economics). 

#1 The Great Japan Crash

However, perhaps the most beneficial long-term policy of the Thatcher years was enticing foreign inward investment, particularly the Japanese. It was a bold attempt to make the native British industry ‘pull their socks up’. As a teenager one of my friends had a crappy yellow Japanese Datsun car that smoked a lot, bits fell off and it did not impress the girls. Everything rubbish was an import from Japan.

However, overnight this somehow changed and everyone was discussing VHS and Betamax and buying the latest Sony Walkman and the latest high-tech Japanese gizmos. A few people moaned that all the indigenous British TV manufacturers were being driven out of business but the Japanese had somehow mastered the knack of building great products, with high quality and efficiently so they could make money so nobody cared. They even had fairly enlightened personnel policies (if you could put up with the daily corporate exercise routine). Japan was booming.

The Nikkei rose from around 7000 in 1985 to over 36,000 in 1991 and the Tokyo property market was so overvalued that the land on which the Emperors Palace was built on became supposedly worth more than all the real-estate in California. The Japanese loved playing golf and they bought every golf course they could lay their hands on.

Actually, everyone was terrified they would buy everything in sight. I was in Japan doing a big physics experiment on a particle accelerator and bought a book ‘Japan, the coming economic crash’ or some such which seemed pretty far-fetched at the time.

I remember a Sean Connery film 1993 ‘Rising Sun’ about an evil dastardly Japanese conglomerate operating in California, murdering hookers and thinking they were above the LAPD. However, by the time the movie came out the asset bubble had burst as the Bank of Japan (BoJ) raised interest rates from 2.5% to 4.25% in 1989 and to 6.0% in 1990. Crude government intervention crushed the bubble.

The Nikkei crashed and the “lost decade” started in Japan. In fact, a lost decade is an understatement since the bear market never really stopped and the Nikkei has never fully recovered despite three decades and massive economic stimulus in the form of Quantitative Easing (QE) of all forms. The scale and length of the declines are like nothing we have seen in the West. I think the market bottom was below 8000 in 2008 and back to 1985 levels almost 20 years after the initial crash!

To prop up the market and economy during this time the BoJ has become the master of QE – buying bonds, equities and just about anything else but to no avail. Ironically my first job in finance was for a behemoth Japanese bank and I had first hand exposure to what a portfolio of bad loans was and how they could be optimistically marked and juiced up to make them look better for regulators and accountants. My boss, when he was not snoozing at his desk, was arguably the smartest in the bank and the best at putting lipstick on a pig.

#2 Black Monday 1987

A major equity market event in the 80s was the 1987 stock market crash or ‘Black Monday’. The Dow Jones fell an impressive 22% in several hours and was a dramatic event in the recent history of crashes. Nobody has even given me a convincing explanation for the origin of the crash but it may have been exacerbated by computerised portfolio insurance hedges, that reduce risk by selling in a falling market, which became popular at that time. However, we can really label 1987 as a correction since the recent rise in the market in the previous 12 months was a massive 45%.

Importantly for our story the Fed market reaction to stabilise markets was limited in scope but highly efficient. Recently appointed Fed Chairman Alan Greenspan made a succinct statement that the Fed “affirmed its readiness to serve as a source of liquidity”, rates were cut by 0.5% and made some limited purchases on the open market. Global markets were calmed relatively easily. The Fed had demonstrated its ability to support markets and they recovered over the next couple of years.

#3 George's Black Wednesday

In the 1990’s there followed a series of secondary crises which had limited global impact. In 1992 the UK were snookered into the politically motivated European Exchange Rate Mechanism (‘ERM’) that stupidly obliged Sterling to float in a narrow band. Speculators like George Soros made billions and became infamous household celebrities by breaking the currency band on ‘Black Wednesday’.

In a futile attempt to defend the band UK rates were raised to a massive 15% which unsurprisingly caused a major housing crash. The words ‘negative equity’ entered into the English lexicon and people left right and centre were posting the keys through the letterbox and legging it. In the end, thanks to Gordon Brown sensibly ignoring Tony Blair, we never did join the Euro. 

