“The World Is More Leveraged Than It Has Ever Been Before”: Beware the Time Bomb in the Trump Economy – By William D. Cohan (Vanity Fair) / May 10 2019
Addicted to the unnaturally low interest rates Trump keeps pushing on the Fed, Wall Street has begun experimenting with risky new financial instruments. Sound familiar?
There’s a time bomb in Donald Trump’s economy, and it’s likely to detonate before 2020.
Of course, it’s hard to see right now. His trade war with China notwithstanding, the economy seems to be the brightest star in the Trumpian universe. Despite the last few days, the stock market remains at all-time highs. Annualized G.D.P. is forecast to be a respectable 3.2 percent. The falling unemployment rate—which Trump derided as fake news until he took office—is at 3.6 percent, the lowest in nearly 50 years. Trump has even succeeded in jawboning Jerome Powell, the chairman of the Federal Reserve Board, into backing off his plan to raise short-term interest rates. As a result, interest rates—which determine what it costs Americans to get a mortgage or a car loan—remain historically, and unnaturally, low. An economy this good, many Democrats worry, could even get Trump re-elected, insane as that might seem.
But the economic picture is more complicated. On the one hand, Trump can lay a legitimate claim to having once again unleashed the “animal spirits” across the land. He has greatly reduced corporate tax rates and regulations, giving businesses a much freer rein to do pretty much whatever they want in search of more and more profit. And he is doing his level best—and succeeding, at least temporarily—in keeping interest rates lower than they otherwise would be but for his ongoing meddling into the affairs of the Federal Reserve.
Ironically, the very actions that Trump has taken, and that he believes are responsible for supercharging the economy (which I must hasten to point out was already doing pretty well under Barack Obama), will come back to haunt him. There’s always a price to pay when capitalists are allowed to roam free without supervision. But the real problem for Trump will come from his Fed gambits. By keeping interest rates at artificially low levels for so long (it’s been nearly 11 years and counting), debt investors are on a worldwide hunt for higher yields—the so-called “yield-hunger games”—forcing them to overpay for bonds, loans, and other debt-like instruments, and to take higher and higher risk without getting properly compensated for them.
When the economy turns—and it will; it always does—investors will lose hundreds of billions of dollars as a result of mispricing risk. “At this point, there’s more actual risk exposure than Trump would have you believe,” says one senior Wall Street banker, a friend of mine. “The world is more leveraged than it has ever been before at the corporate level, at the sovereign level, and collectively at the consumer level.”
Wall Street has always been very good at providing investors with what they want. If they want higher-yielding bonds, loans, and debt securities, then that’s exactly what Wall Street will start manufacturing and selling. You will remember, no doubt, that’s exactly what happened more than a decade ago when Wall Street started manufacturing and selling mortgage-backed securities that promised higher yields for AAA-rated credits. Of course, that was a chimera. And it all ended very badly, in the worst financial crisis in memory.
Now, Wall Street is inventing a new generation of risky instruments, of which there are many, many examples. From loans issued without covenants, to risky loans packaged up as securities and sold around the world as good investments, to “junk bonds” that yield 6 percent when they should be yielding closer to 10 percent or more.
One such symptom of the current situation, which arrived in my inbox the other day: an offer for a so-called “structured investment,” courtesy of the geniuses at JPMorgan Chase. What they have successfully served up to investors, hungry for yield, is a six-month note that promises to pay investors annualized interest of 16 percent under certain circumstances. Those certain circumstances depend almost entirely—believe it or not—on the performance of G.E.’s stock. As long as G.E.’s stock stays within a certain range each month for six months—basically not falling more than 30 percent from roughly where it has been—then JPMorgan Chase will pay investors at least 1.333 percent per month interest on their investment, or 8 percent for six months, or an annualized rate of 16 percent.
Given that six-month Treasury bills are now yielding around 2.4 percent, an investment that yields 8 percent for the same time period begins to look pretty damn good. Sure, there’s risk—if G.E.’s stock falls out of the range, the investor can lose his money; the note is callable if G.E. stock rises above the range. There is some small risk that JPMorgan Chase goes out of business and can’t pay off the note (think Lehman Brothers, circa September 2008)—but probably not enough to dissuade investors from the chance of getting that 8-percent yield for six months. It’s a way for investors to bet on the performance of G.E. stock, without having to buy or sell G.E. stock—while getting some protection if G.E. stock falls, but not too much, in the next six months. It’s all a bit wacky, with a twist of genius. Some investors think these kinds of “structured investments” are daft. One, Russell Clark, a London-based hedge-fund manager, has plowed much of his approximately $650 million fund into a massive bet that the market for these kinds of investments will come a cropper. It’s “unsustainable,” he told Bloomberg News recently, “and will end badly. I’ve seen it twice, three times even. And it feels so close to that inflection point. Everyone’s in the same trade.”
It turns out that structured investments are big-ish business these days on Wall Street. The market is around $60 billion a year in the United States, and growing, according to statistics provided to me by SIMON—the Structured Investment Marketplace and Online Network—a company nurtured by Goldman Sachs, and recently spun out of Goldman as a stand-alone company with new, big-bank investors. SIMON is in business to provide increasing transparency and information around these kinds of products, which in turn should further “legitimize” them so that more can be sold. (The market for structured investments in Europe is closer to $180 billion, or three times larger; in Asia, it’s closer to $350 billion, according to SIMON.)
So what’s the problem? First, I reflexively get worried when Wall Street starts getting hyped about how clever it’s being in providing investors with the risks they want to take. (Remember synthetic C.D.O.s?) Second, these notes—whether for six months or four years—are illiquid. You must hold them to maturity (unless they are called). You can try to sell them back to the big Wall Street bank that sold them to you in the first place, but investors should prepare to get hosed in the process. (On-demand liquidity always comes at a high price.) And if the bank that sold it to you runs into financial difficulties—think Bear Stearns, Lehman Brothers, Wachovia, Washington Mutual—then forget it.
I asked my banker friend about these kinds of structured investments and what they portend for the financial markets and risk-taking generally. He said he doesn’t buy these kinds of products. Period. “This is really a bet on G.E. stock, where you get no upside but have total downside exposure if it falls to 70 percent. You get paid 16 percent a year for that set of characteristics versus just owning the stock. Not insane unless it’s being marketed as being a ‘safe’ investment. I personally don’t buy structured notes.” He has become decidedly risk-averse. At this point in his life, he says, “A dollar of loss is more painful than the pleasure I get from a dollar of gain.”
But, of course, this is not remotely the message being conveyed by the tweeter in chief, or by Larry Kudlow, Trump’s national economic adviser. Trump is so unconcerned about the danger posed by years of artificially low interest rates that he’s taken to arguing that the Fed should actually lower short-term rates even more. “We have the potential to go…up like a rocket,” he tweeted on April 30, “if we did some lowering of rates, like one point, and some quantitative easing”—a reference to the Fed’s nine-year policy, abandoned in 2017, of keeping interest rates low. “Yes, we are doing very well at 3.2% GDP,” he continued, “but with our wonderfully low inflation, we could be setting major records &, at the same time, make our National Debt start to look small!”
These are the unfiltered ramblings, as we learned this week, of a pathetic businessman who used other people’s money to fuel his debt-crazed acquisitions, and then watched as one after another went down the drain. Like a Roman candle, the Trump economic rocket might go up—but like everything else he touches, it’ll also come crashing down.
https://www.vanityfair.com/news/2019/05/the-time-bomb-in-the-trump-economy
