What We’re Reading (Week Ending 02 July 2023) - 02 Jul 2023
Reading helps us learn about the world and it is a really important aspect of investing. The legendary Charlie Munger even goes so far as to say that “I don’t think you can get to be a really good investor over a broad range without doing a massive amount of reading.” We (the co-founders of Compounder Fund) read widely across a range of topics, including investing, business, technology, and the world in general. We want to regularly share the best articles we’ve come across recently. Here they are (for the week ending 02 July 2023):
1. Creating a Monster – Marc Rubenstein
Dennis Weatherstone needed a number. He’d just been appointed chairman and chief executive officer of JPMorgan and was in the process of reorienting the bank away from traditional lending towards trading…
…A currency trader by background, Weatherstone understood the risks inherent in such businesses. According to colleagues, he maintained “a steely insistence on evaluating the downside risk” of any trading decision. It was an insistence he imposed on the overall firm. Every afternoon, at 4.15pm New York time, JPMorgan held a treasury meeting to go through its various risk exposures. As risks proliferated, Weatherstone thought it would be useful for the risk management team to present a single number at the meeting, representing the amount of money the bank might lose over the next twenty-four hours. “At the end of the day, I want one number,” he instructed staff.
In 1990, JPMorgan introduced a new model, Value-at-Risk (VaR), to satisfy Weatherstone’s request. Volatility had long been used to measure fluctuations in a security’s price; Value-at-Risk took this further, using volatility as an input to estimate the minimum loss that might be expected on a day where the firm suffers large losses.
To illustrate, let’s say you own a portfolio of stocks worth $10,000. If the portfolio’s 99% daily Value-at-Risk is $200, it means that one day out of a hundred, you would expect to lose $200 or more; the other ninety-nine days, you would expect either to make money or suffer losses lower than $200.
The measure was a useful way for JPMorgan to keep track of firmwide risk and became the basis for risk budgets. Years later, JPMorgan would use it to measure risk on 2.1 million positions and 240,000 pricing series. But rather than keep it private, JPMorgan opened this valuable intellectual property to the world. In October 1994, it published full details of the model under the name Riskmetrics. Other banks and trading firms swiftly adopted it.
A currency trader by background, Weatherstone understood the risks inherent in such businesses. According to colleagues, he maintained “a steely insistence on evaluating the downside risk” of any trading decision. It was an insistence he imposed on the overall firm. Every afternoon, at 4.15pm New York time, JPMorgan held a treasury meeting to go through its various risk exposures. As risks proliferated, Weatherstone thought it would be useful for the risk management team to present a single number at the meeting, representing the amount of money the bank might lose over the next twenty-four hours. “At the end of the day, I want one number,” he instructed staff.
In 1990, JPMorgan introduced a new model, Value-at-Risk (VaR), to satisfy Weatherstone’s request. Volatility had long been used to measure fluctuations in a security’s price; Value-at-Risk took this further, using volatility as an input to estimate the minimum loss that might be expected on a day where the firm suffers large losses.
To illustrate, let’s say you own a portfolio of stocks worth $10,000. If the portfolio’s 99% daily Value-at-Risk is $200, it means that one day out of a hundred, you would expect to lose $200 or more; the other ninety-nine days, you would expect either to make money or suffer losses lower than $200.
The measure was a useful way for JPMorgan to keep track of firmwide risk and became the basis for risk budgets. Years later, JPMorgan would use it to measure risk on 2.1 million positions and 240,000 pricing series. But rather than keep it private, JPMorgan opened this valuable intellectual property to the world. In October 1994, it published full details of the model under the name Riskmetrics. Other banks and trading firms swiftly adopted it…
… But VaR is no panacea. While good at quantifying the potential loss within its level of confidence, it gives no indication of the size of losses in the tail of the probability distribution outside the confidence interval. The one-in-a-hundred day event may be a lot more debilitating than the $200 loss in the example above. In addition, correlations between asset classes can be difficult to ascertain, particularly when banks begin to act in unison. The diversification benefits that VaR supposedly captures in a portfolio of different asset classes falls away when crisis hits and correlations surge.
In 2008, the year Weatherstone died, the complex balance sheets his number facilitated unravelled spectacularly. Citigroup took $32 billion of mark-to-market losses on assets that year, an order of magnitude greater than the $163 million of VaR it reported at the end of 2007. Value-at-Risk didn’t cause the crisis, but it certainly cultivated a false sense of security leading up to it.
“Dennis, you created a monster by asking for that one number,” says Jacques Longerstaey.
