The content analyzes the current market environment, highlighting concerns about the ongoing war, the opaque nature and potential risks within the private credit sector, and the psychological factors influencing investor behavior, drawing parallels between current private credit executives and those on Wall Street before the 2008 financial crisis.
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President Trump asserted there has been
a regime change suggesting the war is
ending. I still find it hard to believe
that President Trump will end the war
with the straight closed because that
would be viewed as defeat. We now know
that private credit understates its
software exposure that the industry
wants to massage the data to make it
seem smaller. The lesson here is that an
entire generation of private credit
executives have mistaken a lack of a
credit cycle for genius. When private
credit eventually blows up, it's going
to be a shock to the industry's
executives. Just like the GFC was a
shock to Wall Street executives, it's
Hi, this is Steve Eisman and welcome to
another edition of the weekly rap.
Because of Good Friday, this is a
shortened week. So, this wrap is for the
week ending Thursday, April 2nd, but
recorded Wednesday, April 1. The first
quarter is over, and it was a tough one.
The market started the year with a nice
January, the market was up a bit over 1%
by the end of January. However, largely
because of the war, but also because of
fears about the impact of AI and private
credit, the quarter ended with the S&P
down 4.6% for the year and NASDAQ down 7.1%.
7.1%.
I will have more to say about the
quarter and the performance of all the
sectors and important subsectors on next
week's rap. But on this wrap, we will
discuss the following. One, while the
war in Iran continues to grab headlines,
we need to keep focusing on the
underlying economic issues at play. Two,
more bad news about private credit.
Three, the psychology and herd mentality
of hedge funds. Four, the psychology of
the executives of private credit funds
and how similar that is to the
psychology of Wall Street executives pre
the great financial crisis. And finally,
five, I answer two questions from
viewers. So, let's get started. We have
now entered the fifth week of the war.
Over the weekend, President Trump
threatened to destroy Iran's energy
infrastructure and Car Island unless the
Iranians negotiate and reopen the
straight of Hormuz. Like I have said
before, we are now in an environment
where there is only one variable that
matters, the war. On Monday, the market
attempted to rally but ended down on day
after the publication of certain
negative headlines. But on Tuesday, the
market was up strong on a Wall Street
Journal article which stated that
President Trump told aids that he is
willing to end the war without reopening
the straight of Hormuz. After our
interview with Steven Cook of the
Council of Foreign Relations, which we
posted on Monday of this week, I must
say that that headline does not sound
right. On the other hand, on the same
Tuesday morning, President Trump put out
a scathing statement on Truth Social. He
said, quote, "All of those countries
that can't get jet fuel because of the
straight of Hormuz, like the United
Kingdom, which refuse to get involved in
the decapitation of Iran, I have a
suggestion for you. Number one, buy from
the US. We have plenty. And number two,
build up some delayed courage. Go to the
straight and just take it. You'll have
to start learning how to fight for
yourself. The USA won't be there to help
you anymore, just like you weren't there
for us. Iran has been essentially
decimated. The hard part is done. Go get
your own oil." unquote. By Tuesday
morning, after the market soared almost
3%, President Trump asserted there has
been a regime change suggesting the war
is ending. Even given this and the truth
social statement, I still find it hard
to believe that President Trump will end
the war with the straight closed because
that would be viewed as defeat. But
that's just my opinion. Clearly making
any investment decisions right now is
very difficult given that the markets
are literally trading headlines. Moving
on, more bad news on private credit.
Shocking, I know. Monday morning, the
Wall Street Journal published a very
interesting article about private
credit's exposure to the software
sector, pointing out that the actual
level of exposure is considerably higher
than the 25%
that has been estimated. By looking
through the filings of scores of private
credit funds, some commentators have
reached that 25% estimate number. They
say 25% of all direct lending loans are
to software companies. specifically to
software companies bought out by private
equity from 2018 to 2022. The journal
article suggests that there is leeway
and how private credit classifies a
company as being or not being in the
software sector. I call this data
massaging. Private credit funds classify
software companies that service other
sectors such as health care as being in
those sectors as opposed to software
tomato tomato. If that isn't data
massaging, I don't know what is. The
journal looked at four private credit
funds, four major private credit funds,
and found the following. One, the Blue
Owl Credit Income Fund, a $34.8 8
billion fund reported 11.6%
of its portfolio in software, but the
journal found its software exposure at
around 21%. 11.6%
versus 21%. It's quite a discrepancy.
