Tiny Bubbles

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A recent trip to Piero’s, an old-school Rat Pack-era Las Vegas institution, a place with high-backed banquette seating, white-glove waiters and even today, a real-life Pia Zadora entertaining in the restaurant lounge, brought back memories of my very first trip to Sin City. I was not even 21 and had traveled there with my best friend’s family, who I later came to appreciate with having had a long history of operating casinos. There on the Strip, at the Flamingo, I wore a bonafide, albeit borrowed, evening gown for the first time, as opposed to something better suited to prom night. My friend’s mother, bedecked and bejeweled, with her hair piled high, had insisted we adhere to, for the times, the city’s strict evening dress code. Surrounded by men in black tie and bevies of glamorous women, we took in the pomp and circumstance required to hit the blackjack table or spin the roulette wheel.

These days, Vegas is conspicuous in its absence of any dress code. And one wonders if the next stop for slot machine installers will be bathroom stalls. In truth, as football season rages on, any mobile phone will serve as an adequate conduit for those inclined to throw the cyber-dice. For that matter, a land line and a quick call to your friendly bookie or stockbroker, as the case may be, will work in a pinch. Such is the backdrop of today’s global financial markets, which increasingly resemble casinos. The stakes are rising for investors cum gamblers as markets are increasingly fizzing with tiny ticklish bubbles rising up to their surface and threatening to pop.

Evidence of any bubbles forming in the financial markets are criticized as inflammatory in nature and roundly dismissed. After all, are we seeing a repeat of the dotcom era wherein profit-bereft firms are given VIP access to an IPO private reception…en masse? Well no. Are average-income-earning Americans financing exceptional mansions using fraudulently-underwritten, nefariously-negative-amortization mortgages? Well, not exactly. Have investment bankers the world wide wrapped $23 trillion in high-yielding contracts around a fraction of notionally physically deliverable commodities? Without question – absolutely not.

To be precise, not one glaring market is jockeying to be crowned the singular bubbly culprit of the current era of ultra-loose monetary policy. Therein lies the challenge for policymakers and investors alike. The latest bout of market upheaval certainly has all parties on high alert. But no one, including yours truly, can lay credible claim to soothsaying what’s to come.

That’s not to say there aren’t plenty of suspicious bit players, hence those Vegasesque lyrics of Don Ho’s from way back when. High-end housing, high yield bonds, marquee market office buildings, emerging market debt, luxury apartments and hotels, for that matter, go-go momentum stocks, fine art, private market tech financing, student debt and runaway commercial lending and commercial real estate are just a few that jump out.

Valuation is a subjective endeavor, even at history’s most blatant evidentiary junctures. Think of the insistence of market cheerleaders in early 2000. Forget tech IPOs. At the time, when I was still on Wall Street, I couldn’t even get a straight answer as to why our firm’s energy analysts wouldn’t budge on their Enron price target. Or even more egregiously, the circa 2006 reader hate mail I received during my stint as a columnist. These allegations called into question my allegiance to my country simply because I had the audacity to disagree with the Maestro himself on home prices, which, after all, had never, and never would decline on a national level. (See the many Liscio Reports that focused on this misunderstanding back in the day.)

Today’s criticism is more nuanced, though no less pointed. The U.S. banking system is purportedly clean as a whistle. Regulators have made sure of that. I’ll agree that most of the pre-crisis toxic rot has been jettisoned, but serious imbalances have emerged on bank loan books. Never before have banks held such a small proportion of residential mortgages and hence had such concentrated exposure to commercial and industrial (C&I) loans on their books. Regulators have begun to sound warning bells about some industry-specific risks, such as energy loans.

But as banking expert and good friend Joshua Rosner recently pointed out, the harm to the system has already been done. Since 2011, C&I loan volumes have expanded by more than 60 percent while the loans’ average yields have declined to under three percent from five percent. Meanwhile, the terms of these loans have shortened meaningfully. If these were your grandfather’s conservative credit borrowers, these statistics wouldn’t be so worrisome. But once again, lower for longer has allowed sickly companies to stay alive purely because credit has been cheap for long enough to sustain them. The quick resetting of so many of these loans presents a massive challenge to the Fed in lifting interest rates.

As for student debt, the emerging consensus is that new laws ensure it cannot be a bubble. As long as the cottage industry, designed to help students expunge rather than pay off their debts, continues to grow and thrive, student loans are simply a future taxpayer headache. Furthermore, student loans outstanding are nowhere near the size of the mortgage market when it blew, so no harm, no foul. (A trillion here, a trillion there. Moral Hazard, anyone?)

