Quantitative Easing and the Corruption of Corporate America

Quantitative Easing and the Corruption of Corporate AmericaThe art of brevity was not lost on Abraham Lincoln. It is that brevity in all its glory that shines through in what endures as one of the most beautiful testaments to the art of oration: The Gettysburg Address rounds out at 272 resounding words. The nation’s 16th President humbly predicted that the world would quickly forget his words of that November day in 1863. Rather, he said, history would solely evoke the valiant acts of men such as those whose blood still soaked the consecrated battleground on which they stood. Of course, Lincoln was both right and wrong. Neither the men who sacrificed their lives nor his words would be forgotten. We remember and know that a terrible and ever mounting price would ultimately be paid, some 623,026 American lives, the steepest in man’s bloody history.

In what can only be described as the pinnacle of prescience, a 28-year old Lincoln foretold of the coming Civil War, which he presaged would come to pass if the scourge of slavery remained unchecked. In an address to the Young Men’s Lyceum of Springfield, Illinois in January 1838, Lincoln spoke these haunting words: “If destruction be our lot, we must ourselves be its author and finisher.” The enemy within.

Since that devastating brother against brother Civil War, so prophetically foreseen by Lincoln, more than 626,000 American soldiers have lost their lives defending the ideals and freedom of our Union. Today that Union stands, but it must now face the threat of an enemy rising within its borders to wage a different kind of war against our hard fought freedom.

To be precise, today’s dangers emanate from our nation’s boardrooms, where officers and executives have authorized an era of reckless abandon in the form of share buybacks. In the event the word ‘hyperbolic’ just came to mind, the ramifications of a lost generation of investment in Corporate America should not be lightly dismissed. This trend, above all others, has weakened the foundation of U.S. long term economic growth.

The real question is whether those who have facilitated the malfeasance will be held accountable. Before the launch of the second iteration of quantitative easing (QE2) that the Fed voted to implement on November 3, 2010, Richard Fisher, to whom yours truly once answered, raised serious concerns. An October 7, 2010 speech before the Economic Club of Minneapolis was the venue.

The contextual backdrop is key: Just weeks before at Jackson Hole, Ben Bernanke had unleashed the mother of all stock market rallies by hinting that QE2 was indeed coming down the FOMC pipeline. The hawks were understandably hopping mad as the debate on the inside was anything but settled. Fisher indicated as much, albeit with notoriously diplomatic panache:

“In my darkest moments I have begun to wonder if the monetary accommodation we have already engineered might even be working in the wrong places. Far too many of the large corporations I survey that are committing to fixed investment report that the most effective way to deploy cheap money raised in the current bond markets or in the form of loans from banks, beyond buying in stock or expanding dividends, is to invest it abroad where taxes are lower and governments are more eager to please.”

Six years on, corporate leverage is hovering near a 12-year high and domestic capital expenditures have plunged. In the interim, reams of commentary have been devoted to share buybacks and with good reason. Companies reducing their share count have, at least in recent years, been where the hottest action is, courtyard-seat level action.

But now, it looks as if the trend is finally cresting. A fresh report by TrimTabs Investment Research found that companies have announced 35 percent less in buybacks through May 19th compared with the same period last year. And while $261.5 billion is still respectable (for the purpose of placating shareholders), it is nevertheless a steep decline from 2015’s $399.4 billion. Even this tempered number is deceiving – only half the number of firms have announced buybacks vs last year.

Have U.S. executives and their Boards of Directors finally found religion?

We can only hope. The devastation wrought by the multi-trillion-dollar buyback frenzy is what many of us learned in Econ 101 as the ‘opportunity cost,’ or the value of what’s been foregone. As yet, the value of lost investment opportunities remains a huge unknown.

In the event doing right by future generations does not suffice, executives might be motivated to renounce their errant ways because shareholders appear to have stopped rewarding buybacks. According to Marketwatch, an exchange traded fund that affords investors access to the most aggressive companies in the buyback arena is off 0.8 percent for the year and down 9.8 percent over the last 12 months.

The hope is that Corporate America is at the precipice of an investment binge that sparks economic activity that richly rewards those with patience over those with the burning need for instant gratification. The risk? That central bankers whisper sweet nothings the likes of which no Board or CFO can resist. Mario Draghi may already have done so.

In announcing its latest iteration of QE, the European Central Bank (ECB) added investment grade corporate bonds to the list of eligible securities that can satisfy its purchase commitment. Critically, U.S. multinationals with European operations are included among qualifying issuers. As Evergreen Gavekal’s David Hay recently pointed out, McDonald’s has jumped right into the pool, issuing five-year Euro-denominated paper at an interest rate of a barely discernible 0.45 percent.

Hay ventures further that the ECB’s program will have the welcome effect of mitigating the widening of the yield differential, or spread, between Treasurys and similar maturity U.S. corporate bonds the next time markets seize up. The firm’s chief investment officer takes one last step over the intellectual Rubicon with the following hypothesis, “The Fed might want to imitate the ECB but may be restricted from doing so by its charter,” Hay posits, adding that, “We wouldn’t discount the possibility it will try to amend, or get around, any prohibitions, however.”

Talk about sweet nothings on steroids. But could it really happen in a theoretical launch of (God forbid) QE4?

For the record, Hay is right. There is no explicit permission in the Federal Reserve Act that authorizes open market corporate bond purchases. Hay is also correct, however, that there could be legal wiggle room. This possibility was corroborated by Cumberland Advisors’ in-house central banking guru Bob Eisenbeis, who noted that the Fed’s emergency powers provision, when invoked, allows for purchases of almost any security, especially those that are not expressly disallowed in the Act’s language.

As for the prospect that politicians would put their foot down and insist that the Fed stand pat and not cross the line? What are the odds of that happening if the economic backdrop is dire enough for the subject of QE4 and open market corporate bond purchases to be matters of public debate?

Given markets’ maniacal machinations of late, the degree to which the economic data remain mixed, and the growing vocal consensus among Fed officials that June is a ‘go’ for a rate hike, it’s a safe bet that the details of QE4 will not be a focal point of the upcoming FOMC meeting.

When the time does come, and it’s sure to come before rates are normalized, Corporate America will hopefully be capable of resisting the temptation to play along. To bolster their resolve: Required reading on all CEO, CFO and Board officer bedside tables should be last November’s missive by Bank of America Merrill Lynch’s Michael Hartnett.

In it, the firm’s Chief Investment Strategist paraphrases Winston Churchill and how the great statesman would have described the risk of what Hartnett cleverly warns could be, ‘Quantitative Failure,’:

“Never in the field of monetary policy was so much gained by so few at the expense of so many.”

May those words be ones Janet Yellen lives by.

Hartnett then goes on to encapsulate the one statistic that should haunt the current generation of central bankers more than any other: For every one job created in the United States in the last decade, $296,000 has been spent on share buybacks.

Recall that the fair Chair is a labor market economist above any other field. Surely she will be able to see the damage past QE has wrought and forgo the facilitation of further bad behavior. Should she ignore the potential for further QE-financed share buybacks to exact more untold economic damage, it would be akin to intentionally corrupting Corporate America.

In the words that have mistakenly been attributed to Abraham Lincoln, arguably with sound reasoning: “Nearly all men can stand adversity, but if you want to test a man’s character, give him power.”

Since the turn of this century, debt-financed share buybacks have severely tested the character of those charged with growing publically-traded U.S. firms. The time, though, has come for these wayward companies’ banker and enabler, the Fed, to hold the line, no matter how difficult the next inevitable test of their character may prove to be. It’s time for the Fed to defend the entire Union and end a civil war that pits a chosen few against the economic freedom of the many.


Retailing in America: Valley Girl (Interrupted)

RETAILING in America: Valley Girl (Interrupted), DiMartino Booth, Money Strong

Ah, the 80s. It’s safe to say many Generation X-ers have certain movies inexorably etched in their minds. 1983’s Valley Girl, featuring an as-yet-to-be-discovered Nicholas Cage as ‘Randy’ is surely one of them. While there is little doubt Director Martha Coolidge found inspiration in Shakespeare’s Romeo & Juliet, there is equally little doubt that the highly successful film’s most ardent fans never made the connection. The plot is simple enough: perfectly popular high school girl from the oh so right side of the tracks falls for the ultimate bad boy from the equivalent of San Fernando Valley’s oh so wrong side of the tracks.

In one particularly memorable scene, Julie, played by Deborach Foreman, approached her bizarrely former hippy father for guidance in navigating the closest thing to an existential crisis she’d ever experienced, as in falling head over heels for the taboo Randy. Before Julie can begin to explain said dilemma, her father cuts her off with, “That’s easy. Take it back and get the more expensive one. The expensive ones always fit better.”

No words could better capture the vapid materialism that put the 80s on America’s pop culture map. Teenage girls, armed with daddy’s Amex, lived to troll the malls and set the next fashion trend, self-actualization be damned.

It’s safe to say, mall owners and the stores within, pine for those halcyon days that preceded Amazon’s forever altering of the American retail landscape.

The dichotomy between the most recent batch of retailers’ earnings and the Commerce Department’s monthly retail sales data have set off a firestorm of a debate: Is the American consumer hitting a rough patch or have they embraced the world of e-commerce for good rendering traditional brick and mortar trends so yesterday?

As was widely lauded, April retail sales were so robust as to be characterized as “blockbuster” by the economists at Bank of America Merrill Lynch (BofA). Not only did headline retail sales jump by 1.3 percent, the so-called ‘control group,’ which excludes autos, gasoline and building materials and feeds into gross domestic product (GDP) math, “surged 0.9 percent.” In the, “But wait, there’s more! category,” the February and March data were revised up to such an extent BofA raised its estimate for second quarter GDP by a half a percent to 2.5 percent as well as that of the first quarter, to 0.8 percent from 0.5 percent.

For all of the strength in the data, prudent market veterans will remain skeptical until they see May and June’s data given the near consensus among retailers that spending slowed into the second quarter, the opposite of what the data suggest.