2. Shanghai 2023 – Graham Rhodes
I visited Shanghai this month, my first overnight trip to mainland China since January 2020. So much has happened in that time, and I can’t tell you how much I’ve yearned to be back. Separated by just a river, Hong Kong is a world away. It’s been hard to be apart from friends, and harder still as an investor to understand the nuance of events in China without being there in person…
…The purpose of my visit was to present to a group of fellow investors who meet monthly to discuss a business and share what they see at work…
…My most important observation first: Mainland China’s dynamic-zero COVID policy is history, and everyday life has returned to normal. I had to make a health self-declaration upon entry, but that was it. Only a tiny minority of people wore masks, even on public transport. Restaurants and bars were open and bustling. The Bund, Shanghai’s riverfront promenade, was heaving with visitors from out of town. I raised the topic of Shanghai’s almost three-month lockdown with my friends, more as a way to enquire about their emotional well-being than to probe for details. And, for the most part, it is a thing of the past. They survived and have moved on. Perhaps their most lasting trace of zero COVID will be an unseen one: the children they didn’t have because they chose to wait until better times.
Twenty years ago, when I first visited Shanghai, there were a lot of rough edges. Now, you have to look hard to find them. I enjoyed the tasteful elegance of Swire’s HKRI Taikoo Hui Mall on West Nanjing Road and was awed by the opulence of Hang Lung’s Grand Gateway 66 Mall in Xujiahui. Even the malls in the outer inner suburbs, whose names I forget, were pleasant enough. Service in restaurants and elsewhere has improved dramatically, too, I suspect because of the transparency and intense competition created by rating apps like Meituan’s Dazhong Dianping. And I did everything through WeChat; if apps killed the open web in China, have mini-programs killed apps?…
…You can tell an EV in China by its green licence plate, and there were many of them on the streets of Shanghai. I have never seen cars showcased in shopping malls before. But Tesla and its Chinese EV competitors are doing just that. Does it reflect intense competition? Or cutting out the dealers to sell direct? Or both, perhaps? The Chinese EVs look good: they have stylish interiors and many clever features.
My friends wanted to know if I have less invested in China today than four years ago. The answer is yes. It’s been hard to keep confidence without regularly spending time on the ground. And given how far certain events were out of my expectations, I have had to ask myself if what I once took as understanding and insight were simply overconfidence and luck. It was reassuring to hear, then, that some things puzzled them too. For example, what impact will the sudden dismissal and arrest of the CEO of China’s best bank have on its development?…
…We’re not out of the woods, though; one friend opined that business sentiment today is worse than it was in October last year. The real estate market has not healed, and local governments have no money. Businessmen lack the confidence to invest. The consensus is that China has already entered a period of low growth. We discussed the implications of this for long-term stock-picking: can organisations built and tuned for the days of high growth adapt and re-invent themselves? Will first-generation founders be able to slow down? Will second-generation managers have the vision and chutzpah? And will either be willing to return capital to minority shareholders rather than chase at windmills?
It was amusing to hear that the group’s ‘deep value’ investors now own erstwhile growth stocks, while the more ‘quality-minded’ investors have become “flexible” enough to buy coal and utilities. China is, after all, a complex economy with the breadth and depth of listed companies to match. All companies have their cycles, too.
3. Scott Goodwin – Know the Names – Patrick O’Shaughnessy and Scott Goodwin
Patrick: [00:03:28] I think there’s different personality types that thrive in equity versus credit. I know early on in your career, you figured out that equities weren’t for you. Maybe describe, in your mind, the prototypical skill set differences between those two types and who would thrive the most.
Scott: [00:03:42] Well, Morgan Stanley didn’t want me back after my junior year of summer. So everybody’s work going to be for me because I said, “No. Give me a job.” I think for me, I’m naturally skeptical, and in credit, you’re always thinking about how much can I lose, how am I going to get my principal back, am I going to get my interest payments.
And when I think about the smart equity investors I know who have, the last 10 years, made a lot more money than I have because they’ve been thinking about the upside. How can earnings or revenue for this business double, triple, quadruple? So that difference of thinking about downside versus thinking about upside is very fundamental.
And then when you think about credit investing, you have the asset side of the balance sheet, which the equity guys are focused on, okay? So how many widgets does this company make? How many PCs does this company make? But then there’s the liability side of the balance sheet, that the equity universe, frankly, misses a lot. I think they’re learning about it again now a little bit.
Thinking about what Carvana or companies like that have gone through, you’re seeing the liability side start to matter more. But what’s the debt structure? When are the maturities? What are the covenants? What assets can the company sell? What can they not sell? Can they move assets around? So that liability structure and the sort of the unholy acts that can be done, by creditors or to creditors, is something that we like to meld into our process from a credit perspective…
…Patrick: [00:06:02] Can you talk about the concept of a credit cycle, which listeners will be roughly familiar with, but I think it drives a lot of where the opportunity is? And I want to talk about, in the credit cycles that you’ve seen and/or studied, but really seen and participated in, how they felt different, maybe going back to, like, say, 2000? So that we can talk about this one specifically and how it’s different. But first, what is a credit cycle from your perspective?
