Could the whole thing go?

Just finished ‘Too Big to Fail’ about what the US fed and treasury did with bailing out the banks in 2008 and I have a lot of thoughts.

The last crisis was mortgaged backed securities, synthetic credit default swaps and terrible mortgages that the banks owned and traded. They assumed the housing market was going to keep going up. When it turned, people couldn’t pay mortgages and they started defaulting. When they defaulted on their mortgage, the mortgage backed securities were worthless.

The thing I learned was AIG was the one buying all the CDOs. Because AIG is one of the biggest insurance companies in the world, if they went down, the whole world’s financial system suffers.

I bet now the world is even more intricately linked than we thought. If a great unwinding happens where it’s not only hedge funds but also the banks are the ones holding most of the short positions, it’s going to get ugly. Big sell offs are going to happen because they have to make sure they have enough collateral to meet their obligations.

Otherwise bailouts happen all over again. Banks could fall. If one bank falls, others could as well. Meaning the US government is going to have to step in again for a bailout, like they have since 2008. Did it last year with the credit market and injecting trillions of dollars into the market. Because the banks and financial system know the government always exists as a backstop, they don’t have any incentive to change their behaviour.

What happens now? No idea but a couple thoughts.

If the US government bails out the banks/financial industry and has to print trillions of dollars, on top of the trillions of dollars that have already been printed, you’re going to run into some real issues. If money gets printed even more, are other countries going to trust the US dollar? Are we going to move to a different reserve currency?

Let’s say it doesn’t, the US government could print trillions of dollars more in money, causing inflation. Inflation means rates go up. Interest rates going up means the US government has to pay interest to its debt holders, which are other countries. How do they pay back interest if they don’t have any money in the first place and are already running such a high deficit?

This is obviously a doomsday scenario, which may not happen. But what if it does? I hope that banks have collateral to cover all their positions and its only hedge funds that get screwed. Because if the banks have to book losses on their books, because of liquidating hedge funds, then it could spiral.

The difference in this situation though is there are winners on the other side of the shorts. Retail in Gamestop and AMC are going long, as well as other institutions, and the folks paying are hedge funds. The problem is if the hedge funds have to pay and they get too over leveraged, then the banks have to pay. If the banks have to pay too much off their book, and they don’t have enough collateral, then people aren’t going to get paid.

Oh man, if that happens where hedge funds go bankrupt but banks have to pay off their balance sheet to retail, that would be insane. Unlikely it ever gets to that point because the government is probably going to step in or market makers like Citadel and make sure people can’t get paid the full amount they are owed. Depends how high retail runs up the stock, but there’s definitely going to be some shady stuff going down in the next little while.

Another difference with 2007/2008 is you didn’t have inflation. You didn’t have the government printing trillions of dollars before a crash. In this case, it crashed because of Covid last year, so the government had to cover the credit markets and Trump passed the CARES Act, a 2.2 trillion dollar bill.

Now if the banks were to fail, does the government step in again? I don’t think it can because of what could happen politically, but it also might have to because you can’t collapse the world financial system.

America is at a tipping point socially where something could set it off. Trump was a sign. Brexit was a sign. Bolsinaro was a sign. Populism is coming back. Inequality is growing. People are tired. Covid made everything worse. This could be that match, and if the governments don’t handle it responsibly, there will be repercussions in the next decade to come, no matter what happens in the innovation economy.

We can’t be too deluded into thinking that everything acts in a silo. In today’s world, everything is connected. What happens to the financial markets affects your ability to work, your ability to earn a fair wage, your ability to buy a house, your ability to buy food, etc.

What about other repercussions?

In my industry, my sense is we’re going to go through a tough time in the biotech IPO and public markets for several years, but M&A will be bumping. Pharma has cash on its balance sheet and given the price of companies is going to get cheaper; it could turn into a spending spree. BD guys are going to be busy in the next few years.

The private biotech markets I think will still be ok in the short term because of how much money US venture and crossover funds have raised that are focusing on healthcare. But because the exits may not be there in a few years, it will eventually cycle back into the private markets.

Even in tech, I think we’re in for a huge correction. Tech had it’s time in the spotlight in the 2010s. There will still be some fantastic companies, but as a whole, it’s not going to be one producing high yield in the next several years. Valuations will come back to normal in tech and biotech as asset managers will start to shift their money into inflation hedges, commodities, metals, oil and energy.

It’s an interesting time to be an asset manager. I love it. Volatility, if you know how to play it properly, can be your friend. The great investors love it. They understand what it’s like to invest through multiple cycles and when you should be pushing your money in. They know, and they’re definitely waiting.

The smart investors know this is going to pop, and when it does they’ll be ready.

Question is how bad will it pop?