Of course, the weaker the consumer is, the more they rely on finding the lowest possible price for what they can buy. Enter Amazon. E-commerce sales rose 2.1 percent in April, building on a 3.7-percent gain in the first three months of the year, which itself was twice that of the fourth quarter’s pace.

Within the category of e-commerce, electronics sales reigned supreme at the expense of clothing sales, which major retailers across the full spectrum from Kohl’s to Macy’s to Nordstrom’s confirmed with their weak earnings reports.

But the full story goes deeper than weak brick and mortar sales. It comes down to a cultural paradigm shift best reflected in what today’s teens don’t say. Shrieking “Gag me with a spoon!” and so many other forgotten catch phrases has been replaced with rapid fire texting, “OMG!” And, gone too are the brands LIKE Calvin Klein and the long list of must-haves followers displaced by the next generation iPhone.

BofA does a great service every month, aggregating and reporting its proprietary credit and debit card spending records availing to those who read its research a bounty of insights. As subsequently validated in the formal data, BofA saw a smart rebound in overall spending in April. And it wasn’t just steeper prices at the gas pump; electronic sales surged while spending at restaurants held steady.

As for clothing, sales of wearables sank 2.9 percent last month. Dig in deeper, though, and you’ll see teen and young adult apparel were the weakest of the bunch, spending nosedived 9.2 percent. On May 5th, as if foreshadowing what was to come, teen retailer Aeropostale filed for Chapter 11 bankruptcy protection. It followed a slew of its competitors.

This type of news must come off as something of a mystery to Gen-Xers who can to this day still recite the lyrics of Madonna’s 1984 smash hit, Material Girl. No teen retailer on their watch would have dared had slumping sales, much less go belly up. How else did ailing (today) Gap establish itself as a powerhouse of (yesteryear’s) posterity?

As for what’s to come, the biggest question is whether the nascent signs of rebounding consumption in the formal data will have staying power. Leave apparel aside for a moment and consider reports from two retailers that have a birds’ eye view on nondiscretionary purchases, as in necessities.

Home Depot might not jump immediately to mind, that is until you factor in Americans staying put in their homes for appreciably longer than they historically have. That trend has translated into the need to maintain those homes, which has led to boom times for Home Depot and its competitors and their shareholders. It was thus with trepidation that the comparable-store sales decelerated to 4.3 percent in April from 6.7 percent in March and 10.2 percent in February.

Things weren’t much better down the road at Target whose same store sales growth of 1.2 percent was, well, off target. CEO Brian Cornell lamented the “increasingly volatile consumer environment” and the “slowdown in consumer trends.” The sum total of sales at the giant retailer amounted to 5.4 percent less than they did over the same three-month period last year. Say what you will about publically traded companies tinkering with their earnings; the top line doesn’t lie.

Depleted purchasing power certainly corroborates the most recent run of layoff announcements. U.S. companies announced 65,141 job cuts in April, according to Challenger, Gray & Christmas’ latest tally. That brings the total for the first four months of the year to 250,061, the highest since 2009 when the economy was still in recession.

Notably, it wasn’t just the oil patch. Retailers and IT firms have also been busily writing up pink slips. Though politicians are loath to accept the reality of the math, the imposition of new overtime rules on top of higher minimum wages can only lead to more bloodletting in headcount.

While undoubtedly speaking on behalf of its constituents in its capacity of a mega-lobbyist, it was still befitting that the National Retail Federation characterized the new OT rules as “a career killer.” Companies will quickly calculate the easiest solution to preserving margins, as in reclassifying employees as hourly from salaried. This evolving practice will enable employers to better track actual hours worked. And voila, incomes will take yet another body blow.

As if on cue, households report that they are increasingly discouraged about the prospects for rising incomes at exactly the same time as a separate data set reveals a spike in credit card usage. It’s no coincidence that these moments tend to occur when paychecks disappear, which the Challenger data seem to suggest is happening with greater frequency.

Evidence is mounting that the unemployment rate has bottomed for the current cycle. That can only mean one thing – voters will be angrier yet by the time Election Day arrives. As things stand, only those populating the tony top decile of earners have seen their incomes rise over the past decade. Rising unemployment will give new meaning to kicking the American worker while they’re still struggling to get off the ground.

As for the future of retailing in America against that troubling backdrop, it’s safe to say that Simon Property Group, which owns or has interest in over 230 high-end retail properties nationwide, has a solid take on what’s to come. In its most recent annual report, Simon noted that only three of its top 10 tenants of 1993 exist today in the same form as they did then.

The severity of the shift suggests something beyond the ‘Amazon effect’ is at work. The key is marrying stagnant wages to the cultural backlash against the conspicuous consumption glorified in the Valley Girl era and to varying degrees beyond. Do this and a clear picture emerges, one that explains why families still stroll the strongest malls but simply cannot spend well LIKE really I just have to have it LIKE. So they window shop, have a meal at the mall, and head home using their smart phones to buy what they can on Amazon Prime, of course.

Perhaps the missing link is what most Fed officials appear to not grasp, as in wage growth, or the lack thereof. It would be amusing if it wasn’t so sad.


Central Banks and the Rise of Extremism


“Those who honor me I will honor.” So read the scripture on a piece of paper slipped into the hand of 1924 gold medal Olympics runner Eric Liddell. Liddell’s earlier refusal to run on the Sabbath catapulted him into a jeering hall of athletic infamy. That gut-wrenching scene is memorably and painfully recreated in Chariots of Fire, winner of the 1981 Oscar for Best Picture. Ultimately, it was the idealism of so gifted an athlete standing unflinchingly before his stunned country to defend his principles, and the appeal of his unwavering faith that earned Liddel the title of “Champion of Conviction.”

On a recent trip to England, that classic film and its not-so-distant period setting of a Britain deeply divided across class and religious lines were both brought to mind. Portrayed against this backdrop, Liddell’s Chariot co-protagonist, Harold Abrahams found himself continually confronting the scourge of anti-Semitism so readily apparent in his fellow countrymen’s thinly veiled bigotry and snobbery. Time and ability saw these two real-to-life athletes prevail. The country under whose flag they ran was not to enjoy such a storied fate.

Britain and its superpower counterparts are chronicled in Liaquat Ahamed’s Lords of Finance. It is this more than any other written work that so clearly captures the era depicted in Chariots, an era in which the increasingly speculative financial markets were fonts of brewing instability. Booms were followed by busts in a seemingly perpetual cycle. Geopolitical tensions were at a generational peak. And the world’s all-powerful central bankers were driven blindly to cleave, come what may, to an orthodoxy that was to prove fatally flawed. Now, if only the past could be placed squarely in the past.

Ahamed’s book also recalls a time when the world suffered from a leadership vacuum. It is this parallel in particular that, combined with today’s equally myopic monetary philosophy, makes one shudder to contemplate what the future holds. If there was one takeaway from traveling abroad, it was that the anger emanating from the U.S. populace is matched and then some overseas.

It is no longer as simple as squabbling about Greek debt or fretting over the possibility of a Brexit. The very fate of the euro hangs in the balance as the migrant crisis bleeds into economies and feeds nationalistic leanings. Look no further than Germany itself and its announcement that it would begin to rebuild its armed forces for the first time since the Cold War. The acknowledgement that conflicts will rise, not fall, is in itself a confirmation of the growing menace of extremism.

It is increasingly a simpler task to tally the countries within the Eurozone that are not expressing outrage at the deteriorating landscape. The ouster of Turkey’s prime minister greatly decreases the probability that a controversial deal the EU struck with the Turks will reduce terrorism in that country. Hungary’s parliament has voted to hold a referendum challenging the EU’s migrant redistribution quotas. Meanwhile, voters in Austria, Denmark, the Netherlands, Poland, Slovakia, Sweden, and even France are backing anti-immigration efforts in one shape or another.

Of course, the migrant crisis is a relatively new phenomenon in these countries; but one country, Italy, has  been entrenched in this crisis for the better part of a generation. And, while all eyes may now be on Great Britain and its upcoming vote, some suggest that Italy’s September constitutional referendum poses the greater near term threat. The hypothetical dominoes could line up as such: Prime Minister Matteo Renzi quits in protest over the failure of the referendum and Mario Draghi comes to the rescue of his embattled country, leaving his post at the ECB before his term ends in 2019. Germany easily gathers the necessary consensus to replace Draghi with a hawk from its own country, who then reestablishes monetary order.

If this scenario seems far-fetched, consider the tie that binds the yesteryear of the 1920s to today; that is, debt. According to figures compiled by the International Monetary Fund (IMF), public debt as a percentage of global gross domestic product (GDP) reached its nadir in 1914, at 23 percent. The onset of World War I would alter that economic landscape for generations to come. Global debt peaked at nearly 150 percent of GDP in 1946, following the Great Depression and World War II.

By all appearances, the global economy has now come full circle – without the World War part, that is. In a March 2011 report, the IMF made the following observation as the world crawled its way out of the darkest moments of the financial crisis:

“While the impact on growth of the recent crisis is less dramatic than that of the Great Depression, the implications for public debt appear to be graver. That’s because the advanced economies were weaker at the outset of the current episode – with debt ratios 20 percentage points of GDP higher in G-20 economies in 2007 than in 1928. In addition, the sharp drop in revenues (due to the collapse in economic activity, asset prices and financial sector profits) and the cost of providing stimulus and financial sector support hit debt ratios harder during the recent crisis than during the Depression.”

How sweet it would be to report that since 2007 the tide of debt has turned. But instead, an early 2015 McKinsey report documented that global debt had ballooned, with none of the world’s major economies taking positive steps toward reducing their debt levels. Such is the disastrous bent of modern-day central banking thinking, with its belief that the only way to alleviate the problem of overindebtedness is with ever-increasing debt.

In all, according to McKinsey’s math, global debt increased by $57 trillion in the seven years ending 2014. The gold medal winners among creditors were the sovereigns: at 9.3-percent growth, government debt swelled to $58 trillion from a starting point of $33 trillion. Corporations came in second place with their debt levels rising by 5.9 percent to $56 trillion from $38 trillion. The onus was clearly on these two competitors to offset the relatively weaker growth of financial and household debt which was no doubt dragged down by the collapse in U.S. mortgage availability and the recapitalization of (some) lenders.