The Blackstone Private Credit Fund, aka
Bred, an 82.5 billion fund, reported 25.7%
25.7%
in software, but the journal found 33%
exposure. Three, Aries Capital Corp. A
29.5 billion fund reported 23.8%
exposure, but the journal found nearly
30% exposure. And finally, Apollo Debt
Solution Fund $25.1 billion fund
reported 13.6% software exposure, but
the journal found 16% exposure. What
conclusion should we draw from this?
It's pretty simple. Private credit's
exposure to software is so large that
the industry wants to massage the data
to make it seem smaller. If and when the
software industry suffers massive
problems because of AI, this will have a
huge and negative impact on private
credit. Losses could be ugly. Now, do we
care if a few private credit funds
suffer huge losses? Yes, if it impacts
the banks who may or may not be involved
in financing either the equity or the
credit behind these deals take huge
writedowns and if pension funds across
the country are invested and take a
large hit and if other entities with
retail exposure like life insurance
companies are invested and take a large
hit as well. The impact will be felt but
more importantly any sense of trust,
safety and security will be seriously
eroded. Once the trust is broken, it's
hard to restore. One more point. This
software classification story is one
more aspect of the opakqueness of
private credit. We now know that private
credit understates its software
exposure. Also, the marks on its
portfolio, the value of the loans is
priced by the private credit funds
themselves. Now, how reliable is that?
There is opakquakeness in this industry
everywhere you look and that is part of
the problem. Investors always fear what
they don't know and here we don't know a
lot. The role of psychology is a topic
that does not get enough examination.
The most you hear about it is when
business news reports panic selling or
sometimes panic buying of stocks.
However, psychology plays a much larger
role if you know where to look. We're
going to discuss first the occasional
herd mentality of hedge funds and then
the role of arrogance in the realm of
private credit. Let's first look at the
herd mentality of hedge funds. The hedge
fund industry likes to think of
themselves as the smartest people in the
room, the independent thinkers, the
risktakers. And that is sometimes true.
Here's what is also true. Hedge fund
managers and analysts know each other.
They see each other at conferences. They
go to idea dinners where they share long
and short ideas. It can create a herd
mentality in certain trades. And we can
see that in the strange price movements
of certain asset classes since the war
in Iran began. Since the beginning of
the war, oil prices and interest rates
are up, but gold prices are down. Now,
oil prices rising makes perfect sense.
Interest rates rising is less intuitive.
Normally in a crisis, investors will
flock to US treasuries, thereby driving
yields lower. This time, however, rates
are up because higher oil prices have
tapped into investor fears about
inflation. Fair enough. Gold going down
makes no sense. Gold is viewed as a
hedge against the demise of fiat
currencies, rising inflation, and an
increase in overall risk. So, normally
gold prices go up during a war. The
combination of a war with rising
inflation expectations should cause gold
to skyrocket. Here we have a war and
fears of inflation and yet gold has
declined about 10% since the war began.
What explains this negative move in
gold? Answer her mentality. Apparently,
a bunch of major hedge funds from Caxton
to PIMCO to Citadel to Millennium and
Balazni all had similar trades where
they were betting on lower interest
rates and higher commodity prices,
including gold. When the war began,
their interest rate bets went badly
against them. All of the funds in these
trades have suffered fairly significant
losses since the war began. And I'm
guessing that the risk managers of these
firms ordered all the portfolio managers
with these trades on to reduce risk.