Scott: [00:06:23] So when we think about credit cycles, we think of booms in Boston business, booms in Boston economy associated with companies that are either cyclical, that have a problem due to an economic change. So in COVID, that meant rental car companies and cruises and airlines that literally couldn’t perform their business. Their balance sheets were fine one day and not fine the next day. And then you have another type of credit cycle which is more driven by secular change, so Amazon killing all the retailers over the past 10 years.
So for us, credit cycles aren’t just ’02, ’07 and ’08, and COVID. There are series of micro-cycles going on all the time in different sectors. Maybe the energy thing in 2016 is the best example of that. If I unpack that and go back — I started at Salomon City in 2002 working for Jim Zelter, and what kind of the learnings were from him early on, it was there are a lot of companies that need money right now for project finance in telecom and power. That’s what’s been built up, and there was a series of asbestos bankruptcies as well.
That was a bubble built up largely in the high-yield market. Tradable bonds, investment-grade market, power, telecom, and fraud were the main parts of that credit cycle. There was a huge amount of money to be made in distressed because you had mutual funds that would — bonds would default or they get downgraded and they sell them to distressed guys. And there wasn’t as much competition for those people in distressed.
And the liability side of the balance sheet we talked about, those people had real edge, go to the courthouse. They would have lawyers. They would know exactly what’s going on. That liability side edge, because of the advent of real research and everybody having a dock person on staff, has largely been competed away within the credit universe. That’s the first cycle I was a part of.
Then we get to the LBO boom and bust. So if you think about LBOs and — probably 40% of high-yield issuance was driven for LBOs in 2007. I don’t think we’ve seen that number since then. And there was a ton of leverage built up in the system very quickly, chasing a private equity boom, you had a housing bust that took the economy down that took those deals down as well. So those companies weren’t actually the problem. It was the housing bust that took the economy down caused them to have a problem. That was another very fast V for a lot of those companies.
I was at Citi and then left in 2010 to go to Anchorage. But I’m at Citi, my mentors, Jim, John Eckerson, Ronnie Mateo, had all left. They’re gone. I’m kind of there by myself with a few people who are left, moving the deck chairs around, watching the stock be at $1, and frankly, learning from my clients.
One of the reason I went to Anchorage was I had a lot of the same shorts as the Anchorage guys in ’08, and we worked to turn them into longs in ’09. A lot of my career has been about finding shorts then getting long in the other side and following these credits through the cycle. And I liked how Kevin and Tony and the Anchorage team did that. So they asked me to join in 2010, and I joined them coming out of the GFC cycle.
But then soon after that, we had a cycle in Europe. I got there, I think, in May of 2010, and there — all of a sudden, Greece is exploding. Frankly, the learnings from the European sovereign cycle were very relevant to what happened during COVID because it was the first time in my career that you’d seen real intervention by sovereign corporate debt markets, buying a lot of debt and supporting the market.
So you had, in ‘20 and Draghi, whatever it takes, they’re going to buy Italian bonds, buy Spanish bonds. Eventually, they ran out of those bonds to buy. They bought corporate bonds with the CSPP program, and then distorted the corporate bond market in Europe for a long time which allowed REITs to issue at 1% that’s going to now create a good distressed opportunity. But what we saw then was whatever-it-takes intervention works in investment-grade and corporate bonds.
2015, ’16, ’17 is the energy and commodity bust. That’s a real credit cycle, sector-driven like I was talking about. So there’s a ton of new issuance in energy. The shale boom is being built up over many years.
I remember meeting with Aubrey McClendon from Chesapeake in 2003 or 2004 at Citi in a road show. And he showed us a chart — I think they issued the Chesapeake 9s 1032 that year, the 9s of like ’08 or ‘09. And he showed us a chart of where natural gas was going to go. And I don’t think it saw that target for a long time, but that was the beginnings of it, like in the early 2000s.
At Anchorage, in 2010, ’11, and ’12, we were financing companies in the Bakken, the Marcellus, the Mississippi Lime, the Permian. We knew all these basins. So when energy started to trade poorly in the middle of 2014 and started to trade down a lot, and you’d start to have these high correlation sell-offs, that’s one characteristic of credit cycles is. Whether it’s a sector-based cycle or it’s a macro-cycle, the beginning sell-off in credit is 0 dispersion, high correlation.
People are selling what they can sell. That creates tremendous opportunities because in that first wave, things will go down that probably shouldn’t have gone down at all. And you can buy those and short the bad stuff.
So we looked at that, that first sell-off, in 2014, and you had the Permian credits, many of which have now been rolled up. The Parsleys, the CrownRocks, the Diamondbacks had gone from par to $0.70 on the dollar.
The Mississippi Lime, which is a worse basin, the SandRidges, and the offshore credits had gone from, say, par to $50. The distressed funds are all looking at the south of $50. They’re heuristically saying, “I have to buy the lowest dollar price. That’s what I’ve been trained to do.”
And they’re generalists, generally. They don’t have sector specialists, although that’s changing because of some of the mistakes made in the teens. But they’re drawn to that low dollar price. We’re sitting there saying, “Wow, this stuff in the Permian is covered at par even if oil is at $30 or $40.”