Where does that leave us? Apparently angry. Very, very angry.

Refer back to the IMF’s warning about the critical importance of the starting point for indebted countries’ economies. Then flash forward to the reality that the global economy today is that much more indebted. As for the world’s economies, they are on ever-weaker footing.

Maybe the anger stems from the injustice of it all, and the knowledge that future growth has been sacrificed for little more than yet another run for a place in the history text that chronicles rampant speculative fervors. Though the average person on the street might not be able to put their finger on it, they do know it’s impossible to put food on the table with the ethereal proceeds from a share buyback that does nothing more than prop up a stock price.

As The Credit Strategist’s Michael Lewitt recently noted,

“Debt drains away vital resources from economic growth. Fighting a debt crisis with more debt is doomed to failure, yet that is not only what global central banks did during the crisis but long after markets stabilized (though the crisis never truly ended, just slowed). This was an epic policy failure that continues today.”

Failure or not, odds are that today’s central bankers will double down on their failed philosophy. If you don’t believe me, ask any German life insurer buckling under the strain of running their business. It’s no wonder regulators estimate that insurers will begin to fail after 2018 due to the impossibility of operating in a negative interest rate environment with over 80 percent of said insurers’ investments in fixed income. These dire circumstances almost make the plight of U.S. pensions’ plight pale in comparison even as managers come to grips with the fact that there can be no Prexit, as in a Puerto Rico exit. Here, the haircuts on the damaged bond holdings will be withstood.

The real tragedy is that the smoke and mirrors perpetuating the veneer of calm in world markets can persist for a while longer. The U.S. consumer remains the world economy’s mightiest source of growth. Cheerleading economists were no doubt levitated by news that U.S. household borrowing exploded in March at a breakneck speed that hadn’t been clocked since 2001. The $29.7 billion one-month gain works out to a 10-percent annualized pace.

The usual suspects of the current recovery remained hard at work – student debt and auto loans continued their journey into the stratosphere. But the most record smashing category was credit card debt, which spiked by $11.1 billion, or at a blistering 14-percent pace.

In all, household debt rose at a 6.4-percent pace in the first quarter, just shy of three times the pace at which average hourly earnings grew. Looked at through a slightly different prism, personal income grew by $57.4 billion in March, the same month in which American households tacked on about half that amount in fresh debt. This is good news how?

The very absence of a full scale global conflict is without a doubt a huge blessing. At this juncture, it’s difficult to fathom how the world’s super-creditors could finance a war. History, however, suggests that times exactly like such as the ones in which we find ourselves are fraught with risks. Unprecedented levels of income inequality combined with profoundly threatened developed world pensions make for a frightening recipe for social unrest that threatens to boil over onto something grave on the world stage.

It is therefore of little surprise that voters worldwide are protesting at the ballot boxe. Debt spirals ever upward, even as the masses struggle to get by on less and less knowing there will be a dearer price yet to pay.

On June 28, 1914 Archduke Franz Ferdinand was infamously assassinated marking the beginning of a time in world history rife with bloody conflict. Though extremism is clearly on the rise in Austria again today, history never repeats itself to a T. Though we can’t yet know, history may mark May 9, 2016 as a turning point of a different sort – the day a Slovak border guard fired the first shot at a car of migrants crossing into his country.

The migrant crisis promises to exact its own costs, at first political and inevitably economic. It is then that the past 30 years’ bad habit of borrowing from Peter to pay Paul will be tested. What happens, one must ask, when Peter himself runs out of money?

Perhaps the world will have to wait a good long while to finally be graced with leaders who are willing to stand by their convictions and make hard, maybe even highly unpopular, choices. Such leaders might have to risk sacrificing their political careers to be crowned the next true Champions of Conviction, giving us all a shot, once again at a storied fate.



Drain No More: Fed Funds R.I.P

Fed Funds R.I.P. Drain No More

Following the Great War, indoor plumbing became without a doubt a Godsend for much of the world. However, few innovative leaps, including even the wonders of indoor plumbing, have ever been entirely free of at least a few drawbacks. Think of electricity and its dependence on any number of variables from lightbulbs to Mother Nature. Or the inevitability of those scratches that marred our favorite vinyl, or later CDs, rendering them unfit for the human ear. And, oh, the sparks that flew the first time we married metal with that fantastic new convenience, the microwave. The greatest innovative leap of our lifetimes started out easily enough with the personal computer. But even that technological disruptor has proven it too can be disastrously disruptive with nasty viruses, bugs and glitches working 24/7 to wreak havoc on our universal connectivity.

As for the wonders of indoor plumbing, its vulnerability rendered it anything but wondrous as it invited that inevitable bane to be borne, known worldwide as the dreaded backup. While no doubt it was a huge relief to no longer have to tiptoe into the night on an outhouse run or tow water to and fro for this and that, plumbing didn’t turn out to be exactly turn-key and stress-free. Anxieties soon arose from the prospect of that first call to the pricey plumber. Even in the 1920s, their service charge and hourly rate were bound to have given pause to the humble housewife. The beauty of the profitable plumber pariah was the subsequent innovation that followed, that of Drano, which was thankfully introduced in 1923.

Over that same 100 years, give or take a few, the financial system has also suffered its own bouts of clogged pipes though the culprits have tended to be a wee bit trickier to dislodge than gelatinous grease and hardened hairballs. Recall that in October 1979, Fed Chairman Paul Volcker formally announced that the monetary base would be the new and improved target to better control the price of credit. When overnight credit is priced perfectly, the funding spigots stay open just enough to keep credit flowing, but not flooding the financial system.

Volcker’s pivot away from the fed funds rate, however, proved more Pandora than panacea. And so three years later, in October 1982, policymakers re-adopted the targeting of the federal funds rate where policy technically remains to this day. An Econ 101 refresher: the fed funds (FF) rate is the interest rate at which depository institutions lend reserve balances to one another on an uncollateralized basis in the overnight market.

Fast forward to the here and now and all is well for the rate setting masters of the universe save one niggling detail: for all intents and purposes, the fed funds market no longer exists. Relatively new regulations have simply made redundant the FF market as it once was and no longer is.

As intrepid readers of these weeklies, you should certainly be aware of one Zoltan Pozsar and his 20 years of groundbreaking work. Today, the thorough brilliance of his work has catapulted him to the rank of world’s preeminent professional plumber, at least as far as the global financial system is concerned.

Pozsar’s ascendance began as many things do, innocuously enough when one day early in his career he was tasked with a particular objective — to contextualize the importance of collateralized mortgage obligations and special investment vehicles within an obviously inflating housing bubble.

Conjure up an image of Russell Crowe in A Beautiful Mind, without the schizophrenia. Now you have a good idea of the ‘aha’ moment Pozsar experienced as he began to connect the dots between the various working pieces that had for years held together the housing market. His peers at the New York Fed knew it was no secret that subprime securitization had opened up housing availability to millions of Americans. But the extent to which toxic mortgages could infect the entire global financial system had not been readily apparent until Pozsar fully diagrammed the plumbing on a three-by-four-foot map. Google it for your edification. You’ll be the wiser for it.

Since leaving the Fed, Pozsar has been conspicuously prolific in his productivity. While at the IMF, he managed to remap the post-crisis financial system (it now resembles a one-foot-thick atlas). He then moved on to Credit Suisse where he is today, educating financial market participants on the vastly changed regulatory regime that has, by the way, eradicated the fed funds market.

Pozsar opens his latest Global Money Notes piece by redefining understatement given the impetus to invent a new monetary mouse trap, so to speak: “2016 is shaping up to be an important year for the Federal Reserve.” Before the year comes to a close, the Fed will not only specify the intended size of its balance sheet but also the securities to be stored on it over the long haul. Spoiler alert: there’s no shrinkage in the offing.

At the nexus of the Fed’s perennially large balance sheet are two seemingly complex terms: the Liquidity Coverage Ratio (LCR) and High-Quality Liquid Assets (HQLA). Hopefully your eyes didn’t roll into the back of your head after being hit with not one, but two, acronyms because these particulars are, well, important for understanding what’s to become the new normal of U.S. central banking.

The Third Basel Accord, or Basel III as it’s become less than affectionately known among banks, was handed down by the Bank for International Settlements (the global central bank to central banks) in 2009. The intent was to reduce the risks in the banking system in the aftermath of a crisis that revealed banks were anything but safe and sound. It should come as no surprise that the subject of reserve requirements was smack in regulators’ crosshairs. By the end of 2019, if all goes according to plan, when Basel III is scheduled to be fully implemented, the capital reserves that banks worldwide must hold against losses will have trebled.

Enter the LCR, which is effectively a global reserve requirement mandated by Basel III. For U.S.-based banks, the focus is on the ‘L’ in the LCR, as in liquid. Regulators prefer reserves over bonds to meet minimum capital requirements. From stage right then enters HQLA, which is the Fed’s baby and emphasizes that the quality of liquid assets held be high, as in pristine. The combination of these two regulations translates into banks having to hold loads more in reserves than they once did and that those reserves be of the highest quality.

“In the post Basel III world order, base liquidity (reserves) will inevitably have to replace market-based liquidity,” Pozsar explains. “This in turn means there are no excess reserves – every penny is needed by banks for LCR compliance. And this also means that the Fed has only limited ability to shrink its portfolio.”

Where does the fed funds rate fit into the picture? As mentioned above – it doesn’t.

Banks would never choose to hold their liquidity buffers in unsecured interbank markets as they would be penalized (the fed funds market is unsecured). Rather, they will be compelled to use the secured repo markets, backed by Treasury collateral, or by accumulating reserves directly at the Fed.

“Excess reserves are not sloshing but rather sitting at the Fed,” Pozsar continues. “They sit passive and inert because banks must hold these reserves as HQLA to meet LCR requirements. You have to fund what you hold and since HQLA cannot be encumbered, you can only fund them unsecured. And banks always attempt to fund assets with positive carry.”