#4 Tequila and Tigers

A series of well contained emerging market crises followed. The 1994-1995 Mexican Peso crisis or ‘Tequila crisis’ where Mexico was effectively bailed out by the Fed. Our exuberant investors that had bought 2-3x leveraged emerging market bonds took a bath but life continued as normal.

The 1997 Asian crisis where the (too) fast growing ‘tiger’ countries of Thailand, Indonesia etc hit a pot hole in the road. The crisis was mainly caused by sovereigns issuing Eurodollar debt in USD and their local currency plunging when people spotted that all the money had been spent on empty office blocks and unfinished infrastructure.

This was my first experience of using Credit Default Swaps (CDS) to short sovereigns and it led to big arguments about what constituted a Credit Event especially when Indonesian companies just refused to pay their debts and kept on operating as normal and ignored all the western lawyers. One large Indonesian taxi company just defaulted, kept driving and never looked back.

#5 The Russian GKO Bust

In the 1998 Russian crisis, Russia unexpectedly defaulted on its local currency debt which although very traumatic for the Russian people was extremely annoying for all those investment banks that had been putting theirs and their clients’ money into Russian GKO bonds. These bonds were seen as magic 'free' money guaranteed by the Russian state that paid 30-50% per annum when hedged into USD.

My friends at one major Swiss bank actually had ‘cleverly’ invested most of their bonus pool into those GKOs which made us all laugh at the time. For Russia it marked a post-soviet low as a drunken Yeltsin presided over a plummeting, gangster economy where even the $5bn of IMF/World Bank funds were apparently stolen on arrival.

#6 Too Big to Fail

Now the period of 1997-1998 the Fed was not super concerned about the Russia crisis itself but by a spin-off crisis involving a high-profile hedge fund called Long Term Capital Management (LTCM). LTCM employed high leverage arbitrage strategies, mainly in fixed income instruments like bonds and associated derivatives. They were viewed as a market leader, employing the most sophisticated technologies.

There was even two future Nobel Prize winners Myron Scholes (co-author of the famous Black Scholes model) and Robert Merton as founders. All my friends at the investment banks who helped them put on complicated 'arb' trades raved about them as pure geniuses. What could possibly go wrong? Well they blew up totally and their trades were so intertwined with all the other major names on the street that the Fed viewed them as a major systemic risk to the financial system.

A major rescue was secretly initiated involving a slew of banks (who also curiously had many of the same trading positions on). Russia etc was a side show. LTCM was closer to home was about 25x leveraged in 1998 had $4.7bn of equity and had borrowed $124.5bn for total assets of around $129bn. $4.7bn sounded amazingly big at the time but later in our story the numbers will become unfeasibly larger.

When all the positions were finally liquidated the loss was almost 100% of the original investors’ equity but no US tax-payers money was injected. However, the implications of the event would set the stage for future government interventions. LTCM was viewed as “too big to fail” and the Fed was prepared to use its power (even persuasive and arm twisting) to protect the markets and other investors from reckless 3rd parties (including the investment banks that helped them out).

#7 The .con Bubble

The .com (or .con) bubble was a marvel of human gullibility and a spectacle to behold. The arrival of the internet and start-up mania arrived suddenly. Small companies with rubbish websites that took minutes to load were set to take over the world overnight and destroy dinosaur bricks and mortar retailers. It was a compelling story and somehow nearly everyone (Warren Buffet excepted) believed it. 

I ran an equity derivatives team at the time and all work on the trading floor stopped for several months whilst everybody speculated on the latest .com offerings with their own money. Nobody was interested in serving clients much to the frustration of the senior management who sent round memo after memo telling staff not to use the banks trading systems to trade equities for themselves.

All the guys working for me, however junior, were using all their spare cash looking for instant massive gains. The guy next to me had a huge position in pets.com (soon to be worthless). Even I bought 5k of some stupid bookstore called Amazon (what would that be worth now?). Some colleagues had made several hundred k of paper profits. I cashed in and went on hols to New Zealand. When I came back the trading floor all had long faces and were a bit more subdued since the market had crashed.