Whereas the Mississippi Lime stuff, we didn’t like anyways. “Let’s buy the Permian stuff at $70 and short this at $50.” And that trade ended up making maybe 30 points on the long and 50 on the short. I wish we’d held at that whole time. In extremis, that’s what it would have made, but you had multiple bites at the apple and fits and starts in that credit cycle, and you usually do.
Rarely do you go, like COVID, from A to Z in 1 month. Credit cycles are — and one we’re about to talk about, the post-COVID cycle that we’re about to enter now is it’s a slow-moving cycle, much more like the ’02, ’03, ’04, ‘05, what I went through at the beginning of my career, which was a buildup of excess in certain sectors driven by some economic shifts and changes in the interest rate environment that led to a cycle.
The things in 2011 and ’12, systemic. GFC, systemic. Energy, not systemic, but commodity price. If you have a bond that’s at par, that works at $70 oil, that was – and oil is at $20, it doesn’t work — it’s not that the bonds were at $50. It might be worth 0.
Now, what happened in the energy thing was you had all these bonds that went to trading at $0 to $0.20 on the dollar. But some of them had a couple of years of cash around and could fund their interest payments. So — I could buy for $0.05 to $0.10. When I think about the best trades I saw in ’08 and ’09, it was people coming in and buying the LBO unsecured debt — I was a — the broker-dealer of Citi — because there was a lot of option value at those spots.
Now, we’re sitting here at Anchorage and we’ve got – “Wow, there’s some really interesting opportunities.” These bonds are at $0.05, $0.10, $0.15. So we tried to figure out which ones had enough runway and the – and same thing happening again in COVID. And you ended up buying what were IOs that recovered par because oil didn’t stay at $20 or $30 forever. It went back up eventually because supply and demand balances.
And I think in commodities, you had the same thing in Freeport and some of the copper companies as well. When you have a commodity, a first-quartile or second-quartile commodity company, that trades down a lot in credit, it’s a really unique opportunity because the commodities have such a high volatility factor associated with them. If they have enough runway that they can last 12 to 24 months, you’re supposed to take a shot on that debt…
…Patrick: [00:17:44] Could you give a story, hypothetical or real, that helps us understand like one of these decision moments where it is seconds or minutes that you’re making, I’ll call it, a substantial decision, whether that’s with dollars or percent of the portfolio or however you want to interpret it? I just want to like get in the room a bit on why this all comes together as an advantage for you and your investors.
Scott: [00:18:03] Sure. Sure. I’ll give you an example from COVID. That’s maybe the most interesting example. The levered loan market is a market that is very opaque. 70% of the market is private issuers, which means there’s no public stock you can file. You have to go on the interlink 1819 site to get the financials.
And levered loans don’t settle like stocks or bonds. It’s mind-boggling, but levered loan settlement process could take anywhere from a week to months. Hopefully, someday blockchain will fix that, but it hasn’t yet.
So we’re sitting there in the second week of March, and we share with the banks names we’re focused on. So I’m sharing with the banks each morning, “Here are the names we’re focused on.” So they know if they get a sell-off of anything on that list, they should call me. We want to be transparent and open with them. Again, we’re trying to make them smarter, warehousing that risk they’re looking to move in.
Patrick: [00:18:52] Are you e-mailing them, calling them?
Scott: [00:18:54] I’m sending them an IB and then I’m also talking to them. For each bank, sort of nuance the list a little bit, as are the traders on our team. And the head of loan trading at — BofA calls me. He says, “Hey, at 7:00 a.m., I’ve got a mutual fund that’s got a $1 billion outflow in loans.” They’re calling us because we are the fastest settlement process for loans.
“Well, okay. They own these names on your list. Can you buy $500 million by 8 a.m. because I want to make some progress?” I call Jon. We’re like, “Let’s not buy cyclical stuff. We don’t know what’s going to happen here.” We’re starting to buy a little bit of IG because we think the government is going to start buying IG, but this is junk-rated loans.
And we had had our analysts in software learn all the software loans in 2019 because we said, “Well, if there’s a recession and there is a cyclical environment, the whole loan market is going to trade down because that’s where a lot of the excesses are building up, but software will be the most defensive place. It’s stickier.”
So we bid that firm for $500 million of loans, of which $350 million was software loans. Let’s say the average price on them the prior day was in the high 80s 1954. We bid around 80s, so down, say, 10% or 8 points, and they sold it to us.
And I think there are probably 2 firms in the world that could have responded to that call within 15 minutes. And we responded, I think, within 5 minutes. But they called us because, a, we had shared the list with them, and, b, they knew we had a track record of providing liquidity into these dislocations and responding fast.
So that speed of capital in that situation provided a lot of alpha. Two of the loans were Sprint, which is getting bought by T-Mobile, and Infor Lawson, which was getting bought by the code 2025 family. So they were getting bought by investment-grade companies, we were buying them in the lower mid-80s. Sprint was a little higher.