That last part refers to the fact that banks get paid interest by the Fed for reserves they have parked there

Does all of this mean that the Fed will be forced to shirk its role as directive general of the price of credit? Of course not. But the fact is, it can’t just leave the fed funds rate swinging in the wind; the FF has yet to be replaced as the means by which to price a full array of contracts in the financial markets. Lest ye worry, a committee mandated with replacing said FF rate has been actively pursuing an ideal replacement thereof since January of last year. Of course it has an important name! It is none other than the Alternative Reference Rate Committee.

Presumably this esteemed group is working furiously to devise a new overnight bank funding rate (last acronym, promise – OBFR), which Pozsar says is a “necessity, not a choice” given the disappearance of the FF market. The new OBFR will not be interbank, as is the case with the FF rate, but rather a customer-to-bank target rate that’s a global dollar target rate rather than just an onshore dollar funding rate. It will be as if the Fed was targeting LIBOR today.

“What this means for the Fed’s reaction function isn’t clear,” Pozsar concludes. “But our instinct tells us that we will deal with a Fed inherently more sensitive to global financial conditions, inherently more sensitive to global growth and inherently more dovish than in the past…”

Far be it from yours truly to worry. Still, it’s hard to take comfort in the knowledge that the Drano we’ve all come to know, though maybe not love, is now off the market. Less comforting yet is the fact that the plumber among financial market plumbers managed to end his forecast for the future with an ellipsis. He may as well as have ended with, “Better the devil you know…”


Central Bankers to the Masses: “Let Them Eat Rate!”


There never was any cake, just crust.

And the French Marie had nothing to do with it. Rather, a Spanish-born queen married to France’s King Louis XIV a century earlier was the ill-mannered Marie who dared to taunt the peasantry. So how then exactly did, “Let them eat cake!” become so universally associated with Marie-Antoinette? In a nutshell: Blackmail.

Historians have uncovered the nasty truth, and it can be laid squarely at the feet some far from scrupulous London-based thugs, intent on shaking down King Louis XVI with threats to besmirch his young bride’s reputation. According to Simon Burrows of Leeds University, a criminal network, drawn to the French monarchy’s vast wealth, plotted to profit by producing a series of pamphlets filled with lies about the ill-fated queen. Those lies included a charge that she had callously suggested her subjects eat cake in response to news of a bread shortage plaguing the masses. Though the king paid a dear price for the pamphlets’ destruction, some 30 copies were not burned as promised and found their way into the public’s hands sealing the queen’s fate kneeling before the guillotine.

Today, the shortage plaguing angry masses of savers worldwide is not one of bread or cake, but rather one of positive rates of return on their cash holdings. The central bankers know best as they command us to eat one rate cut after another. And like it.

For nearly 30 years, central bankers have based their haughty reasoning on the idea that the lower the interest rate, the greater the generation of economic growth. As then Fed Chairman Ben Bernanke explained in 2012, “My colleagues and I are very much aware that holders of interest-bearing assets, such as certificates of deposit (CDs), are receiving very low returns. But low interest rates also support the value of many other assets that Americans hold, such as homes and businesses large and small.”

It’s certainly been the case that the prices of homes and businesses have been upheld. Though their appetite may have waned a bit, investors have richly rewarded companies who use low interest rates to finance share buybacks with debt. And there’s no doubt investors of a different ilk did more than their fair share to prop up home prices at the lower end while wealthy individuals have bid up the prices of luxury homes to record highs.

The question is, is that what Bernanke intended? It would appear not as one of the stated objectives of the punishing policy of ultra-low rates was to spur income-generating job creation:

“Healthy investment returns cannot be sustained in a weak economy, and of course it is difficult to save for retirement or other goals without the income from a job. Thus, while low interest rates do impose some costs, Americans will ultimately benefit most from the healthy and growing economy that low interest rates help promote.” Or at least that’s what Bernanke led us to believe.

While it is true that returns on risky investments have been stellar, fewer and fewer Americans are comfortable with the risks associated with owning the most common of the pack — stocks. According to an April Gallup poll, the percentage of U.S. adults invested in the stock market has fallen to 52 percent from 65 percent in 2007, a 20-year low. So while there are definitely benefits to some, Bernanke’s “ultimately benefitting most” part has fallen far short, and to an increasing extent.

Digging into the data, at -14 percentage points, those aged 18 to 34 were the most aggressive lot to abandon stocks. Meanwhile, at -9 percentage points, those aged 55 and above were the least. There seems to be an intuitive disconnect somewhere in that divide, one that should keep policymakers up at night.

There is a very real refute that we’d have to return to the bad old days of rampant inflation, when the degradation of the purchasing power of the dollar more than offsets the plump interest rates on offer at our local bank branch.

While we collectively rue that era, it’s fair to say most seniors would gladly settle for a happy medium, a return to the turn of this young century when you could get a five-year jumbo CD sporting a five-percent APR, which was offset by inflation somewhere in the two percent vicinity. Traditionally, two to three percentage points above inflation is where that old relic, the fed funds rate, traded. So the math worked.

Of course, it could be worse. At least U.S. yields on savings are positive. That’s more that can be said of the $7 trillion of foreign sovereign bonds trading at negative yields. This dynamic spells disaster for life insurers to say nothing of pensions. Increasingly, foreign pensions are raising retirement ages as well as requiring higher employer and employee contributions, all the while lowering the salaries against which benefits are calculated, even as they segue benefits onto 401k-style platforms.

For now, the judiciary in the U.S. is holding the legal line. As long as that’s the case, actions to shore up pension underfunding will be avoided. Of course, at some point drastic measures will be required as the tax bases supporting future benefits shrink in proportion to the highest tax payers fleeing the fleecing.

Public pensioners with no back-up savings are sure to be enraged when their day of reckoning arrives. Then, today’s non-pension-backed retirees making crumbs on their cash holdings will be flush in comparison.

And yet Bernanke deigns to wonder. Last fall after leaving the Fed, he had this to say to Martin Wolf of the Financial Times: “It’s ironic that the same people who criticize the Fed for helping the rich also criticize it for hurting savers. What’s the alternative? Should the Fed not try to support the recovery?”

This coming from the same man who once said, “No one will lend at a negative interest rate; potential creditors will simply choose to hold cash, which pays a zero nominal interest rate.”

According to one recent Wall Street Journal story, that last observation certainly does hold true. Negative interest rates do benefit at least one of our contingencies: U.S. companies with European subsidiaries. Now that the European Central Bank (ECB) is in the business of buying corporate bonds, demand for issuance is all but a lock given the ECB can buy up to 70 percent of an issue, at issuance, to boot. Bully for that?

Not so fast says Standard & Poor’s (S&P), which just stripped the energy giant ExxonMobil of its coveted since 1949 ‘AAA’ credit rating. Why? Share repurchases and dividend payments have “substantially exceeded” internally generated cash flows in recent years even as its debt load has doubled. That leaves two solitary AAA-rated U.S. credits, Johnson & Johnson and Microsoft. It’s getting mighty lonely at the top.

But of course, there’s nothing of the wildcatter in ExxonMobil’s overindulging its shareholders. For seven straight quarters, over 20 percent of the companies in the S&P 500 have reduced their year-over-year share count by at least four percent, which conveniently translates into at least a four percent pop in their PER share earnings. Ain’t math grand?

Based on the data thus far, the trend is becoming increasingly entrenched. S&P’s Howard Silverblatt anticipates that public filings will reveal that over one-in-four deep-pocketed (debt-pocketed?) issues were in the aggressively juicing earnings cohort in the first quarter.

The end result of all of these financial shenanigans? For starters and enders, a whole lot of nothing productive. According to Bookmark Advisors’ Peter Boockvar, the absolute level of core capital spending (nets out transportation) was $66.9 billion vs. $69 billion in 2011. As for the percentage of capacity that’s being utilized, it remains well below its long-term average seven years into this economic expansion.

“Cheap money has created too much excess,” Boockvar noted. “On top of that, some CEOs are more interested in the short term focus on other capital uses such as buying back their own stock in the now second-longest bull market of all time.”

Is it any wonder small investors continue to lose faith in the stock market? Should they be chastised for wanting a teensy weensy return on their cash? Dare we brand these conservative souls greedy, wanting to have their cake and eat it too?

Perhaps. But maybe the real solution to placate the angry masses is an admission that the original intent of zero-to-negative interest rates has utterly failed. Sufficient economic growth to offset the forced risk taking simply has not materialized leaving Grandma and Grandpa with their life savings hanging in the balance.

Perhaps the current conundrum will present an opportunity when the next recession arrives, a chance to recognize the failure of the low interest rate era. As counterintuitive as it would seem, why not use the next period of economic weakness to set a permanently higher floor on interest rates. Will the weakest operators meet their makers at the corporate guillotine? Naturally that will be the case. But isn’t that the American way?

A new generation of revolutionary central bankers must be called to arms for all of our sake. Their battle cry: We commit to never returning rates to zero or below again, to never let be money be free and forever ensure there is a true cost associated with borrowing. Release the markets to set interest rates now and forever!

Will it work? Stranger things have been known to succeed in capitalistic economies with competitive and freely functioning markets.


Distress Testing the Efficient Frontier

Distress Testing the Efficient Frontier

Many historically inclined residents of White Plains, New York can recount the legend of Sleepy Hollow and what inspired it. The day was October 31, 1776 and our young Revolution was in the throes of a heated battle. One this bloody All Hallows Eve, so stirred by his witnessing of a horrific incident on the Merrit Hill battlefield was American General William Heath that he dramatically recorded the horror of it in his journal as such: “A shot from the American cannon at this place took off the head of a Hessian artillery-man. They also left one of the artillery horses dead on the field. What other loss they sustained was not known.”

It was the general’s vivid recollection of this scene that was to be the inspiration for author Washington Irving’s penning of his classic ghostly retelling of Heath’s journal entry, America’s version of a common folk tale dating back to Celtic times when for the first time the Headless Horseman set out on his eerie ride.

