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  • Charts of the Month - March '23

Charts of the Month - March '23

Unfunded Liabilities, BTFP, Derivatives, Q1 Sector Performance, Housing Affordability, Netflix Loves COVID, SVB

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Unfunded Liabilities

In last week’s Research publication, Roger explored a not-yet-mainstream story that is beginning to pop up more often in the dark corners of the finance world.

The sequence of higher rates -> depressed real estate prices -> soon-to-come markdowns in private equity (PE) funds (mark-to-market accounting rules allow for delayed markdowns), of which most public pension funds have significant exposure, is a looming issue that could very well make its way to main street sooner than later.

How so?

Public pension funds have recently hit unfunded levels that now surpass that of 2009 (when PE exposure was significantly less widespread) and, as referenced above, the markdowns have not even really begun yet…

To add insult to injury, in a world of sustained higher rates, where pension fund managers can now earn a meaningful return on investments in assets significantly more liquid than PE (something like commercial paper), we’re likely to see the beginning of a significant reduction of the massive inflows that went into PE from pensions that have catapulted the asset class to AUM levels historically reserved for public market asset managers.

We try our best to not post this chart because it’s the most used and abused chart in all of finance.

But this month is a bit different as the Fed balance sheet came back into the crosshairs of finance pundits across the country, stemming from the SVB fiasco and the pending banking crisis fallout.

The Fed announced back in November of 2021 the end of the free money era by signaling their intention to shrink their balance sheet - Quantitative Tightening (QT) was finally here. There were plenty of those who mocked them (including yours truly) stating that there’s simply no mathematical way they can do this without cratering the economy. Then, the balance sheet actually started to shrink (very modestly) as asset purchases slowed (but didn’t stop) and maturities of assets began to roll off. And the anti-Fed prognosticators fell silent… for a while.

Enter the risk management geniuses of Silicon Valley Bank…

After the bank went belly up (with Signature Bank soon to follow), Janet Yellen gave one of the most cringe-worthy performances from a Treasury Secretary in our lifetimes, followed by the announcement of a new acronym that would save the banking sector, the BTFP (Bank Term Funding Program), and with it, the balance sheet did what we all prophesized, it went back up!

But here’s the deal, the BTFP is not QE, no matter how much the Fed-haters want to say it is.

The reality is that this program is, in my view, a bailout, but it’s not QE, where the Fed goes out and buys treasuries and MBS to inject liquidity and confidence into the market.

BTFP loans, which are being made for up to one year to banks that need them, will see the banks post collateral to the Fed (the US treasuries on their balance sheet that are underwater) which the Fed will value at par (the difference between the market value of the treasury and par is what shows up on the Fed balance sheet as the loan) and upon maturity, the bank will receive the full value of the treasury, and the BTFP bump on the Fed balance sheet should disappear. (I know I know, QE was supposed to be temporary and inflation was supposed to be transitory… so the bump very well may turn into a permanent blemish).

There are plenty of reasons to bash the powers that be, and I love to do it, but this one feels different. There are elements to consider on both sides of the ideological spectrum.

  • Whatever Yellen said, there’s some truth to it – bank runs happen fast, and the contagion effect can destroy an economy overnight, so something drastic had to be done. This is also the view that Bill Ackman (leave your personal opinions of him aside) takes, and I have to agree somewhat with them.

  • But there are plenty of shades of moral hazard here. Gross mismanagement followed by a bailout is almost an American pastime at this point (airlines, autos, banks, etc.) and main street continues to bear the brunt of these screw-ups. We just went through this with the COVID bailouts, TARP, Fannie and Freddy prior to that, LTCM, and the Savings and Loan before that.

No matter what camp you fall into, it would be prudent to take note of the fact that the world is still adapting to a higher for longer interest rate environment and no one, quite literally no one, knows what the next bomb to go off will be. But we’re all pretty sure there are more to come. So stay alert and nimble.

Yes, I watch too much Nature is Metal


Derivatives, comprised of futures contracts, currency swaps, options, and other instruments all tied to the fluctuations of underlying assets, are primarily used to 1) generate returns and/or 2) hedge risk.

And the market for these contracts is big. Really, really big.

Like, bigger than global GDP big.

Not to mention, the market makers for these contracts are highly concentrated. Like unbelievably concentrated.

I’m not trying to yell fire in a crowded theatre, but given that the SVB story is still playing out, and given just how grossly mismanaged that balance sheet was for one of the deemed SIB’s (Systemically Important Banks), given that just about every bank, pension, asset manager, and corporation on the planet is exposed to this market, and then having listened to a Bill Fleckenstein rant on a recent Grant Williams podcast about just how unprepared the banks and regulators are, my confidence is a bit shaken at the moment:

“I want to take a step back on something that you said. You went back to ‘08. You talked about the inconsistency. I saw the same thing. I was actively involved with my short fund, but I would make the point that some of the quote-unquote “inconsistency” was because until we got really deep into ‘08 and Paulson and everybody got involved, they didn’t really have any idea what was going on. Remember, after Greenspan championed repealing Glass-Steagall, as part of the deal to let commercial banks and brokerage firms merge, the Fed was supposed to specifically regulate those entities. They did not do their job. And not only that, they let them get away with the special purpose investment vehicles so they could take all that toxic garbage and hold it off balance sheet and lever themselves up to the moon. So they had done all of these things that many of us saw, and yet when it started to go bad, they didn’t understand it, and they’re going at it ad hoc.