Despite hopes for a rally the crash continued for some time and many .coms were annihilated. Everyone was more philosophical and realised that the companies they had bought were mostly rubbish with rubbish business plans. In my mind this was a perfect semi-irrational bubble and the subsequent well-deserved crash worthy of capitalism at its best. The bubble created lots of ideas and in the process eliminated those business models not worthy of future investment. Now great names survived the crisis like Amazon, eBay, Expedia etc and created the internet revolution that we now enjoy. Importantly there was little government intervention, interest rates were cut but nobody was rescued with tax-payer money. 

When equities hit bottom at the end of 2002 after the .com crash there followed a bull market until 2007. Rates had fallen from around 6.5% at the end of 2000 to 1% by 2003. Everybody now knew that the Fed had their backs and the Fed Chairman ‘Greenspan put’ became widely discussed amongst traders who laughed about it outside the City watering holes. If the Fed had your back how could you possibly lose right? The S&P500 index accelerated back to the .com highs by the autumn of 2007.

#8 The Lehman Moment

By this time rates were pushed by the Fed back to over 5% to slow things down a bit. Financial innovation and easy access to leverage and credit led to a significant bubble forming over several years in many asset classes. Early in the decade I had been structuring and trading a new fangled financial instrument called Collateral Debt Obligations or CDOs where portfolios of bonds would be sliced into different tranches of risk to investors. Portfolios would have to contain diversified assets to spread the risk but by 2007 the only collateral available for these trades with enough juice were so called sub-prime mortgages.

A visit by Barclays super-keen head derivatives salesman telling me to sponsor a CDO and that 100% US subprime would supply the ‘juice’ made alarm bells ring. These were based on essentially highly risky mortgages and often NINJA loans (No Income No Job. No Assets and cynically No Money back). The ratings agencies were cunningly ‘persuaded’ by several eager investment banks to unwisely allow US sub-prime mortgage only CDOs.

The dubious rating agency theory was ‘property prices never fall across the US at the same time’ and correlation risk was low but this unfortunate assumption was to ignite the global Credit Crisis. By the end of 2009, with Robert Peston gleefully moaning on TV every night about the forthcoming apocalypse, even my cleaning lady knew that maligned CDOs were deadly toxic waste and contributed to global warming, ozone hole depletion and every other known affliction.

During the Credit Crisis, major financial institutions astonishingly failed like dominos as their internal leverage unravelled at breakneck speed. The Fed intervened early to help find a solution for Bear Stearns (an early casualty) but blinked when confronted by the highly leveraged Lehman Brothers. Based on past LTCM form the market expected a bailout.

I rang Lehman the day they closed hoping to speed them up to wire the money they owed me from a swap unwind. Only one week before their credit people were in checking if our hedge fund was credit-worthy and assuring us they were safe as houses. Someone picked up and screamed down the phone “It’s all over. Everyone is gone. It’s finished …aaagh” then stone silence.

On TV there was immediate chaos of watching people run out of their building holding cardboard boxes and carrying stripped office fixtures but then absolute calm reigned. Everyone was left wondering what all the fuss had been about but a couple of days later all hell broke loose and the roller-coaster took another leg down.

The Fed, making things up as it went along, was forced into saving a string of companies and the whole financial system on an unprecedented scale. Many mighty financial institutions succumbed to the pandemonium in equity and credit markets and were rescued. All my fund’s money was stashed in a couple of Wall Street investment banks that would go bust Monday if they were not saved by the Fed at the weekend.

Even the great AAA rated AIG insurance company, with whom I had often traded super-AAA CDO tranches, blew-up as they were forced by accountants to inconveniently mark-to-market their CDO trading book just as the buyers (and the market) suddenly disappeared and ran for the hills.

The Anglo-Saxon institutions ‘took the losses on the chin’ as our beloved Boris would say. However, in mainland Europe the immediate, inextricable problems were papered over by bureaucrats in quasi-Japanese style as all those worthless loans were moved to the banking book, marked at par (100%) and hidden from shareholders to fester and nastily mature for the next decade.

The scale of the Central Bank intervention was unprecedented in modern times as global attempts were made to prevent a chain reaction of banking failures and avoid spill-over to the wider economy. The Fed slashed interest rates to their lowest ever levels (0.0-0.25%) and injected over $2 trillion in financial stimulus by mainly buying bonds off the various financial institutions and providing them unlimited liquidity to stave off disaster.