Today, investors may find themselves wondering just what financial spirits have already been unleashed to darken the legacy of the Federal Reserve’s current head. They know what lingers to ominously shadow two of her notable predecessors. Alan Greenspan will forever be disturbed by the ghost of irrational exuberance, and his successor Ben Bernanke by the vestiges of subprime being “contained.” Given the state of the financial markets today, odds are Janet Yellen will be perennially preoccupied by the death of the efficient frontier.

In a perfect world, as we were schooled in Portfolio Management 101, investors maximize their return while minimizing their risk. To accomplish this, we’ve long relied on the work of Harry Markowitz who, in 1952, developed a system to identify the most efficient portfolio allocation. Using the expected returns and risks of individual asset classes, and the covariance of each class with its portfolio brethren, a frontier of possibilities is conceived. Where to settle on this frontier is wholly contingent on a given investor’s unique risk appetite. And so it went – in yesteryear’s perfect world.

Unfortunately, the Fed’s fabricating of a different kind of perfect world has all but rendered impotent the efficacy of the efficient frontier. There are countless ways to illustrate this regrettable development, one of which can be viewed through the prism of volatility.

Investors are now so enamored of the good old days, when assets traded in volatile fashion based on their individual risk characteristics that the “VIX” has become a household name. In actuality, it is as it appears in its all-cap glory – a ticker symbol for the Chicago Board of Options Exchange Volatility Index. What the VIX reflects is the market’s forecast for how bumpy things might, or might not, get over the next 30 days.

As is stands, at about 13, the VIX is sitting on its 2016 lows which are on par with where it was in August following the Chinese devaluation scare. But it has not been uncommon in market history for the VIX to dip below 10 into the single digits, as it did in late 1993. It again broke below 10, but with much more fanfare, in 2007 ahead of a vicious bear market that ravaged investors in all asset classes.

Writing up to 16 markets briefs per year for nearly a decade inside the Fed required no small amount of title-writing technique. One of the most memorable of these immortalized in early 2013 was “Fifty Shades of Glaze,” which touched on the very subject of investor complacency using the VIX as evidence. The Wall Street Journal reported on March 11 of that year that investors were “worry free” in light of the VIX falling below 12, a number not seen since 2007.

The hissy fit that markets pitched a few months later following the Fed’s threats to taper open market purchases served to send the VIX upwards. But things have since settled down, convinced as markets are that lower for longer is the newest ‘new normal.’ In a seemingly comatose state, the VIX has breached 15 on the downside twice as often since 2013 as it has on average since 2005.

“I’ve been making the argument since 2010 that heavy-handed central bank policy is destroying traditional relationships,” said Arbor Research President Jim Bianco, who went on to add “stock picking is a dead art form.”

By all accounts, Bianco’s assertion is spot on – the death of stock picking has not been exaggerated. It’s no secret that indexing is all the rage; index-tracking funds now account for a third of all stock and bond mutual fund and exchange-trades fund assets under management.

The problem is that the most popular index funds have distorted valuations precisely because passive investing has become so popular. Consider the biggest index on the block, the S&P 500. Now break it down into its 500 corporate components. Some are presumably winners and some not so much. But every time an investor plows more money into an S&P 500 index fund, winners and losers are purchased as if their merits are interchangeable. The proverbial rising tide lifts all boats – yachts and dinghies alike.

If that sounds like a risky proposition, that’s because it is. Not only are stocks at their most overvalued levels of the current cycle, index funds are even more overvalued, and increasingly so, the farther the rally runs.

As Bianco explained, “In today’s highly correlated world, company specifics take a back seat to macro considerations. All that matters is risk-on and/or risk-off. Unfortunately, this makes the capital allocation process inefficient.”

The question is, what’s a rational, and dare say, prudent investor to do? In one word – suffer.

Pension funds continue to fall all over one another as they jettison their hedge fund exposure; that of New York City was the latest. It’s not that hedge fund performance has been acceptable; quite the opposite. But ponder for a moment the notion that pensions no longer need to hedge their portfolios. Is the world truly foolproof?

Of course, hedge funds are not alone in being herded to the Gulag as they are handed down their Siberian sentences. All manner of active managers have underperformed their benchmarks and suffered backlashing outflows. They’ve just come through their worst quarterly performance in the nearly 20 years records have been tracked.

And so the exodus from active managers continues while investors maintain their dysfunctional love affairs with passive, albeit, aggressive investing.

When will this all end? It’s hard to say. Bianco contends that it’s not as simple as what central banks are doing – they’ve abetted economic stimulus efforts before. Remember the New Deal? What’s new today is the size and scope of the intervention.

How will it end? We actually have an idea. Passive bond funds “enabled the borrowing binge by U.S. oil and gas companies,” as reported by Bloomberg’s Lisa Abramowitz. It was something of a vicious process that started with – surprise, surprise – zero interest rates compelling investors to reach for yield.

Enter risky oil and gas companies whose bonds sported multiples of, well, zero. It all started out innocently enough in 2008, with these issuers having some $70 billion in outstanding bonds. But every time they floated a new issue to hungry managers, their weight in the index grew proportionately. In the end, outstanding bonds for this cohort rose to $234 billion.

“Their debt became a bigger proportion of benchmark indexes that passive strategies used as road maps for what to buy,” Abramowitz wrote. “Leverage begot leverage begot leverage.”

Since June 2014, some $65 billion of this junk-rated debt has been vaporized into a default vacuum. Yes, passive investing involves lower fees. But it can also suffer as indiscriminate buying can just as swiftly become equally indiscriminate selling. Such is the effective blind trust index investors have put in central bankers to never allow the rally to die.

“The actions of people like Janet Yellen or Mario Draghi matter far more than any specific fundamental of a company,” Bianco warned. “It’s as if every S&P 500 company has the same Chairman of the Board that only knows one strategy, resulting in a high degree of correlation between seemingly unrelated companies.”

Nodding to this dilemma, several years ago, the CFA Society raised a white flag on the efficient frontier in a Financial Times article. Any and all applicants were welcome to suggest a new order, a new way for investors to safely design portfolios to comply with their individual risk tolerance.

Just think of the inherent quandary facing the poor folks who run insurance companies. These firms have a fiduciary duty to own at least some risk free assets. That’s kind of hard to do when yields on these assets are scraping the zero bound, or worse, are negative as is the case with some $7 trillion in bonds around the globe.

“Investors have traditionally been able to build balanced portfolios with the inputs of risky and risk-free assets,” said one veteran pension and endowment advisor. “Now that risk-free assets sport negative yields in many countries, to earn any return at all, you have to take undue risk. This breaks the back of the whole equation that feeds the efficient frontier.”

A while back, Yellen warned investors of the potential pitfalls of owning high yield bonds. She was no doubt studying data that showed mom & pop ownership of these high octane assets was at a record high. Many onlookers balked at the head of a central bank wading into the wide world of investment advice.

But perhaps it’s simply a case of recognizing one’s legacy well in advance. Small investors today have record exposure to passive investing. If Yellen fully grasps what’s to come, she’s no doubt preemptively struck and tormented by the future ghost of rabid animal spirits.

“It’s like giving a teenage daughter a Ferrari and hoping she won’t speed,” the advisor added. “If central banks keep price discovery in shackles indefinitely, Markowitz will have to return his Nobel prize.”

Let’s hope not. If that’s the case, and the efficient frontier never regains its rightful place in the investing arena, we will find ourselves looking back with less than wonderment as the hedgeless horseman gallops away with our hard earned savings.



Has the Fed Bankrupted the Nation?

Has the Fed Bankrupted the Nation?

Volcker, Greenspan, Bernanke and Yellen. Which one does not belong? Logic dictates that Volcker should have been odd man out. After all, there is no legendary “Volcker Put.”

The towering monetarist made no bones about never being bound by the financial markets. The same can certainly not be said of his three successors. And yet, history contrarily suggests it is to Volcker above all others that the financial markets will forever be beholden.

Many of you will be familiar with Michael Lewis’ memoir, Liar’s Poker. Yours truly first read the book in a Wall Street training program much like the one Lewis survived to describe in his autobiographical work. The take-away then, in late 1996, was that Gordon Gekko was right — greed was good.

Recently, a second reading of Liar’s Poker, following nearly a decade inside the Federal Reserve, delivered a much different message than did that first youthful reading and was nothing short of an epiphany: Paul Volcker, albeit certainly inadvertently, created the bond market.

On Saturday, October 6, 1979. Volcker held a press conference and announced that interest rates would no longer be fixed and that further the Fed would begin to target the money supply in order to curb inflation and “speculative excesses in financial, foreign exchange and commodity markets.”

Alas, this new regime was not meant to be. In trying to introduce an alternative to interest rate targeting, the Fed replaced one guessing game with another. Predicting the demand for reserves and then buying or selling securities based on that demand proved to be just as dicey as a similar exercise to target a given level of interest rates had been.

Volcker’s experiment ended in 1982. But by then, the genie had escaped the proverbial bottle.

Michael Lewis explains: “Had Volcker never pushed through his radical change in policy, the world would be many bond traders and one memoir the poorer. For in practice, the shift in the focus of monetary policy meant that interest rates would swing wildly. Bond prices move inversely, lockstep, to rates of interest. Allowing interest rates to swing wildly meant allowing bond prices to swing wildly.

Before Volcker’s speech, bonds had been conservative investments, into which investors put their savings when they didn’t fancy a gamble in the stock market. After Volcker’s speech, bonds became objects of speculation, a means of creating wealth rather than merely storing it. Overnight the bond market was transformed from a backwater into a casino.”

What a casino. As Lewis points out in his book: In 1977, the total indebtedness of U.S. government, corporate and household borrowers was $323 billion. By 1985, that figure had grown to $7 trillion.

Volcker left the Fed in August of 1987 after handing the reins over to Alan Greenspan. Two short months later, there would be a celebrated birth, that of the Greenspan Put, a watershed that truly got the party started. At last check, that party’s still going strong though stress fractures have begun to show on the festive facade. Of course, you wouldn’t have noticed them with the celebration of credit continuing to party on.