But that opportunity, I think, exemplifies being ready, learning things proactively, not necessarily because there’s investment to do today, but because you know when there’s an inflection point, there are certain kind of things you want to buy. And that does create some level of busy work, but it’s all that process and being prepared so that you can make fast decisions.
Patrick: [00:20:50] Can you talk about how you think of the evolution of where alpha comes from in credit over — maybe just across your whole career? You said a liquidity provision there, which to me is a really important thing to think about and talk about as a source of alpha. But like what have been the sources of alpha across your career? And what are still here, what are gone?
Scott: [00:21:10] Early on, it was the liability side of the distressed market, and that was the firms that were early in that, that were excellent 20, 25 years ago, that were early and — in there, and they knew the docs and other people didn’t. That was a real source of alpha.
I think that alpha in terms of just understanding the docs better than other people or having the information is gone. If you fast-forward to the GFC, I think a lot of the alpha there was liability structure. Who could hold the trade?
We were — at Citi, we sold most of our levered loan book to a bunch of private equity guys and gave them back leverage. They had to re-up that leverage, but they were able to hold that trade from those loans going from 80% to 40% to par.
And if I look at funds that were successful during that time period, it was those that could hold the trade or had liquid enough investments that they could change their mind. When we think about liquidity, we — and investing, we’re not just focused on what is the best risk-adjusted return, we’re also, for our hedge fund and dislocation fund, thinking about what’s the best liquidity-adjusted return because most of the time, you’re not getting paid enough to go into illiquids if you have capital that’s supposed to be doing liquid things.
And we don’t – I was a lot about holding the trade because if you were levered, Selwood was one of our biggest counterparties. 2007, the market goes down for like 3 days, and they were — I mean these numbers are pretty incredible, but they were something like 90:1 levered on levered loans on LCD, yes, which is a product that doesn’t exist anymore as a secured-, unsecured-basis trade. They were gone in 3 days, basically.
And that was a real lesson for me about gross and leverage and watching how quickly that unwound. And at Citi watching some of the mistakes that were made, there were real lessons to be learned in my career of, frankly, watching other people make mistakes and learning from them versus having to make them myself.
But that source of alpha of liability structure is still around in credit today. I think it’s much more appropriately distributed. Now, you have private credit funds have funding that matches the — not only LP capital, but the leverage matches the duration of the assets.
There are a lot of the CLO equity, which is a more volatile product from market-to-market perspective. Great products through a number of cycles, but maybe not for somebody who has quarterly liquidity. That now sits in different hands, more insurance, more pension, more long-term liability type of money.
There’s still a lot of money in daily-liquidity ETF, mutual fund. That creates a lot of the intraday and intra-month volatility in credit because the underlying assets don’t necessarily match the daily liability structure.
I would say speed is something that — when credit markets were much more liquid and the banks were taking a lot of risk, when I was on the sell side, call it, 2002 to 2010 and maybe a little bit after that ’11,’12, ’13, there was more liquidity in the market. The banks were committing a lot of capital. Speed wasn’t as relevant because the bank traders were always the fastest.
They were seeing everything going on. They knew what everyone was doing. As they became less focused on risk and knowing the names, frankly, and more focused on just moving widgets around from one account to another, the combination of understanding the underlying credits and being fast – because I think a lot of people understand the credits, most of them are slow and reactionary – having a process that allows for speed of decision-making is alpha. There’s no doubt about it. The example I gave you about the levered loan things is an extreme one in COVID, but happens every day…
…Patrick: [00:41:54] We talked earlier about equity versus credit. And the idea of imagination is really important in equity investing, like imagining what the TAM might be, what might become, what a team could accomplish. What role, if any, does imagination play in credit investing?
Scott: [00:42:08] A lot on the structuring side. So if you think about what’s happening right now with a lot of the companies that are in need of money in both, let’s call it, generally the private credit and levered loan space where the bubbles have been built up, they are moving assets away from creditors to raise capital, and they’re doing it in very clever ways. One has just done it by creating a double dip, which is essentially an extra claim through an intercompany without actually moving any assets. There’s a lot of imagination and structure around that.
And then I think about when you’re in a distressed situation, when we’re sitting there looking at Hertz in the middle of 2020, and we’re saying, “Well, what’s this business going to be?”, you have to think about the narrative of a company as it goes through the process.
In equities, you have one stock. In credit, in the case of Hertz, let’s say you have the common equity, then you had the senior unsecured debt. Then you have the second-lien debt, the first-lien debt. Then you got the ABS on the cars. So you have all these layers you can invest in the capital structure.
And you have to think about — Hertz is doing no business right now. But I’m looking at the data from China. And China has reopened already in May, June of 2020. And it seems like nobody is taking a public transportation. Well, what does that mean? They’re going to drive. Well, there are no cars that are being produced. What does that mean then? They’re going to buy used cars.