The BoJ went further and loaded up on most of the Japanese stock market and then deciding that was not enough greedily entered the US market by becoming the biggest buyer of US ETFs. The Swiss SNB (which often suffers from the delusion it’s a hedge fund) even decided that it was fair play to buy tech stocks like Apple on the dips. Luckily it seemed to work and markets stabilised and recovered.

Quantitative Easing (QE) entered the public lexicon and became the new paradigm which left the majority of economists scratching their heads and wondering how it was possible that a country could issue bonds with one entity like the Treasury and purchase them with another like the Bank of England? Surely this was unfair, not playing by the rules and defeated the ‘laws of economics’?

Working at a leading Mayfair hedge fund I spent ages arguing that as a physicist (who thinks most economic ‘laws’ are plain daft) I could see no immediate contradiction but those economically trained and their leading Harvard advisers insisted that under the circumstances shorting JGBs was a good idea and that one day soon Treasuries would crash, since obviously the Fed would have to sell all the bonds they bought in haste.

Anyways the JGB trade continued to be the ‘widow maker’ and the Fed just bought more bonds as the old ones matured. The economists reluctantly came up with a new name for it called MMT (Modern Monetary Theory) and consigned the old economics textbooks to the dustbin. The rule of thumb now seems to be that if every other G20 country is economically screwed MMT works a treat but don’t try it home alone and don’t tell the newspapers how the magic really works.

The extensive use of QE led from 2010 to a self-sustaining bubble for almost 10 years. Low interest rates became ‘rocket-fuel’ for the markets and the trader’s motto became ‘don’t fight the Fed’. Bad economic data was overlooked and the best investment strategy became 100% long equities (or even more since you could borrow at super low rates). A riskier but apparently market guru winning strategy was ‘buy the dips’ since everybody knew that the Fed would step in and support the market if things went too awry.

Curiously, throughout the entire decade inflation never reared its ugly head to spoil the low interest rate party. This too confounded every economic pundit but politically motivated austerity (which now seems ridiculous in the new coronavirus era) was flavour of the decade and led to subdued consumer demand. Instead, civil servants had their salaries frozen, sick people had their benefits taken away and joe consumer was skint had no money to spend.

The yacht elite had more money they knew what to do with and money flowed in bubble quantities into all questionable 'investable' asset types from risky covenant-lite leveraged loans to impressionist paintings and rusty vintage Jaguars. The inflation supply side was also impacted as the relentless improvement of technology increased productivity and the biggest deflator of all – China succeeded in its quest to be the #1 producer for the planet.

#9 Taper Tantrums

The post Credit Crisis bubble eventually started to lose steam as even unlimited QE eventually loses its lustre and becomes boring. Investors began to worry what would happen when the QE punch-bowl was finally taken away? The market was already a complete QE junkie and in 2013 the first ‘taper tantrum’ in the markets occurred leading to a brief sell-off. By this stage the Fed had acquired over $4 trillion of financial assets. The Central Banks now effectively controlled the market and needed to supply the QE ‘drugs’ to keep the show on the road.

There was an interesting Eurozone debt crisis side-show taking place during this period at the general pace of a typical bureaucratic EU escargot. In a nutshell Greece had lied (aided by the notorious Vampire Squid bank) on joining the Euro, the Germans reluctantly dragged their feet on bailing them out and a few investors who had leveraged up on PIGS bonds for the great Eurozone convergence trade were slaughtered. Otherwise, the bulls were 100% in control and the market drove still higher.

The Fed backed away from confrontation with the markets and kept rates low and was only brave enough to attempt to normalise rates to 1.5% by the end of 2017. In early 2018 a short-lived VIX Crash (involving a painful spike in implied volatility) attested again to the markets nerves of the QE bubble being punctured.

Twitter crazy POTUS, griping about the pesky rate rises, promised US corporate tax cuts which kept the market alive for a final gasp. The promised reduction in red tape and the thought of those big tech companies repatriating their hoards of money from ‘dodgy’ tax havens boosted the market again. Share buybacks in the low interest rate environment also nicely bolstered the market as altruistic US CEOs were rewarded by higher share prices.