By year’s end 2015, U.S. indebtedness had swelled to $45.2 trillion. Tack on financials, which few do, and it’s $64.5 trillion and unabashedly growing. We are a nation transformed.

There are many temptations that tantalize when it comes to delving into debt. Uncle Sam now owes a cool trillion more than the nation produces. In our history, only once before has the divide between debt and production been so wide. That time was right after World War II. The difference between now and then — the cost was great but the purchase of our freedom was priceless.

What has today’s vast store of debt purchased? Certainly not freedom.

American nonfinancial businesses are today in hock as never before, to the tune of $14 trillion. Sadly, most of their debt accrued since the crisis has been funneled into nonproductive endeavors that involve balance sheet tiddlywinks to pad earnings. Don’t believe a single economist who dares quantify the consequences of a foregone generation of capital expenditures.

(At the risk of digressing, there was a bittersweet irony to Greenspan’s lamenting a lack of productivity growth when record share buybacks occurred on his watch. Consider his tenure to have provided the training ground for today’s C-suite occupants.)

At the most fundamental level, it’s the household sector that has undergone the most tragic transformation. We of that sector are, after all, what this country is and what it will be tomorrow. And it was individual citizens who had the good sense and vision to found a democracy built on the tenet of government’s role being protector of our inalienable rights to life, liberty and property. We earned these rights through relentless hard work and proudly claimed them as our own. It was the American way.

But what happens when the incentive system that encourages the honest attainment of that very American Dream breaks down? What happens when people in positions of power add the forbidden fruit of debt to our nation’s recommended daily allowance of consumables cloaked as a bonafide food group?

Whether it’s margin debt, mortgages or car loans, Americans have been brainwashed into believing that living beyond their means will somehow get them ahead. Consider the data, which simply do not lie.

In 1984, disposable income, what we take home in the aggregate after we pay our taxes, was $2.9 trillion. That same year, total household debt was $1.9 trillion. Back then, we covered our debts and had a fair bit left over with which to fund savings and possibly pay for a trip to Disney or for our kids’ college educations.

Then along came ‘measured.’ The first era of ‘lower for longer’ interest rates arrived in the aftermath of the dotcom implosion. Baby boomers, while still years away from retirement, had nevertheless been shocked to see their retirement savings take such a huge hit. But rather than batten down the hatches, they whipped out their credit cards marking a turning point in our nation’s history.

The Gregorian calendar dictates that the first year of this young century was 2001. That also happens to be the first year Americans spent more than they cleared in disposable income by way of accumulating debt: they took in $7.74 trillion and racked up debts that totaled $7.82 trillion by year’s end.

Feeding the shift from those who once had rainy day funds to those who had been had were six words constituting a commitment from Alan Greenspan stating that interest rates would rise at a, “pace that is likely to be measured.” Stand and deliver the famous obfuscator among orators did. The good times lasted for so long that households began to get unsolicited offers for new credit cards and mortgages in the mail…for their children.

Was the Maestro warned of the disaster building? The answer to that is well documented in the terrible tale of Edward Gramlich, who pled with his boss to put a stop to the subprime madness before it claimed countless victims, the largest of which would be the entire U.S. economy.

And yet the borrowing binge continued, even in the darkest days of the foreclosure crisis as mortgage balances collapsed. Of course, by then, Greenspan had exited stage left, off to sign book covers and leave the cleaning up of the disastrous detritus to his successor.

What was the harsh medicine Ben Bernanke prescribed to wean the country off over-indebtedness? Why gasoline. Bernanke poured fuel on the fire in the form of seven years of zero interest rates making debt more accessible than it had been in 5,000 years of recordkeeping (as per Merrill Lynch’s math).

The result was that households never saw even one year in which they made more than they owed. Not one, even though the period of ‘beautiful deleveraging’ was supposedly underway.

From this and that dotcom IPO, bought on margin, no less…to liar mortgages…to super subprime car loans, the elixir of aspiration has simply been too strong to resist. Lost along the way is a culture that once valued waiting for the better things in life. In the wake of this wholesale surrender of a culture, households have slowly succumbed to a subpar existence. That’s the trouble with living beyond your means. It never lasts indefinitely and always leaves you worse off than had you refrained from the get go.

The latest household data for 2015: Disposable income, $13.4 trillion. Debt, $14.2 trillion.

The prognosis? Mortgage debt is rising, credit card usage is back in vogue and student debt continues to spiral upwards. Car lending meanwhile, may be taking its last gasp for this cycle as fresh reports show used car prices have fallen for four straight months, a classic precursor to a downturn in the auto sector.

As for the fair chair, Janet Yellen, by all accounts she is running scared, pulling out all stops to forestall a recession in the hopes that there is such a thing as The Great Moderation, Part II.

To say Yellen is just now waking to the dangers of over indebtedness would be disingenuous. She was President of the San Francisco Fed when the housing bubble literally inflated and burst in her backyard.

No, perhaps what she is now realizing is the deep trap she is in. Her cabal of economists have long since assured her that government, corporate and household debt service is so low that history itself has been rewritten. But therein lies the mother of all Catch 22s, wrought by nearly 30 years of central bankers encouraging, enticing and imploring debt-financed spending while punishing, penalizing and all but outlawing saving.

Yes, the debt service is at record lows, but the mountain of debt that’s been accumulated dictates that the only thing the economy can withstand is low rates in perpetuity. The alternative is simply unimaginable. There would be widespread ruin and perhaps even the bankrupting of a great nation.

If only we didn’t know how we got to this point. But we do. We were duped by Liar’s Brokers and now have to live with the consequences. To quote Michael Lewis one last time, “In the land of the blind, the one-eyed man is king.”


Towers of Dabble

TOWERS OF DABBLEMan’s long determined history of dabbling in the building of touted towers, surely not for his self-gratification, but rather to bring him closer to God, has rarely been met with benevolence. Maybe God doesn’t like man, who He created after all, attempting to smash through His glass ceiling. Consider, if you will, the first known example of such an attempt. Having heeded Noah’s warnings, a postdiluvian band of survivors just couldn’t resist taking a stab at the celestials, raising the Tower of Babel they were sure would be gloriously received.

According to preeminent Bible historian James Kugel, there would be no such reception, just rejection: “The real crime involved in the building project was the tower itself, which was intended for the purpose of ‘storming heaven’ or some related evil desire.”

Though the Old Testament’s telling leaves much open for interpretation, the idea of vengeance being associated with sky-piercing structures seems to have stuck, especially among financial market historians. Analysts at the British bank Barclays originally voiced the idea that if you build it, it will come, as in a financial crisis. That is, every time an erected edifice unseated its predecessor to become the newest world’s tallest building, economically upsetting times tended to follow. It’s uncanny how well that shoe continues to fit.

It all started at the height of the Roaring Twenties on that little 13.4 x 2.3-mile island we know as Manhattan. Walter P. Chrysler was keen to build a monument, namely to himself. But there was competition nipping at Chrysler’s heels with the simultaneous construction of 40 Wall Street, which would indeed be the world’s tallest, that is, for one month between April and May 1930.

On May 28, 1930, it took all of 90 minutes to secret a clandestinely constructed spire atop Chrysler’s building, thus trouncing his downtown architectural rival. Of course, the real victor emerged 11 mere months later when the Empire State Building opened in early 1931 presaging, by the way, the Great Depression. It would be nearly 40 years before a taller tower would rise.

The construction and December, 1970 opening of the World Trade Center would then coincide with the end of the second longest U.S. economic expansion which began in 1961. Chicago’s Sears Tower would go on to wrest away the reign in 1973, a top spot it held for more than two decades. It’s opening’s appeared to herald the nasty stagflationary recession that ended in 1975. Malaysia’s 1996 title sweep arrived alongside the Asian financial crisis. Most recently, the 2007 opening of Dubai’s Burj Khalifa augured the Great Financial Crisis.

Surely these episodes have been sufficient to appease the dieties. In short, quite the opposite. If frenetic skyscraper construction flags misallocation of capital, we could be in for a doozy of a correction in global commercial real estate. Consider the numbers in the aggregate. It took 80 years after the opening of the Chrysler Building to build the next 49 supertall skyscrapers, defined as 300 meters (984 feet) or more.

How on earth, or in the heavens, to put it more aptly, has the hundredth supertall just opened on Park Avenue? It might have something to do with the fact that in the short five years through 2015, a subsequent 50 supertall skyscrapers have been erected.

Economic historians could well have been shaken to their very foundations upon hearing news that financing to construct a historic colossus had been secured late last year. Rising from the sands and promising to reach the seraphs, Saudi Arabia’s Jeddah Tower is to rise 3,280 feet into the stratosphere. That’s 1,000 meters, as in one kilometer, besting the Burj by 591 feet. The question is, will there be economic repercussions?

Judging from the collapse in the price of oil, some might argue divine intervention has already come and gone. It is certainly the case closer to home that the oil patch blues have dragged down commercial real estate. The latest data on commercial mortgage-backed securities (CMBS) delinquencies reads like a who’s who of yesteryear’s shale boom.

Some 17 loans totaling $152 million became freshly delinquent in March, the largest one-month tally since November, 2012, according to a new Morgan Stanley report. Six of these gems are located in ‘oil boom’ territories including Casper, Wyoming; Odessa and San Angelo, Texas and North Dakota’s Dickinson and Bakken Shale regions. Another notch down the distress ladder, 14 loans moved to the status of “specially serviced,” when a new mortgage servicer takes over a loan that’s 90 days or more in arrears; 10 of them had low oil prices to blame.

The working assumption must be that the economic damage inflicted by energy’s woes will be contained. How else to explain the construction of a $1.2 billion mecca in the land of the Saudi kings? Unless, that is, it’s as simple as the money being there for the financing. Stranger things have been known to happen when interest rates are held at low levels for longer than imaginable by yield-starved investors.

History stretching back to Biblical times suggests there will be economic pain between now and the Jeddah’s scheduled opening in 2020.