Okay. Why did Hertz go bankrupt? Well, a, no one is traveling, but, b, most of the Hertz debt is just a margin loan on the ABS and the used car securitizations. So used car prices crash. If used car prices are going to go up a lot, that’s going to benefit Hertz.
So we were an investor in the first lien. And we’re sitting here looking at this, and we bought the first lien at like $0.75 or $0.80. We ended up being — us and Apollo, we’re the two largest investors in the first lien.
If this is what’s happening in China and that happens in the U.S., used car prices are going to skyrocket. And maybe the narrative is going to change in this bankruptcy that the first lien isn’t the fulcrum or the controller of the equity through the bankruptcy. It can be the junior debt, which is trading at $0.15. So we bought the junior debt on that option. You have this convex option that used car prices are going to skyrocket.
That’s a simplistic example, but thinking about how companies evolve through a bankruptcy process, and through their life cycle and how the capital structure interacts with changes in the macro and changes in the micro is a lot of how you have to think creatively about credit. It’s less about, “There’s this huge TAM and delivery. How can I address it?”
What we’re trying to solve for is knowing names and then touching them at different points in their life cycles, be it long, short, different parts of the capital structure, that we think management and the micro and macro economy are going to favor or disfavor…
…Patrick: [00:51:16] As you look at the landscape of investing firms kind of – at large, what do you think most will or needs to change over the next decade?
Scott: [00:51:25] We talked about the shift from equity to yield. I do think that liability structures have tricked people into believing that being illiquid was better than being liquid necessarily. So the vol-washing Kieran talked about with you a couple of weeks ago needs to be exposed.
And the asset classes that have vol-washed to have either sharps that are artificial or low dispersion within an asset class, that will be exposed from an asset management perspective. And then fees can be calibrated not based off what the product is, but based on how good the manager is.
Because right now, if you talk about private credit, which is a business we’re about to get into, you spend a lot of time with Kieran, you’ve had almost no vol in the returns, no dispersion. And the biggest winners have been the guys who had the most second lien or the most equity co-invest who use the most leverage. Those are probably going to be the biggest losers in the next few years.
And the de novo private credit opportunity right now is pretty incredible. You’re talking about first-lien debt, 50% loan-to-value, 11%, 12%. The structure we’re going to use to raise the capital around it — that Apollo is seeding will have a higher return based on the seed economics…
…Patrick: [01:05:30] What else is going on in the world, if anything, that you think matters that change the dynamics of capital markets right now?
Scott: [01:05:37] I mean the banks. So they are being disrupted from a capital perspective in terms of the private credit lenders, direct lenders. And we’re seeing now that the regulators are more focused on them. Obviously, the yield curve doesn’t help. We consider them great partners, but now they’re needing to, through credit risk transfer transactions, do essentially derivative hedging trades to create more capital.
And I think whether it’s Basel III or Basel IV, future regulatory things that are coming, that’s only going to become more acute. And for us to be a counterparty on the other side of those credit risk transfer transactions, I don’t want to get too in the weeds on them because they’re complicated, is a great thing for us.
The banks are transferring us very high-quality risk. We’re taking a junior slice alongside them, and we’re getting paid teens to 20% returns for what we think is a high-quality portfolio of underlying assets. The regulation of banks and the opportunities it creates has been an ongoing opportunity.
4. China will not be able to De-Dollarize under Xi Jinping – Mark Dittli and George Magnus
In early 2023, investors had high hopes of a recovery boom in China. It has turned out to be a disappointment. What happened?
The government has been quite vocal that they wanted to see a consumption led recovery. Many economists thought it was almost inevitable that there would be a consumption rebound as people had become very restrained in their spending in 2022 because of the lockdowns under the zero Covid policy. What’s happened is that although we’ve seen a bit of a rebound in low-ticket items such as eating out and travel, we haven’t seen a robust recovery in home sales, automobile sales and more expensive things. There was much greater caution by households than we thought was likely based on what we’d seen in other countries that had left Covid behind.
Is there a crisis of confidence among consumers?
We may still see a delayed rebound in consumer confidence and sales in bigger ticket items. We shouldn’t rule it out just yet. But the clock is ticking, and there is a possibility that it won’t happen.
Why would that be?
Part of it is a psychological thing, and part of it is a structural problem. The psychological issue is caused by what’s been going on in real estate during the past two plus years, about homes that have been promised that haven’t been delivered. China has a pre-sale model of home sales, which means you start paying your mortgage even before the property is built or finished. A lot of households have been affected by this. Given the fact that so much household wealth is tied up in housing, people have become very cautious. They have built up their savings deposits in banks, and so far they haven’t wanted to liquidate them.
And the structural problem?
