If This Is All True, Then What?

A recent article we stumbled on makes some claims that causes us to ask: If this is all true, then what? As it turned out the author answered the question in short order. The experience of reading the article spurred some thinking. So we thought sharing our thoughts might be of some benefit to those who remain puzzled regarding what we have called "dysfunctional" financial markets.

Here goes... 

First, for context, our author reminds us of the years of cheap money available to businesses ever since the the so-called GFC (Great Financial Crisis) of 2007-2009. Until fairly recently, businesses (and speculative investors like hedge funds) could borrow money at close to zero percent. That luscious apple was apparently as enticing as the one Eve munched on in the Garden of Eden. (Actually, there's not mention of an apple in the Bible, but somehow we all think of her (and Adam) eating an apple.)

So with the eating of the apple of basically "free" money, there were consequences. Oh, and let's add to this the willingness of lenders of free money to keep lending even as borrowers burn through previous borrowings. If the consequences have not been as serious as those that resulted from Adam and Eve's bad decision when it comes to our economy and financial markets, they might be a close second.

The key point: There are consequences. 

An example: 

A company burning $500 million a year does not necessarily have to confront reality if somebody will hand it another $2 billion. A commercial property does not need to be marked down if its owner can refinance it. A private equity sponsor does not have to admit an acquisition was terrible if it can amend, extend, refinance and wait. A venture fund does not need real price discovery if the next financing round can establish a higher valuation. A struggling public company can survive for an astonishing amount of time if equity investors remain willing to finance it.

The fundamental question has gradually changed from “Does this business work?” to “Can we keep financing it?” Those are completely different questions, and for an extraordinary period of time the answer to the second one was yes.

That environment also allowed narrative to become a substitute for analysis. Investors learned that understanding the story could be more profitable than understanding the financial statements...

...you could identify deteriorating economics, ridiculous accounting, absurd multiples and terrible capital allocation, then watch the stock triple because management said “AI” on an earnings call.

You don't need a degree in economics or an MBA in finance to see how those low rates twisted things.

But now that higher rates seem to be seeping into our dysfunctional markets, again, there will be consequences:

The reason is simple. Higher rates restore consequences. When investors can earn meaningful returns in Treasury securities and other relatively safe assets, they no longer need to finance every revolutionary dog walking blockchain SaaS platform that comes along. Junk bonds have to offer genuinely attractive yields. Private credit has to compete against liquid alternatives. Venture investments have to offer enough potential return to compensate for years of illiquidity and enormous failure rates.

Suddenly, the hurdle rate exists again.

Companies burning cash discover that capital has a price. Companies dependent on refinancing discover that lenders have alternatives. Private equity firms discover that an acquisition financed with cheap debt looks considerably less brilliant when that debt has to be refinanced at twice the rate. Commercial real estate owners discover that capitalization rates matter. Governments discover that deficits carry interest expense. Investors discover that earnings expected fifteen years from now are worth substantially less when the discount rate is no longer zero.

Fraud becomes harder…because fraud loves liquidity. It needs it for sustenance. Liquidity buys time, and a questionable business can survive as long as somebody keeps funding it. Once capital becomes scarce, the runway shortens and the questions become considerably less philosophical. Where is the cash? Who owes whom? What is the collateral actually worth? Can you refinance this? Why does EBITDA never turn into free cash flow? Why are you issuing stock every quarter? Why does every supposedly temporary adjustment show up again next year?...

OK. There's a lot to swallow here. But do try to chew on this and digest as much as you can. It's important. And if rates do sustain their recent rise, we may indeed finally find things return to something akin to what anyone with common sense might consider sane, or normal. 

Not that things haven't always swung from normal to insane in the past. It's just that this recent bout of rate suppression has created an extraordinary situation that simply can't just go on and on.

If you read the rest of the article, the author does give his view of just how all this will unfold going forward.  

You can find the whole article HERE: (Source: https://www.zerohedge.com/markets/easy-money-fairy-tale-about-endviolently) 

Well, the weekend's upon us. Fall has arrived. Soon we in the Northeast will enjoy the colors of the season. And while we can't ignore what has befallen us in our economic and financial lives, we can't just dwell on what the government, the Fed, and Wall Street have dumped on us for far too long. With that in mind, let's give Old Blue Eyes the stage from some simple advice about how to deal with life not matter our circumstances.