The fine folks at Jones Lang LaSalle (JLL) would beg to differ. A new study released by JLL, the real estate investment management giant, forecasts real estate transaction volumes will crest $1 trillion by the end of this decade, rising from $700 billion last year. The enabler will be international money flows: JLL estimates $500 billion in annual cross-border activity by 2020.

The movement between regions will be catalyzed by demographics, according to the JLL study, which notes there will be more people over the age of 55 by 2050 than there were inhabitants on earth in 1950.

“This demographic impact will have a profound effect on real estate investment strategies with the amount of private equity capital targeting direct real estate set to increase by over 500 percent, much of it driven by increasing institutional allocations looking at higher yielding opportunities.”

Did you notice something implicit in JLL’s argument? It would seem lower for longer will remain the mantra for the foreseeable future, which suggests frothier markets and subpar growth will continue. The most interesting tidbit comes down to who will be doing the investing, that is private equity.

As it were, private equity “dry powder” directed specifically to real estate investments rang in the New Year at record levels. There is now $231 billion in dry powder available just for properties in the United States after $107 billion was raised in 2015.

For being six years into a recovery in commercial real estate, investors certainly remain enthusiastic, especially public pensions. Pensions have allocated some $207 billion to private equity funds since late 2012. Increasingly, allocations have targeted real estate funds with March of this year providing a perfect example of the merriment surrounding this asset class. Here’s a wee sampling with special notations if the real estate fund is of a particular bent:

Texas Teachers:                                               $500 million
State of Oregon’s Pension:                              $300 million
Pennsylvania Public School Employers:          $307 million
Ohio Workers Compensation Bureau:            $125 million
State of Minnesota’s Pension:                         $100 million (distressed);  $100 million (opportunistic)
State of Maine Pension:                                  $50 million
State of New Jersey:                                       $200 million (commercial)
State of Kansas:                                              $50 million
Texas Municipal:                                             $375 million

“Pensions’ chronic underfunding has prompted them to stretch to achieve unrealistic return targets,” New Albion Partners’ Brian Reynolds explained. Reynolds has been keeping a running tally of these allocations and is quick to point out that leverage is often needed to hit the bogeys, which are 7.5 percent or more. Bear that in mind when you consider the money being shoveled into these funds.

It really comes down to size, that is, of the pension system. In the early 1980s, pension liabilities amounted to about 50 percent of gross domestic product (GDP); today they are 100 percent of GDP. “Because of their growth, their investment flows have led to asset bubbles that have generated permanent losses,” Reynolds added.

Pensions flocked to hedge funds but that strategy blew up after Long Term Asset Management nearly took down the financial system. This strategy was followed by wholesale herding into commodities, which we all know ended is disaster.

The catch is the rate-of-return bogeys have barely budged despite Baby Boomers moving increasingly closer to retirement suggesting some risk should be taken off the table. (Rather than keeping you in suspense, it’s nearly an impossible feat to lower return targets. Less in assumed returns means states and municipalities have to pony up more money they don’t happen to have on hand. The State of Connecticut has reached the point where it is now taking a stab at taxing Yale’s endowment in a desperate attempt to top off its underfunded pensions.)

No matter how you slice it, most public pensions face a dire set of circumstances, which begs the question: Just what are they to do?

Reynolds’ reply: “They have turned to the last remaining asset class with high expected rates of return – commercial real estate. It’s as simple as that.”

Perhaps pensioners should begin praying the JLL report pans out. With commercial real estate prices declining in January for the first time since 2010, the latest data available, and investors balking at rich valuations, it just might take a miracle to keep profitable prospects alive.

In the meantime, all we can do is sit back and wonder what’s to come. Transaction volumes in the trillions and heights exceeding a kilometer – how do tomorrow’s architects top that? Is man’s vanity so great he will risk an even sharper blow to the glass in that celestial ceiling? If he does, what vengeance might follow? The best we can do is hope future history books don’t include records that give new meaning to that old warning, “Look out below!”


Are America’s Workers Playing Hard to Get?

Are America's Workers Playing HARD TO GETPenelope Pussycat might not be the most iconic of Generation X cartoon characters, but she does stand alone in her capacity to confuse. Penelope, a lovely black and white fluff ball of a cat, had a seemingly inescapable penchant for finding herself the unsuspecting wearer of an unnatural and very skunk-like white stripe. A stripe which would of course render her irresistible to the resolutely romantic, albeit malodorous, Pepé le Pew. And so with the stage set, the chase would ensue to Penelope’s long-suffering protestations.

As is the case with all things in love and war, complications arose. There were exceptions, moments when the shoe would find itself on the other foot and Penelope became the pursuer and the dapper, prancing skunk the pursued. This half-century long chase has led some skeptics to ask whether Penelope was not in fact just playing hard to get all along.

The recent string of robust job gains has led others to ask whether workers have finally broken through to the stronger position of pursued as well, with employers in the hunt for their increasingly valuable skill sets.

It’s even rumored that Federal Reserve Chair Janet Yellen’s favorite gauge of labor market strength is the so-called ‘quits rate’ which rises in lockstep with the percentage of workers who feel confident enough to tell their employers where they can put their jobs (the sun doesn’t shine there). Hence the hysteria when the quits rate ticked up to 2.2 percent in December, the highest in over eight years. The conclusion: workers had finally gained the upper hand.

Suffice it to say, the party didn’t last for long. The quits rate retreated back to 2.0 percent in January (the data series is quite lagged and that is the most recent data on hand) and other forward-looking indicators suggest momentum is waning.

A superficial glance at the headline data is misleading on several levels. For starters, at 195,000, the number of jobs cranked out by the private sector slid in at 38,000 fewer positions than the past six-month average. Dig deeper, though, and you’ll note that the 4,000-job downward revision to January’s numbers masked more troublesome figures. The numbers behind that number: Temporary employment was revised downwards by 22,000 while government jobs were revised up by 23,000.

You may be familiar with the tendency of rising temporary workers portending positively for future permanent job gains. Sensing an accelerating rate of gross domestic product (GDP) growth, employers dip their toe in the water by bringing in temporary workers that can in turn be converted to permanent employees if preliminary signs of growth pan out.

The opposite is true of a slowing economy. Firms tend to reduce workers’ hours and trim temporary staff to prepare for what’s to come. “It’s easier to cut hours and contract workers when the economy is slowing, and that is precisely what the data show,” observed AIG’s Jonathan Basile following the data’s release. “Neither the workweek or temporary employment are in a recovery mode.”

To be precise, temporary job growth has decelerated to an annualized pace of 1.9 percent; it was growing at 4.6 percent a year ago. As for the workweek, it fell to 34.4 hours dragged down by a 0.4 percent decline in the manufacturing workweek. The factory sector itself defied forecasts calling for a gain of 2,000 for the month. Instead the sector shed a net 29,000 jobs, the most since December 2009.

The truly good news in the report was that so many sidelined workers endeavored to re-enter the workforce. Only 246,000 of the 396,000 re-entrants were able to find jobs thus causing the unemployment rate to tick up to 5.0 percent from February’s 4.9-percent cycle low.

As for the prospects for further gains in those actively participating in the labor market? A Morgan Stanley report noted that the number of people not in the labor force but saying they want a job fell to 2.3 percent of the working age population. That puts those who are down but not out of the workforce near an eight-year low and not much higher than the prerecession average of 2.1 percent.

The report’s takeaway: “There do not appear to be too many discouraged workers remaining who could potentially keep reentering the labor force to continue offsetting the demographic downtrend of 0.2-0.3 percent a year in the participation rate.”

And it wasn’t only the unemployment rate you read about in the paper ticking up. The underemployment rate, which adds in those who are working part-time for economic reasons, also rose off its low for the cycle. While it’s a cardinal sin in economics to equate one month to a trend, other data have been flagging today’s rising unemployment rate for some time.

“Why would unemployment stop falling?” Basile asked. “With GDP growth at or below trend for the last three quarters, including the current quarter, Okun’s Law should eventually catch up.”

The Law Basile references is the relationship economist Arthur Okun discovered to exist between the unemployment rate and GDP growth in the United States. As unemployment drops, GDP rises, which is intuitive enough. But when the economy slows, as has been the case of late, it also follows that the unemployment rate will rise.

Basile’s analysis being spot on is critical to his Street cred given he’s anything but a plain vanilla economist. As Head of Business Cycle Research, he’s tasked with sniffing out trends when they are in their infancy. That’s why he’s had his eye on the particular query inside the Conference Board survey that gauges workers’ perceptions of the job market – that of whether workers perceive jobs as harder to get.

“The ‘Jobs Hard to Get’ is a leading indicator that turns before the end of a business cycle,” was Basile’s observation. “Ask consumers about jobs and money and they can give you a good idea. They know if they have a job. They know what they make.”

As for the recent string of survey data, Basile worries that, “Jobs ‘hard to get’ troughed seven months ago implying we’re in the latter innings of the current cycle according to historic indicators.” Nine consecutive months of deterioration has historically coincided with recession.

In a seemingly heretical moment, Basile threw out one last nibble to add to all that food for thought with his unorthodox suggestion that there is a form of unemployment that is the economy’s friend. “Yes, Virginia. There is such a thing as good unemployment,” Basile quipped.

It goes like this: When the number of folks leaving their jobs are added to those who are unemployed for extremely short stints (five weeks or less) you get a feel for the underlying velocity of the labor force. If you’re sure you can get a better job and quick, you’re apt to have less anxiety about being among the unemployed. And if you do indeed replace your paycheck as quickly as you’d hoped, then your bravado is validated. Make sense?

Well, there just happens to be an economic indicator for that, one that combines these two metrics into ‘Job Leavers who are Very Short-Term Unemployed.’ It does a bang up job of explaining the last three decades of income growth, or lack thereof. And if you must know, it stopped improving three quarters ago, which indeed qualifies as a trend.

Add to this the rolling over in Conference Board help wanted online ads and it’s hard to deny the data are lining up to give credence to the notion that labor market strength has peaked and is in remission.

