New York | Last week in The Institutional Risk Analyst we mentioned the transition from that carefully managed reality, that “new abnormal” of the past decade, to something very unfamiliar to most investors. Over the past two months, wildfires have swept over numerous industry sectors, leaving a lot of previously expected investment returns in ashes. The real human tragedy in CA will certainly hurt economic growth, but the carnage on Wall Street also is immense and growing.
Financials have taken a hit over the past 12 months, even as the benchmark S&P 500 has managed to stay positive single digits. Exemplars among financials like US Bancorp (USB) have actually stayed even with the S&P at plus single digits, but the KBW Bank ETF is basically flat for the year. In the latest edition of The IRA Top Ten Banks, we talk about why USB is the best performing money center bank in the US. And we also tell you who we believe is the weakest CEO among the top ten US depository institutions.
Most of the market’s attention currently is focused on two related risk hot spots: Asia and Technology. In the case of the former the great deflation in China is gathering speed thanks to Beijing's spending and President Donald Trump’s asymmetrical trade war. As illustrated by the massive liquidation of HNA, the implosion of Uncle Xi’s paper tiger continues apace. When we say “paper” of course we are not only referring to mystical papier-mâché creatures that can be used in parades, but rather our suspicion that China’s mountain of bad debt may be imploding under its own weight.
When global investor Kyle Bass says China needs a reset, he knows not how right he is this time around. Savings obsessed Japan is very different from crazy rich China under the early years of Xi Jinping. The use of leverage in China over the past decade dwarfs even American levels of fiscal profligacy. China’s banking system, for example, is twice the size of the US if you believe the statistics.
“It’s insane how levered this market has become,” Bass told Reuters. “You’re starting to see bankruptcies across the board in China that are hard to hide, if you look at the corporate default rate, the bankruptcy rate, M1 and M2 (money supply), the slowest money growth in over four decades.”
When you combine decades of economic mismanagement with the natural tendency of members of the Chinese Communist Party (CCP) to steal everything in sight, the obvious conclusion in that there is no equity underlying China’s economy or financial markets. Add the random factor of President Trump and the CCP is left in disarray.
The “Belt and Road” initiative is alienating many important overseas relationships for China and leaves behind a huge cost in terms of bad debt, but economics is not the point. As one close observer of China joked during dinner in New York: “Think of Chinese infrastructure spending as a giant pension plan. It is literally a way to occupy people and get them out of the cities or even out of the country entirely. Profit is secondary.”
Goldman Sachs: Chasing Growth
Much of the risk coming out of Asia has to do not just with economic slowdown but also plain vanilla fraud. Consider the 1 Malaysia Development Berhad (1MDB) scandal involving Goldman Sachs (GS), which has seen its common shares drop double digits for the year and now trades comfortably below book value.
Vampyroteuthis infernalis
The 1MDB scandal features Malaysia's former Prime Minister Najib Razak and "financier” Jho Low and is Exhibit A for the Age of Credulity scrapbook. As with highly leveraged conglomerate HNA, nobody had any idea as to the origins of Low or where the money came from or was going. Somehow GS raised another $6 billion from investors to support this apparent act of fraud against the Malaysian state.
We can’t help but wonder if GS, the organization famously dubbed the “vampire squid” by Rolling Stone’s Matt Taibbi, knew about the assistance one of its partners gave to Mr. Low, contrary to what former Goldman Sachs CEO Lloyd Blankfein suggests. Or maybe they did not want to know. And here's our question: Did Blankfein step down as Goldman CEO in anticipation of the 1MDB blow-back?
Like Citigroup (C), which suffers periodic breakdowns in its internal controls related to the offshore venues where it does business, Goldman is also known for regular operational risk events. And chasing growth in Asia, to paraphrase Blankfein, is an ideal way to get into big trouble.
That noise factor, the near certainty that both Citi and Goldman will trip up when it comes to operational risk events such as fraud and money laundering, seems to keep these names trading at a discount to less exciting peers like USB. We could tell you a story about John Reed, Citibank Private Banking and Raul Salinas de Gortari in Mexico, but we digress.
Ben Walsh at Barron’s writes: “[T]he bank has warned that the investigation could result “in the imposition of significant fines, penalties, and other sanctions. Whether or not Goldman is penalized, the 1MDB scandal is a huge setback to its campaign to repair its public image after the financial crisis.” Agreed. But we wonder, regarding Q4 earnings, whether GS will be forced to take a reserve for the cost of cleaning up this mess, including the return of $600 million in ill-gotten investment banking fees?