That meant selling bonds and gold and
that's why gold prices are down when
they should be up. It also could explain
why interest rates have gone up so
quickly. Now, let's turn to the world of
private credit. When I watch business
news and see interviews of the
executives of private credit, I'm struck
by how almost universally they defend
the industry. The defense is not
surprising, but the tone somewhat is.
Most of these executives are arguing
that there is nothing wrong, just bad
publicity. Since there is obviously
something wrong, the question is whether
they actually believe what they are
saying. I'm convinced that they do. They
actually believe that there is nothing
wrong. There is an arrogance to their
presentation and that arrogance feels
like the same arrogance Wall Street
executives displayed before the great
financial crisis. History does not
necessarily repeat, but it sure can
rhyme. And here's the rhyme. Prior to
the great financial crisis, Wall Street
executives suffered from one of the
worst cases of arrogance in business
history. And that requires an
explanation. I'm creating a master class
on how to analyze banks and lending
companies. And I'll go into all of this
in much more detail there. But here's a
quick version. Banks make money with
leverage. As long as they are making
money, the more leverage, the more they
make. The formula to understand is that
return on equity equals return on assets
times leverage. Imagine two banks each
with a 1% return on assets. If bank one
is levered 10 times, its ROE is 10%. If
bank 2 is levered 40 times, its ROE is
40%. From an economic perspective, both
banks are equally profitable because
they had the same exact return on
assets. The only difference is the
leverage. Historical footnote. Between
1997 and 2007, leverage in the banks
more than tripled, but the ROAS stayed
flat. It was the leverage that caused
Wall Street profits to explode. And you
don't need to be a genius to take on
more leverage. You just have to borrow.
And anybody can do that. Wall Street
executives are compensated not on return
on assets, but on a combination of net
income and return on equity. Wall Street
executives got paid tens of millions
largely because they took on more
leverage. An entire generation of Wall
Street executives mistook leverage for
genius. And the resulting arrogance was
on full display precrisis as executive
after executive got on business news and
claimed nothing was wrong when in fact
everything was wrong. Something similar
has happened in the world of private
credit. But the arrogance is not from
leverage. Most private credit funds can
only be leveraged 2:1. The thing to
focus on here is the lack of a credit
cycle. Since the GFC, the level of
losses in virtually all asset classes
has been consistently low, almost
subterranean. It's been a great time to
be a lender. What makes lending a unique
business is that the cost of goods sold
is unknown at point of sale. In the case
of lending, the cost of goods sold is
losses, and those losses always occur
sometime in the future. When a lender
makes loans, they underwrite those loans
with a level of losses in mind. If
losses come in lower, that creates
excess profits. It's been 17 years since
there has been losses in the United
States, and private credit, as a result,
has generated excess returns throughout.
The lesson here is that an entire
generation of private credit executives
have mistaken a lack of a credit cycle
for genius. And that's why private
executives believe that nothing is
wrong. Why? Because times have been good
for so long that they have forgotten
what it's like to experience serious
levels of losses. It's been so long that
it seems unimaginable. When private
credit eventually blows up, it's going
to be a shock to the industry's
executives. Just like the GFC was a
shock to Wall Street executives, it's
not going to be pretty. Now, I'm going
to address two questions from viewers.
First question is from McCormack, who
says, "Hi, Steve. Massive fan of the
show and the way that you conduct
interviews, breaking down extremely
complex information is into something
that even someone from a non- finance
background can digest. I, however, have
probably one of the dumbest questions
you will receive. is GameStop, symbol
GME, at its current price, which is
around 22, a value stock. I am not one
of the people that would invest looking
for short squeezes or other nonsense,
but in this current environment where
private credit is threatening the US
economy, I see a stock with a massive
stockpile of cash and wonder if it would
be worth investing in. I know that
Michael Bur has mentioned that he sees
some value in the stock, particularly if
they use their cash to acquire other
businesses with more upside and revenue.