Of course, it helps to know where to look to get a first read. Just think of Penelope the next time you tune in to a talking head assuring viewers all is well in the job market. Especially at first glance, looks can, and do, deceive.


The Smell of Dryer Powder in the Morning

Apocalypse Now Redux.li


It takes a certain, shall we say a more stalwart, kind of a person to willingly endure a second showing of certain movies some find unsettling. Deliverance, The Silence of the Lambs and Taxi Driver all come to mind. So too does Apocalypse Now, one of the most stunning cinematographic accomplishments of the 20th Century but also one of the most disturbing. Thus the renewed “Horror!” when Francis Ford Coppola endeavored to remake this classic for the 21st Century, and in the process 49 additional minutes for fans’ viewing pleasure.

But something, perhaps to critics’ surprise, rose from the cutting room floor. An even better film emerged. In the words of legendary film connoisseur Roger Ebert, it was “more clear than ever that Francis Ford Coppola’s ‘Apocalypse Now’ is one of the great films of all time.” The majesty of Redux stemmed from Coppola and his longtime editor Walter Murch’s approach to the new version. They conceived the May 2011 movie from scratch, using the original dailies, as if the first movie had never been made.

There is now another possible 21st Century remake on another cutting room floor, the trading floor, that is. With this potential remake comes a question that no doubt haunts today’s investors: Are the markets capable of producing an equally miraculous encore? Determining markets’ fate largely comes down to their overlords, the kingpins of private equity. At its most simplistic, a central bank is considered to be the lender of last resort, if circumstances should force that outcome. The mirror image is private equity and the role it can play as buyer of last resort when cycles are nearing their denouement.

It’s safe to say that the chronological moment of truth is upon us as April crosses the line in the sand making the current stock market rally the second longest in history, trailing only that which creschendoed in March of 2000. Last year at this time, the list of rally-rousers was appreciably longer. Sovereign wealth funds were not in liquidation mode defending their countries’ fiscal wellbeing. The initial public offering market was still wide open for business. Unicorn funding was still making believers out of California dreamers. And central bankers’ actions held sway over animal spirits for longer than a few trading days.

But those halcyon days have come and gone leaving in their wake sidelined skeptics at just about every turn, including private equity insiders faced with a forecast that calls for a perfect economic storm. There is, however, one mammoth impediment to private equity joining other would-be buyers who are now in self-imposed holding patterns: money, and lots of it.

In private equity parlance, this ‘money’ is actually capital their investors, known as limited partners (LPs), have committed to invest through funds that have been raised. Those in the business refer to it as ‘dry powder,’ as in readily deployable weaponry to wage war on the acquisition front.

A fresh off the press report by the global consultancy Bain & Co details the year ahead for the private equity industry. The comprehensive study first looks back to 2015, which would have been one for the record books if not for its predecessor.

For starters, 2015 marked the fifth consecutive year that cash distributions from private equity funds to their LPs eclipsed capital calls (cash infusions) LPs had to cough up for fresh investments. Among LPs, fewer than 10 percent had wired in funds in excess of what they had allocated for the calendar year, the lowest since 2007. While this imbalance is great from a cash flow perspective, it also highlights the challenge overvalued assets present to private equity firms that are in the business of buying assets of every kind from public companies to real estate to venture capital.

At the core of the hostile buying environment is the Federal Reserve. Private equity has traditionally been largely in control of its own destiny, especially in the buyout arena. You know the legends of leveraged buyouts (LBOs); the takeover of RJR Nabisco was so renowned for its hostility it merited infamy in its own book and movie, Barbarians at the Gate. But that was so ‘80s.

More recently, we have Clear Channel, Harrah’s and TXU as LBO reference points. Some of the vestiges of these deals are still, in fact, with us today though the sensation evoked at the mention of these names is indigestion not elation, also care of the Fed.

How so? Bear in mind, the Fed was also private equity’s BFF early on in the aftermath of the Great Crisis. Exits that would never have been possible in the real world were rendered so with the magic of zero interest rates. After all, why restructure when you can refinance into a junk bond market that never had it so good? Such was the mantra in the world of private equity. That is, until rates were left too low for longer than even the barbarians could bear.

By the beginning of last year, buyout funds found themselves ponying up record sums based on multiples of a target’s earnings before interest, taxes, depreciation and amortization (EBITDA). At 10.1 times EBITDA, 2015 multiples trumped even those of 2007’s 9.7 times.

It’s safe to say few ever anticipated the bawdiest buyout time in Wall Street history to ever be taken out, especially given LBO volumes. At $282 billion last year, global buyouts were only a hair above that of 2014 and deal count actually fell. Peak valuations suggest that deal volumes should also be running at record levels but in fact, the last two years haven’t witnessed even half the activity of record years 2006 and 2007.

And yet, at over $4 trillion, mergers & acquisition (M&A) activity did dethrone 2007’s former peak. That’s the funny thing about ill-conceived monetary policy. The unintended consequences show up in the least likely places, like the M&A battlefield. Corporations, which have been decreasingly rewarded for buying back their own shares, are still reluctant to invest in their businesses. (The Fed, more than seven years in, has yet to wake up to this reality. But the fact remains companies will simply not make major investments until they know how to envision a clean operating environment, an impossibility with artificially low interest rates.)

The alternative to share buybacks to juice your earnings: Buy other companies to grow the top line in the absence of economic growth that justifies organically growing the company, and payrolls, from the inside out. And that’s exactly what companies have been doing with their inflated stock prices and cheap debt financing. The nasty side effect for private equity firms is that corporations have literally priced themselves out of their own LBO market.

As the Bain report dryly concludes: “With generally benign debt markets continuing to finance most deals, this confluence of favorable conditions has created attractive industry economics for every constituency save one: current buyers.”

What’s a private equity chieftain to do? Well that is the trillion-dollar question weighing on just about every professional investor’s mind. You see, at $1.3 trillion, they’re sitting on $100 billion more than they were at this time last year. That’s what happens when you’re taking in more in capital commitments than you’re shelling out to make fresh investments for five years running.

That said, 2015’s fundraising of $527 billion did not surpass 2014’s $555 billion, nor did it come close to the $681 billion record raised in 2008. But the figure was nevertheless extraordinary against a backdrop of anemic global growth and cratering commodities prices.

2015’s slightly lower level of fundraising also masks the fact that the year did not put an end to one of the biggest road trips of all time. No fewer than 12 large buyout funds, each of which was targeting funds of $5 billion or more — that’s $86 billion in aggregate — were still on the road at the beginning of this year. And that’s just the big boys. In all, some 318 global buyout funds were road-showing at year end, seeking to raise $247 billion, the largest dollar figure since 2008 and the highest number of funds in the market at one time on record.

The main driver: insatiable demand on the part of those ravenous limited partners, which the Bain report characterized as “hungrier than ever.” Bain might have added that LPs are in a hurry: Private equity funds require lock-ups of a decade or more in some cases and tend to take about a year to raise a given fund. That makes it more remarkable yet that 40 percent of buyout funds closed in six months or less.

As the Bain report noted: “Funds are closing faster, and the share of those that hit or exceeded their goals was higher in 2015 than at any time since the precrisis boom of 2007.”

Not surprisingly, LPs are also particularly keen on the biggest names with proven track records. Among the five largest funds closed in 2015, all exceeded their fundraising targets and every one was significantly larger than its predecessor. The biggest of the bunch was Blackstone Capital Partners VII, which raised $18 billion, the second-biggest since that record year, 2008. Launched in November 2014, the fund closed before the holiday season with committed capital at 111 percent of its predecessor fund, as in BCP VI.

Odds are high that LPs appetites won’t wane any time soon. You may have noted in recent headlines that efforts to right Chicago’s pension plan were ruled unconstitutional by the judiciary, prompting Fitch to downgrade the city’s credit rating to one mere notch above junk status.

In the event you’re not connecting the dots, pensions, tethered as they are to unrealistic rate of return assumptions, will remain beholden to private equity investments until such time as they’re allowed to revert to prudent portfolio allocations. That, however, won’t happen until the time comes to truly reform the pension system, which might never happen if the courts stand their ground.

The sad thing, for retirees whose pensions will run dry if something doesn’t give, is that higher interest rates could have prevented this gigantic mess in the first place. But the decline in interest rates has been relentless and has yet to let up. The ultimate Catch 22: the lower interest rates fell, the further pension managers had to swing for the fences to make up for the shortfall. Hence pensions’ record and reckless allocations to private equity funds, which are egregiously inappropriate given their risk profile and pensions’ inherent liquidity requirements as Baby Boomers begin to retire en masse.

Of course, all may turn out well if private equity firms somehow manage to thread the needle, a feat that requires them to deploy committed capital and not pay up for overpriced assets even as recession looms and threatens their ability to execute deals in the junk bond market.

Just keeping the high yield market open for business is a tall order. Even if the current cycle takes out the one that crashed to a halt in 2000, it would take a miracle of monetary policy to get all the junk debt coming due refinanced.

According to Moody’s, U.S. junk-rated companies have $947 billion of debt maturing between 2016 and 2020. The furious rate at which high yield firms have been accessing the capital markets is best illustrated by the fact that five-year maturities have risen by a fifth from Moody’s February 2015 report and 18 percent from the previous high of $805 billion recorded in 2010.

The coming deluge of junk-debt refinancing helps explain why the last of the big three credit rating agencies, Standard & Poor’s (S&P), recently reported the average rating on high yield issuers had fallen to a record low. As sure as day follows night, S&P warns, defaults promise to chase crippled credit quality into the sunset.

So what is private equity to do? As buyer of last resort, does the industry have a moral obligation to keep the fires burning under the current historic rally? Most will hope so. But the risk grows with every mega-fund raised that the perverse investing environment will render private equity’s record pile of dry powder into something akin to napalm. Can you say Apocalypse Then?



The linked piece below my signature is a follow-up to last year’s private equity primer. It’s difficult to fathom a way out for pensions. Your thoughts on the subject, as always, are most welcome.



The Smell of Dry Powder in the Morning