This predates Covid. It’s the familiar story that in China, because of the unbalanced nature of its economy, household incomes are a low part of the economy, and consumer spending is only about 40% of GDP. They don’t account for nearly as high a proportion as in other emerging market peers, let alone in the US, Europe and East Asia. That’s the structural issue which the government has not wanted to deal with for years. So we’re looking at a double whammy, a structural constraint and a psychological problem which both affect consumers’ willingness to spend…
…The property market, which is around 20 to even 25% of GDP, seems to be unable to gain traction. What’s the problem there?
In a nutshell, it’s the result of a long term housing boom. The property market in China has seen minor cyclical downturns before, but it has never really had a shakeout. It was continuously propped up and expanded to the point where it’s become laden with debt and excess capacity. It’s possible that the property market is just going to mark time for the next five to seven years, because there is such a vast amount of overconstruction. This is not necessarily a problem in Tier 1 cities like Shanghai or Shenzhen, but it is a huge problem in smaller Tier 3 or 4 cities. This is where about 60 to 75% of the housing stock and most of the excess inventory is located. No markets go up forever. Eventually, overly high prices and high inventories combine to bring about a problem. There is also a huge demographic challenge, given that the cohort of first-time buyers, who are typically aged between 25 and 40, is going to fall by about a quarter over the next 15 to 25 years…
…The Party leadership has talked about a rebalancing of the economy and strengthening the consumer sector for years. Why is that so hard?
A large part of the answer arises from the economic philosophy of the CCP. It does not believe in the welfare state as we know it in Western Europe. It’s very much focused on what it calls supply side structural reform, which is really about the community benefiting from the uplift in economic growth which arises from allowing companies to produce more. The Party has a strong focus on production, but not a big focus on consumption. Xi Jinping’s China has this view that if they can fine-tune the production side, that this will lift employment and incomes throughout the economy…
…So the property market will not be a driver of growth, investment neither, consumption is not coming along, and exports are in a slump. This looks rather bleak, doesn’t it?
Yes. We’ve all developed our careers in the last twenty or so years being accustomed to either double digit economic growth in China or something close to that. But in fact growth in China has been halving each decade recently. We had growth of roughly 10% to 12% per annum during the 2000s, then about 5 to 6% in the 2010s, and I think in the 2020s China’s sustainable rate of growth is probably no more than 2 or 3%. That stepwise halving in each decade is a reality, you can’t argue that it’s some freak factor. There is obviously something going on in terms of sources of sustainable growth. So I think China’s policy makers will have to choose between either good 2 to 3% growth or bad growth. The good growth would come from a rebalancing of the economy, if they were finally to do something about household income and consumption. Bad growth would be if they tried to fuel it just by building more infrastructure and real estate…
…Can they achieve a de-dollarization?
My answer is No. This is not like changing a pair of shoes. I don’t think many of the people that advocate de-dollarization – which includes some emerging countries or the crypto crowd, which has a vested interest in undermining the dollar-based system – really have thought this through. It’s very easy to talk about de-dollarization, but to really achieve it, you’d have to turn the entire global financial and economic system on its head. I don’t think that’s going to happen. This does not mean that the dollar will forever be the dominant currency, but for the foreseeable future I don’t think it’s under a great threat.
Saudi Arabia selling crude to China for yuan, or Brazil selling soy to China and getting paid in yuan: That’s not de-dollarization to you?
If you sell products for yuan instead of dollars, you are technically de-dollarizing. But what really matters for the global monetary system is not the currency in which you settle your trade, but the currency in which you accumulate your balances. If you are Saudi Arabia and you peg your currency to the dollar, you have no use for accumulating balances in yuan. You need dollar reserves. If you are Brazil and you are exporting commodities that are globally priced in dollars, you have to accumulate liquid dollar reserves. The dollar system allows large imbalances in the global economy to accumulate because the United States is unique in allowing unfettered foreign access to all of its assets, be it bonds, equities, or real estate. If the people who are advocating de-dollarization really wanted to achieve it, it would mean that China, Germany, Japan, Brazil, Saudi Arabia, etc. would no longer be able to run current account surpluses if the US no longer accommodated their surplus savings. It would mean imposing symmetry between surplus and deficit nations. Do you really think the surplus countries would want that?…
…What about talks about a BRICS currency?
If I twisted my own arms, I could possibly see them setting up something they might call a BRIC, which is an accounting unit for settlement of transactions, in much the same way the Special Drawing Right is an accounting unit for the IMF. But I don’t see a BRICS currency. How would it be valued? What would it be linked to? China has a convertible currency only for current account transactions, not for capital transactions. A BRICS currency is really just a fancy way of talking about a pumped up internationalization of the yuan in a way that makes the other members of the BRICS club feel better about it.
So, it’s rather simple: As long as China’s capital account remains mainly closed, there won’t be any de-dollarization?
