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Obscene Risk Hidden In Plain Sight

Recently there have been numerous major economic agencies warning of the growing and severe risks in the debt markets. Investors have shrugged them off as they seem to think that their bond fund is immune as are equities. They’re not.

The Geneva Report, released last month, revealed that there has been no progress made in reducing debt levels around the world in the years since the financial crisis. In fact, debt levels have only grown over that time, even here in the US. This should be worrisome, they report, because, “there is considerable evidence that a high stock of debt increases vulnerability to the risk of a financial crisis.”

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Chart via Geneva Report

Clearly, the BIS is looking at the same research because back in July they warned these growing debt levels could kick off ‘another Lehman.’ BIS General Manager, Jaime Caruana, told the Telegraph, “We are watching this closely. If we were concerned by excessive leverage in 2007, we cannot be more relaxed today.”

This week, the IMF joined the chorus:

…Prolonged monetary ease has encouraged the buildup of excesses in financial risk-taking. This has resulted in elevated prices across a range of financial assets, credit spreads too narrow to compensate for default risks in some segments, and, until recently, record-low volatility, suggesting that investors are complacent. What is unprecedented is that these developments have occurred across a broad range of asset classes and across many countries at the same time.

For all of these bankers, economists and regulators, there’s just too much debt for their liking and much of it carries too much risk – and it’s spread beyond the debt markets to a broad variety of other asset classes. That’s funny because even the Fed has been warning about the very same thing lately! And they’ve pointed their finger directly at the leveraged loan market.

There’s not really one definition for these things but leveraged loans are typically floating-rate loans made to companies that carry an above-average amount of debt and, for this reason are labeled, “high-yield” or “high-risk.” The “high-yield” might actually be a misnomer because lately these things have been issued at a rate of around 5%. Many of these loans are used for leveraged buy-outs and the “high-risk” label is right on the money.

Back in 2012, the volume of these sort of loans rebounded to a new all-time record as investors, hungry for yield in a zero-interest rate environment, couldn’t get enough of them. Last year blew 2012 away and this year is on track to do even more than last.

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Chart via Dallas Fed

What’s more troublesome than just the sheer volume of these loans is the quality. Although the Fed has advised bankers not to loan an amount greater than 6 times EBITDA to any given borrower, in the third quarter of this year new LBO debt levels ran 6.26 times EBITDA. This amount of leverage would normally be very risky but it is especially troublesome today because current EBITDA for these companies is based on record-high profit margins. Should margins contract at all, it would make these borrowers less likely to be able to service their debt. In other words, a simple reversion in profit margins closer to their historical average level would probably mean rising defaults, maybe dramatically so.

With yields currently at 5%, investors in these loans currently don’t need to worry about defaults hovering around the 2% level (unless you think a net 3% return is silly for the amount risk you’re taking, as I do). But prior to the financial crisis, before the s*** even began to hit the fan, default rates were nearly twice that level. At the height of the crisis defaults soared to nearly 13%. Now consider that these companies are more highly leveraged than ever and a huge portion of their debt floats at rates that are now near record lows.

On top of that, the share of “covenant-lite” loans has soared. These are loans that place fewer restrictions on the borrowers and give lenders less recourse in the event of a default. So when (not if) defaults rise again lenders will feel more pain in these sorts of loans than they ever have before.

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Chart via Dallas Fed

Richard Fisher summed it up fairly well recently saying, “the big banks are lending money on terms and at prices that any banker with a memory cell knows from experience usually end in tears.” And this time it will be more than just bankers’ tears. Shadow bankers will be affected, too. And by “shadow banking,” I mean your bond fund (among other things).

From the IMF:

While banks grapple with these challenges, capital markets are now providing more significant sources of financing, which is a welcome development. Yet this is shifting the locus of risks to shadow banks. For example, credit-focused mutual funds have seen massive asset inflows, and have collectively become a very large owner of U.S. corporate and foreign bonds. The problem is that these fund inflows have created an illusion of liquidity in fixed income markets. The liquidity promised to investors in good times is likely to exceed the available liquidity provided by markets in times of stress, especially as banks have less capacity to make markets.

This may be why the Fed has been chastising the banks so much lately. Maybe they know how much more difficult a “shadow banking” crisis would be to deal with than just your run-of-the-mill “banking crisis.”

Anyhow, what is troublesome right now is that it looks like profit margins might have already begun to revert. This  puts pressure on all of these highly leveraged companies and makes the prospect of defaults more likely. This is probably why credit spreads have recently widened to their highest levels of the year, breaking the multi-year downtrend that inspired the boom in the first place. All in all, this could be the beginning of the end of the “reach for yield” in this cycle.

