Dead men walking:
Dead men walking.
The banks.
Pension funds.
Insurance companies.
The existing system.
Why?
Realized vs. unrealized returns.
What does this mean?
Realized returns mean you have money in your hand.
This can be because something you owned was sold and someone paid you for it.
However, unrealized returns are different.
They’re when the value of the asset increases or decreases, but the asset hasn’t been sold.
Basically, you can mark the value of something as whatever you deem appropriate.
As per the accounting standards of course.
But accounting fraud happens all the time.
It’s how Enron became the largest accounting scandal in US history.
A company worth 80 billion was faking their numbers.
They were marking their assets not as what they were actually worth but what the people at the company thought they were worth.
Unrealized returns are the cornerstone of the investment industry.
Especially on the private markets side.
I’ve worked in VC on the private side for almost 5 years and have learned a thing or two about it.
I vividly remember my first year at the fund when one of my partners said ‘No one cares what a company is worth, it’s what can a company sell for and how much money you return to investors.’
Industry terms for what I said above.
For almost a year, I’ve had this thought that we haven’t seen the fully realized value of all these private companies.
Many companies raised financing rounds at stupid valuations from 2020-2022.
Preclinical drug companies were worth over a billion.
Crypto was worth a trillion.
All these private companies, specifically across the high risk industries like biotech, crypto and tech were raising money thinking they could continue to grow in their valuation.
Quick lesson from Charlie Munger who taught Warren Buffet this -
‘It’s better to buy a wonderful company at a fair price than a fair company.’
What you pay for a company matters.
Now all these investors who invested in these highly valued private companies are going to have a rough time.
They haven’t marked down their portfolios.
Why would they when the incentives are designed to keep the value up?
When these companies come back to market in the next year or so, valuations will start to come down.
A lot of difficult conversations will be had.
Lots of companies will go under.
Lots of people will lose jobs.
Lots of investors will lose a lot of money.
The value they bought wasn’t realized.
It was unrealized.
This also matters on the public markets.
Specifically in the bond market.
We are in a death trap with no good outcomes.
It’s what happens when trillions of dollars of debt are created at 0% interest rates.
Then interest rates went up 5% in basically a year.
Quick lesson - when interest rates go down, bond prices go up. When interest rates go up, bond prices go down.
So because interest rates have gone up, all the people who bought bonds when rates were at 0% are fucked.
Their bond values are destroyed.
Why is that a problem?
Because that’s the capital that backs all the banks.
Bonds.
It’s how Silicon Vallley Bank failed and a few others.
So what did the Fed do when these banks failed earlier this year?
They committed a bail-out - they just didn’t call it that.
Instead, they called it the BTFP - the bank term funding program.
A program created by the Fed to provide emergency liquidity to the banks.
Banks can take out a loan from the Fed and post their bonds as collateral.
But the real kicker is the Fed will value those bonds at par.
What. The. Fuck.
Let me explain why this is such a problem.
Imagine your bond you bought back in 2020 is worth $100.
Now because rates went up that bond is worth $60.
A 40% decrease.
But you can now go to the Fed, take out a $100 loan and use your $60 bond as collateral.
Because they’ll value it at $100.
That’s insane.
It means they’re backstopping every bank and not marking down their bond portfolios.
That creates problems.
Huge problems because these are all unrealized returns.
If enough of the public and other people find out, you have a bank run.
And like what happened with SVB, if you can’t pay your deposits because the value of your portfolio went down, you are fucked.
Enter Bank of America.
The Financial Times released an article last week titled ‘Bank of America nurses $100B paper loss after big bet in bond market’.
100 billion dollars.
That’s a problem.
The question I have is how long is it going to take before the market wakes up to this difference.
The difference between realized vs. unrealized returns.
We have trillions of dollars in paper losses that are about to be absorbed by the entire world.
Trillions.
From pension funds to banks to insurance companies to venture capitalists to private equity to commercial real estate to basically everything.
And we don’t have the money for it.
Buckle up.
Because there’s a lot of dead men walking.
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