There are certainly officials in the PBoC and government as well as a number of economists in China who think that not only is it unlikely that full internationalization can happen as long as capital controls are in situ, but also that it would be a bad idea. If they did abandon capital controls, it’s highly likely that there would be a huge outflow of capital from China. The yuan would depreciate. That would compromise the stability of the financial system in China. There is an argument that the CCP doesn’t trust its own citizens to keep their capital at home. That’s why I don’t think this is something that the CCP would ultimately endorse. Renminbi literally translates as the people’s currency. The CCP must have control over the people’s currency. Control is what drives Xi Jinping’s interest. I’m not saying it would never happen, but I am confident that it won’t happen under the leadership of Xi.
5. Eastern philosophy says there is no “self.” Science agrees – Chris Niebauer
The great success story of neuroscience has been in mapping the brain. We can point to the language center, the face processing center, and the center for understanding the emotions of others. Practically every function of the mind has been mapped to the brain with one important exception: the self. Perhaps this is because these other functions are stable and consistent, whereas the story of the self is hopelessly inventive with far less stability than is assumed.
While various neuroscientists have made the claim that the self resides in this or that neural location, there is no real agreement among the scientific community about where to find it — not even whether it might be in the left or the right side of the brain. Perhaps the reason we can’t find the self in the brain is because it isn’t there.
This may be a difficult point to grasp, chiefly because we have mistaken the process of thinking as a genuine thing for so long. It will take some time to see the idea of a “me” as simply an idea rather than a fact. Your illusionary self — the voice in your head — is very convincing. It narrates the world, determines your beliefs, replays your memories, identifies with your physical body, manufactures your projections of what might happen in the future, and creates your judgments about the past. It is this sense of self that we feel from the moment we open our eyes in the morning to the moment we close them at night. It seems all-important, so it often comes as a shock when I tell people that based on my work as a neuropsychologist, this “I” is simply not there—at least not in the way we think it is…
…As a matter of background, it is important to remember that the brain has two mirror halves connected by a large set of fibers called the corpus callosum. In research undertaken to try to mitigate severe epilepsy, Roger Sperry and Michael Gazzaniga believed that by cutting this bridge between the two sides of the brain, seizures would be easier to control. They were correct, and Sperry would win the Nobel Prize in 1981 for this work.
While each side of the brain is specialized to do certain types of tasks, both sides are usually in continuous communication. When this connection was disrupted, however, it became possible to study the job of each side of the brain in isolation. With the sides disconnected in these epileptic patients, scientists could test each on its own and gain insight into the functional differences between the left and right sides of the brain. These patients were referred to as “split-brain” patients.
To understand this research, it is also important to know that the body is cross-wired — that is, all the input and output from the right half of the body crosses over and is processed by the left brain, and vice versa. This crossover is also true for vision, so that the left half of what we see goes to the right side of the brain, and vice versa. Again, this only became obvious in the split-brain patients. And research with these subjects led to one of the most important discoveries about the left side of the brain — one that has yet to be fully appreciated by modern psychology or the general public.
In one of Gazzaniga’s experiments, researchers presented the word “walk” to a patient’s right brain only. The patient immediately responded to the request and stood up and started to leave the van in which the testing was taking place. When the patient’s left brain, which is responsible for language, was asked why he got up to walk, the interpreter came up with a plausible but completely incorrect explanation: “I’m going into the house to get a Coke.”
In another exercise, the word “laugh” was presented to the right brain and the patient complied. When asked why she was laughing, her left brain responded by cracking a joke: “You guys come up and test us each month. What a way to make a living!” Remember, the correct answer here would have been, “I got up because you asked me to,” and “I laughed because you asked me to,” but since the left brain didn’t have access to these requests, it made up an answer and believed it rather than saying, “I don’t know why I just did that.”
Gazzaniga determined that the left side of the brain creates explanations and reasons to help make sense of what is going on around us. The left brain acts as an “interpreter” for reality. Furthermore, Gazzaniga found that this interpreter, as in the examples mentioned, is often completely and totally wrong. This finding should have rocked the world, but most people haven’t even heard of it.
Think about the significance of this for a moment. The left brain was simply making up interpretations, or stories, for events that were happening in a way that made sense to that side of the brain, or as if it had directed the action. Neither of these explanations was true, but that was unimportant to the interpretive mind, which was convinced that its explanations were the correct ones…
…I am distinguishing mental suffering from physical pain. Pain occurs in the body and is a physical reaction—like when you stub your toe or break an arm. The suffering I speak of occurs in the mind only and describes things such as worry, anger, anxiety, regret, jealousy, shame, and a host of other negative mental states. I know it’s a big claim to say that all these kinds of suffering are the result of a fictitious sense of self. For now, the essence of this idea is captured brilliantly by Taoist philosopher and author Wei Wu Wei when he writes, “Why are you unhappy? Because 99.9 percent of everything you think, and of everything you do, is for yourself — and there isn’t one.”
Disclaimer: None of the information or analysis presented is intended to form the basis for any offer or recommendation. We currently have a vested interest in Meituan, Tencent (parent of WeChat) and Tesla. Holdings are subject to change at any time.