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Chart via St. Louis Fed

What I find most fascinating about the whole thing, however, is that the demand or appetite for leveraged loans is so closely correlated to the stock market. The black line in the chart below tracks the PowerShares Senior Loan Portfolio, a leveraged loan ETF with $6.5 billion in assets, relative to the 5-Year Treasury Note price (roughly the average weighted duration in the ETF portfolio). The S&P 500 Index is also overlaid. Clearly, the risk appetite for leveraged loans is nearly perfectly mirrored by the stock market.

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Chart via StockCharts.com

Now I don’t know if this correlation will hold up going forward but it sure looks like risk appetites across asset classes are currently dancing to the same beat. And if this credit cycle is going to end in tears then it may be hard for equity investors to avoid a similar fate.

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The New Wolves Of Wall Street

Wall Street is in the midst of some pretty massive change right now. And I’m talking about Wall Street as it relates to Main Street. I’m talking about how individual investors are being courted (hunted) and cared for (killed) by the new wolves of Wall Street.

Brokers have now become an endangered species as the model has been attacked on two sides by fee-only investment advisers (aka, RIAs) and discount brokers advocating a DIY approach. And now there’s a third entrant attacking both the brokers and RIAs: robo-advisers. All in all this evolution is good for investors as it ultimately brings down costs.

But don’t underestimate greed’s resilience and its willingness and ability to adapt. As they say, “the more things change, the more the stay the same.” Many brokers are making the switch to RIAs. In fact, they’re doing it in droves (witness the growth of the likes of LPL Financial). Changing your title and even your business plan, however, won’t magically turn a wolf into a sheep but it does make him harder to identify.

Make no mistake. There are plenty of wolves left on Wall Street. They just don’t call themselves wolves anymore. In fact, they do everything in their power to look like innocent, cuddly sheep. They setup as RIAs now. Many even preach a low-cost, passive or index-based approach to investing, aligning themselves with the likes of Burton Malkiel, Warren Buffett and Jack Bogle, some of the most respected names in the business.

It’s the ultimate hypocrisy. You see, while they preach a low-cost approach and may actually use low-cost products like index ETFs, they’ll charge you an arm and leg for the privilege – as much as 2% per year. As Meb Faber put it, “you’re a predator if you’re charging 2% commissions and or 2%+ fees for doing nothing.” I’m sure the wolves, who normally brag about ‘eating what they kill,’ would take this as a compliment. Meb continues,

Anything more than 0.5% or so on top of fund fees is either paid a) out of ignorance, which is not always the investor’s fault or b) as a tax for being irresponsible.  For the latter I mean a fee to keep you out of your own way of chasing returns and doing something stupid, much in the same way someone pays Weight Watchers or any other diet advice program when you know what you should be doing (eat less, exercise more).

I’d say that anything more than 0.25% for “managing” a passive portfolio of index ETFs these days is obscene (it’s not even really “managing” if it’s passive – more like “overseeing”). And there are plenty of advisers charging nearly ten times that amount. And what’s the money for? What are you paying these fees for year after year? Because if the funds themselves do all the work and merely need to be rebalanced a couple of times it might take 15 minutes per year.

At the end of the day, you’re paying for the pleasure of their company. And that 2% fee might not seem like much but it really adds up over time. As Albert Einstein famously said, “compound interest is the eighth wonder of the world. He who understands it, earns it; he who doesn’t, pays it.” Over 40 years, on $100,000 initial investment, that 2% fee you’re paying compounds into roughly $2 million. Even Kate Upton‘s company is not worth that much.

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That chart above shows the growth of $100,000 over 40 years assuming a rate of return of 9.68% for the index fund (the return over the past 40 years) and 7.68% for the investor paying 2% to his adviser. The DIY guy ends up with a little over $4 million and the guy with the wolf, I mean adviser, ends up with a little less than $2 million. That’s right, the wolf ends up eating over half of your profits.

So when I call these fees “predatory” or “obscene” this is why. Wolves preaching a low-cost, passive approach and charging these fees represent the height of hypocrisy – or the height of greed – take your pick.

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Where’s Wall Street’s Blame In The Buy High Sell Low Game?

The chart above is making the rounds today. The dumb money can’t catch a break. Everybody’s laughing at the poor retail investor. But what I’m wondering is how many of these mutual fund investors are actually being directed by advisers? I’d wager it’s a fair number.

Yes, I know that individual investors are famous for buying high and selling low but advisers are subject to the very same biases and emotions. And their layers upon layers of fees alone can be the cause of significant underperformance.

I’ve seen advisers buy, for their clients – never with their own money, mutual funds that pay themselves fat front-end loads (upfront commissions). Then they turn around a while later and recommend selling the underperforming fund (destined to fail due to its high fee structure) to buy one just like it, paying another fat commission (aka, churning).

Where does this show up in the data and how can we blame individual investors for this sort of behavior?

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