Unicorns are rainbow-hued and mythical creatures, especially for the deep-walleted investors who have ventured as far out West as the eye can see on the risk spectrum. Don’t be anxious, we’re assured, these sophisticates who have poured money into the current stable of 133 unicorn startups, valued at $1 billion or more, know exactly what they’re doing. If they should, for example, lose money by eventually valuing such a unicorn darling as Uber at a higher valuation than that of all Nasdaq stocks combined. That’s their contained problem. Except that niggling issue of mutual funds that invest in unicorns, some of which are distressingly on offer to unsuspecting, less sophisticated 401k plan participants in companies all across America.

At least, as we are constantly comforted, the publicly traded stock market is soundly valued. While some froth has certainly come off the top since the August 24th Chinese yuan devaluation, it’s still nearly impossible to make heads or tails of stock valuation. For one thing, low interest rates have flattered profits while reducing the pressure on corporate captains to grow the bottom line the old-fashioned way. But that’s not where the real juice is. To get to that Shangri La of financial engineering, you have to actually reduce share count via debt-financed buybacks, regardless of whether you’re referring to companies buying back their own stock or buying other companies outright.

While the usual effervescent suspect in bond land is today’s high yield debt market, I worry about yesterday’s and tomorrow’s junk bonds. Looking back in time, it’s difficult to gauge the ramifications of the stunting of the last credit meltdown’s default rate cycle. We know certain companies should have gone into full blown bankruptcy but have avoided that fate thanks to the Fed’s rolling out of unconventional monetary policy. And our public’s inattention to the whole affair. Less appreciated is the potential for a good number of today’s poshest-credit companies losing their investment grade status. And yet, the potential for a dramatic fall from grace is on full display in the case of mining giant and commodity trader Glencore as it battles to dispel rumors that its $30 billion debt load could cause the company to implode. Shares of the company have lost about two-thirds of their value and analysts say another five percent fall in commodity prices will suffice to strip the company of its precious investment grade credit rating.

Further afield, emerging market (EM) debt, of both the sovereign and corporate sort, is a black box. The asset class could prove to be a safe haven. But the preponderance in EM debt of commodity issuers and the lenders that banked the resource-dependent industry does give pause. If you harbor any doubts, just ask Bill Gates about his views on Petrobras, the Brazilian oil behemoth that’s buried itself alive in a corruption scandal for the history books. The Gates Foundation is suing both the company and its auditor for failing to flag signs of bad corporate behavior. Petrobras’ stock has lost more than 90 percent of its value and has been downgraded to junk by the credit rating agencies.

Meanwhile, back in Manhattan, commercial real estate (CRE) continues to trade at bespoke levels. Prices in midtown have long since surpassed their 2007 highs. And showing they can’t be left out of the party, banks’ loan-to-value ratio on their CRE loans nationwide is perched at 118 percent; they’re just as far out on an underwriting limb as they were in the heady months leading up to the 2008 crisis. You could just as easily substitute in similarly bubblicious valuation stats for penthouses in top tier markets, presidential suites anywhere a luxury hotel stands, high-end speculative home construction, fine art, classic cars, wine and partridges in pear trees of the sweetest red D’Anjou variety (OK, I made that last one up).

Perhaps, in hindsight, it’s the very preponderance of prickly little bubbles that market historians will chastise the masses for having dismissed. For now, the lack of an individual, identifiable bubble perpetrator gives the bully pulpit free reign to calm any hint of anxiety. No need to debunk red herring books salaciously titled, “Dow 36,000,” circa November, 2000 or its successor, “Are You Missing the Real Estate Boom?” published in February 2005.

There’s no book I can point to so I’ll stick with Robert Shiller’s take on the current euphoric era. (Sorry, Mr. Icahn – I find it troubling that less than a year ago you were pounding the table for Apple to buy back its shares and now you’re vilifying CEOs who do just that.) In any event, in Shiller’s estimation, we’re in a “fear” bubble, much like that which preceded WWI, a time where people rushed out to secure gold for fear of what was to come. Today’s equivalents are mutual funds and exchange traded funds which promise investors immediate liquid convertibility despite underlying holdings that could prove to be as liquid as dried mud.

Over the years, the Nobel Laureate has defined bubbles in many ways (oddly, he’s had plenty of material to work with since 1987). The one that most aptly captures the mood of the day is as follows: “People are motivated by envy of others who made money….regret in not having participated and gambler’s excitement.”

Do tiny bubbles make you happy? That’s the funny thing about bubbles, especially when they’re so numerous as to delude the beholder into perceiving innocuity. They never play out according to script. So we’ll have to settle for some lyrics to tide us over in the interim, in honor of the dearly departed Don Ho who oft delighted the adoring crowds of blue-haired denizens on that Flamingo stage all those years ago. If not for our subject matter du jour, you’re almost tempted to raise a glass when you hear these two lovely lines in your mind: “So here’s to the golden moon. And here’s to the silver sea.” If only we could know our greedy illusion won’t pop when the sun rises on our collective party. Even in Vegas, night eventually succumbs to day.