And I think that’s the same thing now, only worse. They haven’t thought through any of this. Where was the Fed in regulating these entities, particularly SIVB. The thing blows up in their face, and instead of letting the people who didn’t do their due diligence have to suffer and get 85 or 90 cents and go through some inconvenience and to finally send a message, they just bail them all out. So I think this is... there’s such gross incompetence across the regulatory apparatus and the people who are supposed to be in charge that I don’t know that we can draw much from what they do or say, because I don’t think they know anything. Lastly, remember Bernanke said subprime was contained before the shit had even started to hit the fan…”

Hopefully, Bill is wrong. But he rarely is.

Q1 Sector Performance

Q1 ’23 is in the books, and it was quite a memorable one.

A banking crisis that actually doesn’t look like a banking crisis yet, Bitcoin raging back to life, natural gas acting like Russia / Ukraine is a nothing-burger, energy still leading the way (just barely) on a TTM basis after its historical runup in 2022, and Tech regaining some of its old magic even though it’s still trying to make up for last year’s shellacking.

Housing Affordability

In the inaugural edition of our new podcast “The Ides of Macro” with Roger as host, he and Grant Williams discuss what this ‘new period’ of investing is likely to look like, and what this means for younger generations, in particular, housing affordability, and how in order for the non-boomer and non-Gen X generations to generate any semblance of wealth over their lifetimes, big changes are going to have to be made, particularly when it comes to housing affordability:

“It sounds like a fantastic world for a lot of people but let’s talk about it in practical terms. Because that younger generation, as we move into that world you just described, they’re also moving into their 'getting married, buying houses, having kids' years. And for that world that you just described to be comfortable for them and to be a world they can thrive in, you know what has to happen? The housing market has to get cut in half. That’s it. Right, that’s the first thing that has to happen for that world to be the world that we remember and that we would like to give to our kids. Housing affordability simply has to get dramatically improved. And the only way that is going to happen is if prices come down, because the wages are not going to go up to meet the cost of housing. There’s an awful lot of ink spilled about the housing market, I’ve been talking about it for a long time, because it’s so integral to all of this, the whole puzzle. The boomers and the Gen X’s have gotten rich by just buying houses and buying investment properties in an era of declining rates and it’s pushed the price up beyond the affordability of the generations you’ve just spoken about.”

Saved by the Flu

Most businesses barely survived COVID. Many didn’t and were forced to shut their doors for good.

Netflix was likely saved by it… for now.

The original king of content and the first mover in the OTT space, made a huge bet in 2011 when they decided that original content would become a cornerstone of their offering, to complement the licensing of content from other studios. In 2013, they released their first original series, House of Cards, which went on to be a ridiculous success, and in doing so changed the business model for content creators around the globe. Amazon, Hulu, Apple, all eventually followed suit and began pouring billions into creating original programming to draw in new subs and reduce churn.

But all that content spend took a toll on cash. Big time.

Once the decision was made, cash from operations shit the proverbial bed. From 2015 to 2019, Netflix burned close to $10 billion of cash flow, producing around 1,500 original programs since 2013, and financed almost all that deficit spending with debt.

Subscriber growth was not sufficient to make up for this cash burn which caused net debt to balloon. This one operational decision completely changed the financial profile of the firm.

With COVID, cash flow recovered with an estimated 16 million new subscribers pouring in during lockdowns. However, with increased competition, they're now forced to tinker with the business model once again, adding an advertising tier, increasing subscription prices in the U.S., and slashing them in some international markets.

Big changes are taking place at one of the most influential companies of the last few decades, on par with Tesla. Both were first movers in their space, and both forced their larger more established competition to completely rewrite their own playbooks. You don’t have to like either one of them, but from a business perspective, you need to at least respect them.

One Chart on SVB

There’s been a lot of surprisingly good coverage on the SVB fallout, so I’ll keep this brief and put forward the one chart that I found most interesting.

Modern banks, for as complex as their operations can be, are still at their core mechanically easy to understand. They take in deposits from individuals and businesses. They then lend those deposits out (think mortgages) or invest those funds. Fractional reserve lending allows them to lend and invest more than what they have in deposits. So, as an example, for every dollar they take in as a deposit, they can lend out five dollars.

This system tends to work out quite well for them…until it doesn’t.

As long as withdrawals of deposits don’t exceed the short terms assets of the bank's balance sheet (meaning they have cash and equivalents ready to give to depositors) then the mechanics work just fine (insert your own Ponzi scheme reference here because I don’t mess with low hanging fruit). But if those withdrawals exceed balance sheet capacity, and the bank has to liquidate holdings to cover them, problems can arise in an instant.

During the COVID era when historical amounts of fiscal and monetary stimulus made their way to every corner of the global economy, the deposits side of SVBs balance sheet ballooned, to the tune of 200%+ in a matter of a couple of years.

What to do with all this new cash? Put it to work of course.

The nuance of bank balance sheet risk management however was apparently lost on the SVB management team.

Deposits are short-term in nature and SVB was the bank of choice for many startups, who are notorious for burning through cash at an expedited rate as they ramp up operations. You’d think that, from a risk management perspective, the other side of the balance sheet, the investments side, would align from a duration perspective, so that if, by chance, depositors need their money, the bank can manage those requests with short term investments that have a matched maturity.

Alas, SVB did not do that.

Instead, they made longer-duration investments against their short-term deposits. Not only that, they bought a bunch of treasury notes when rates were pinned to zero, meaning they paid a higher price for the notes. Then, when rates began to rapidly rise, the value of those notes decreased drastically, and in parallel, depositors needed their money to operate their businesses as the COVID sugar rush of spending on tech companies slowed down. So now, you’re double f***ed. Deposits dry up and your investments which have drastically declined in value, must be sold.

Game over. In a matter of 24 hours.

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That's it for this month!

If you haven't had a chance to check out last week's Research publication, "Finding Relative Value in Emerging Markets", now's the time to do it.

As always, we'll see you out there...

The morning commute in Indo | Lombok, Indonesia