Thanks again for doing this show and
being open to receiving questions. My
response, without question, this is not
a dumb question at all. Let's review a
little history. GameStop operates a
declining business. It sells video games
and retail stores, but the entire
business has moved online. In 2021, GME
was a heavily heavily shorted stock, but
then became a meme stock. Leaders of
Reddit boards told their followers to
engineer a short squeeze by buying GME,
and the stock soared multiple times and
wiped out the hedge funds who were
short. Literally wiped them out. That's
the danger of being involved in a
heavily shorted stock. Believe me, I
know you can be right on the
fundamentals and still lose money.
Topline fundamentals at GameStop have
not gotten better, but the company has
cut costs and so is profitable. Also,
the company was very smart and use the
price surge to raise capital. Currently,
GME has 6.3 billion in cash and cash
equivalents, but 4.1 billion in
long-term debt. So, it has net cash of
2.2 billion. The market cap is 10
billion. In a recent Substack, Michael
Bur argued that GME has value because
they could use their cash to acquire
other businesses. I do not find this
argument compelling at all. It sounds
like a pipe dream to me. Buy a stock
because they could buy something
worthwhile at a good price. Good luck
with that. Maybe they buy something good
and maybe they buy something not so
good. Maybe they buy something at a good
price and maybe not. Too many may for
me. Second question is from Malin who
says, "Hi Steve, thank you for the great
coverage of what is happening in the
private credit markets over the last few
weeks. It is my understanding that
within the private lending space,
broadly speaking, there are two types of
lending entities. A closed-end fund that
is publicly listed and retail investors
can buy and sell at the prevailing
price. It provides liquidity to retail
investors and the issuing company is
insulated from redemption pressure. I am
talking about companies like OCSL which
is a public company. The second vehicles
like Bcrad the Blackstone fund where
there is no day-to-day price and limited
5% or so redemption volume can be
liquidated. However, their portfolio
size is huge compared to listed BDC's.
From the issuers's perspective, what is
the attraction for BCred type non-listed
vehicles? Is there more fee income in
it? Why is the entire market not made up
of companies like OC CSL or OBDC?
There's a whole list of companies. Great
question. The answer is all about who is
investing in the private credit fund.
Private credit funds, the ones that are
not public, restrict investors to
wealthy individuals and institutions by
operating under exemptions from
investment company act registration. To
qualify, they must must restrict
investors to accredited investors or
qualified purchasers and limit
marketing. In other words, to very rich
people or institutions. This exemption
allows them to avoid SEC registration as
investment companies, which means no
public reporting, no leverage limits
under the 40 act, and no liquidity
requirements. The public entities that
Malin referenced are all public BDC's,
business development corporations. BDC's
are a structure Congress created in 1980
to let retail investors access private
credit. But in exchange, BDC's must
register with the SEC, file public
financials, and operate under leverage
limits that private funds don't face. So
BDC's are permitted to use leverage, but
only up to 2:1. The non-public private
credit funds do not face these leverage
restrictions. Also, BDC's must
distribute at least 90% of income. This
last Monday, March 30th, we posted an
interview with Steven Cook of the
Council of Foreign Relations, who was a
Mid East expert with deep contacts in
the region. We discussed the war and how
it will potentially change the region.
We also discuss what his contacts are
telling him about what is really going
on. So, check it out. This coming
Monday, we will post an interview with
Steve Leeman, chief economics reporter
at CNBC. Steve is a recurring guest. We
discuss the impact of the war on the
economy, the Fed, private credit, and a
bunch of other topics. So, I hope you
tune in. Be sure to check out our
website, realismanplaybook.com.
If you're enjoying these weekly raps in
our podcast, we kindly ask that you
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Playbook. Subscribing is the best way to
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yourselves, and we greatly appreciate
your support. And that's the wrap. See
you real soon.
This podcast is forformational purposes
only and does not constitute investment
advice. The hosts and guests may hold
positions in stocks discussed. Opinions
expressed are their own and not
recommendations. Please do your own due
diligence and consult a licensed
financial adviser before making any
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