By mid-2019 the Fed became more cautious as Trump’s trade war with China finally crystallised and market volatility increased. Rates maxed out at a totally unimpressive 2.25% before being cut in panic. Any attempt at the Fed attaining a normalisation of interest rates and loose monetary policy was abandoned. The inability to normalise rates and the failure of many global economies to eliminate QE life support in the decade following the Credit Crisis left them ill adapted to cope with the next economic problem. 

#10 The Corona Crisis

We all know what happened next. The coronavirus pandemic is a disaster that was visible coming down the tracks from January 2020 as we witnessed Chinese citizens being mercilessly boarded up in their apartments on the evening news. But in the West the politicians suffered a collective failure of imagination of what would be the effect in our more open economies. Evasive action like limiting flights from China, quarantine and stockpiling PPE was not taken. Somehow humans (at least the ones we put in charge) think linearly unlike viruses that behave exponentially.

To avoid slipping into the abyss the economic support package is enormous and includes corporate loans, furloughing benefits, QE (again) and unashamed printing of money. The fiscal stimulus in the US now includes purchase of corporate bonds and high yield (via ETFs) and the injected liquidity is reportedly over an eye-watering $6 trillion. According to excited, nerdy economic historians we now proudly have the lowest interest rates since Stonehenge was constructed and are in the worst recession in 300 years.

That sounds really, really bad right? But don’t worry since the concerted G20 Central Bank intervention succeeded in stymieing the death spiral of the equity and debt markets. In fact, they have now quickly rebounded to new highs despite horrendous corporate fundamentals. Remember the infantile Gordon Growth Model from primary school? Every equity with a finite dividend should have an infinite value in a zero interest rate World! More than ever the insanely bullish markets are in the hands of the Fed and policy makers. 

"The Best of All Possible Worlds"

The coronavirus crisis will soon hopefully come to an end, Amazon and Netflix will have taken over the World and we will have eaten too many Dominos take-aways but the financial markets will be left in a massively dysfunctional funk. What’s the problem you might ask? They are at all-time highs, which is the Panglossian “best of all possible worlds”. But beneath the surface lurks the murky intractable issue that markets are more highly controlled by the Central Banks than in any time in my career. The Empire with their stormtroopers and quasi-infinite financial firepower are now in total control.

Conventional wisdom (held by anybody now retaining any sanity after the recent events) is that an efficient market should be composed of independent clued-up investors (or ‘agents’) with different views that allow a coherent price discovery mechanism including some element of fundamental value. Although this complex and unpredictable process might have periods of "irrational exuberance", occasional corrections and severe manic depressions, the collective action of multiple ‘free’ agents is what comprises a ‘free’ market and provides ‘objective’ valuation. Now bizarrely Central Banks hold all the cards and control this market valuation in almost a cartel-like fashion whether they like it or not.

Will Chaos Theory Rule?

The influence of the Fed now dwarfs all the other investors and paradoxically could lead to highly unstable markets (remember Chaos theory and that butterfly?). Any false move or bad policy decision could provoke catastrophe for other investors. The Central Banks do not readily desire this responsibility and wholesale ‘sovietisation’ of the markets but they are caught between a rock and a hard place. How to reduce the level of intervention and return to ‘normal’ free markets without crashing the entire financial system on a scale never before witnessed (think Japan 10x over)?

Optimistically extricating themselves and reducing state influence in financial markets could take several decades of nimble footwork even if the Fed was resolute. However, as we have seen in this story Fed inventions are haphazard, have amazingly never regressed in size and indeed expand in a mind-boggling exponential trend. The once terrifying LTCM debacle was a measly $4.7bn and now we are at over $6 trillion and rising, rates are negative and the money printing presses are still rolling as people and companies await their pandemic cheques.

Unless there is an unwelcome, unexpected reckoning it appears to be a predictable one-way street of Fed interventions and ballooning state balance sheets with each subsequent crisis. Arguably they are now running out of tarmac for successful future interventions and bail-outs. In the mean-time, as an investor, best stay on the sunny side of the Fed for your asset purchases and keep your eyes skinned for the ‘true’ reflation trade.

Richard D. Bateson is director of Bateson Asset Management Limited and a long-time sufferer of annoying financial crises.

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