To us the bigger question is whether the new CEO David Solomon, who headed the GS investment bank, will survive the 1MDB scandal. No matter how you cut it, the answer to the key question to Goldman Sachs of why didn’t you know about the relationship between Goldman Asia banking head Tim Leissner and Jho Low is unsatisfactory. Whether the answer is (1) a breakdown in systems and controls or (2) a failure to supervise, Solomon must ultimately shoulder the blame for failure to supervise one of his key managers and direct reports.
Goldman Chairman Blankfein says that Goldman investment bankers “evaded our safeguards, and lied—stuff like that’s going to happen.” Really? Bank holding companies and broker dealers subject to Fed and FINRA supervision, respectively, are supposed to have systems and controls in place that prevent employees from evading safeguards. Blankfein telling us “that’s going to happen” is an absurd response.
The risk facing Goldman is very similar to the situation at Wells Fargo & Co (WFC), where the board of directors failed to take action for more than a year in the face of clear acts of fraud. Given that Solomon was the manager of Tim Leissner, it seems difficult to envision a pathway for the GS board that does not involve Solomon stepping down. At the very least, the SEC, Fed and other regulators will need to extract a pound of flesh from Goldman Sachs a la Wells Fargo to atone for what seems like a truly ugly example of management failure.
Spreads Widen, Deals Slow
Meanwhile in the world of emerging technology and high yield debt, the great deflation being led by the Federal Open Market Committee is starting to show a modest upward impact on credit spreads. Some names are doing better than others. Deal flow is starting to suffer as a result.
Members of the financial punditry will fashion endlessly ingenious explanations for why tech stocks are cheap – and getting cheaper -- yet the simple fact is that rising rates will sink many speculative stories in the debt and equity markets.
For example, even with all the "good" news of the past several weeks, Tesla Motors (TSLA) 5.3s of 2025 trade + 475 bp to the 10-year Treasury bond. This puts TSLA on the wrong side of “B” in terms of ratings breakpoints even after a remarkable rebound for the stock since October 8th when it was down 20% for the year.
Of note, the FOMC seems perfectly content to crater the market for leveraged loans and collateralized loan obligations or “CLOs,” an acronym you unfortunately want to remember. A key indicator of rising investor caution, namely credit spreads, are starting to widen, as shown in the chart from FRED below.
From a low of 316 bp back in early October, the ICE BAML high yield index has widened more than 20% to 400 bp over the Treasury yield curve. That is a very rapid change. As and when this indicator gets to 450 bp or higher, that is a danger signal for both market contagion and economic recession. Deal flow stops when spreads widen too much too fast.
When high yield debt spreads get near 500 bp over the Treasury curve, financing activity for speculative firms essentially stops and related bank lending will follow that example. Of all of the time series and indicators that the FOMC can watch, high yield and corporate credit spreads are the most relevant. Rising high yield spreads will accelerate the reckoning in leveraged loans and CLOs.
The temporary redemption of Elon Musk’s little science project at TSLA, however, cannot reverse the overall market gloom due to the fall of Facebook (FB) one of the big tech beneficiaries of the irrational easing of the FOMC. Going back to 2012, FB is still up more that 330% vs last week’s close – this at a time when the economy was barely growing. But over the past quarter, the stock has moved sharply lower, from up 20% in the first week in July to down a like amount last week.
Idiosyncratic Risks
The negative factor weighing down GS, FB and TSLA, however, is idiosyncratic risk coming from the CSUITE. In the case of FB and TSLA, these two publicly owned organizations have founder risk. Both have reached the point in their development where a transition to a more stable and competent management team could benefit shareholders. But an exit by either Musk or Zuckerberg could crater each stock.
Goldman Sachs, on the other hand, may be in serious jeopardy because of its big dependence upon risky investment banking revenue. GS is a compliance violation disguised as a going concern. Bankers always evade. Or as Richie Metrick, COO of the investment bank at Bear, Stearns & Co was famously known to say about bankers: “If their lips are moving, they’re lying.”
JP Morgan & Co (JPM) was known a century ago as “The Octopus.” Goldman Sachs is merely a squid. That is, fish bait. JPM has trillions of dollars in core deposits, while Goldman has yet to bank the first $100 billion in stable cash funding. GS is too small to be credible as a commercial bank and ranks just behind the largest universal bank, JPM, in the overall global league tables for deals. In the world of deals, GS is pursued by Barclays, Merrill Lynch, Morgan Stanley (MS) and Credit Suisse (CS), among others.
But in the next few weeks and months, Goldman’s fate may rest on how it extricates itself from the 1MDB mess, a when not if proposition that we think could be visible in Q4 earning for GS. The eventual cost of salvation may include disgorgement of the $600 million in fees, appropriate fines and penalties, and perhaps the departure of both Blankfein and Solomon. But atonement in the world of investment banking is, as the Economist wrote in 2002 about the WorldCom scandal, “a worrying process whose end still seems a long way off.”
