0:02 President Trump asserted there has been
0:04 a regime change suggesting the war is
0:06 ending. I still find it hard to believe
0:08 that President Trump will end the war
0:10 with the straight closed because that
0:12 would be viewed as defeat. We now know
0:14 that private credit understates its
0:16 software exposure that the industry
0:19 wants to massage the data to make it
0:21 seem smaller. The lesson here is that an
0:22 entire generation of private credit
0:25 executives have mistaken a lack of a
0:27 credit cycle for genius. When private
0:29 credit eventually blows up, it's going
0:30 to be a shock to the industry's
0:33 executives. Just like the GFC was a
0:35 shock to Wall Street executives, it's
0:48 Hi, this is Steve Eisman and welcome to
0:50 another edition of the weekly rap.
0:52 Because of Good Friday, this is a
0:54 shortened week. So, this wrap is for the
0:56 week ending Thursday, April 2nd, but
0:59 recorded Wednesday, April 1. The first
1:02 quarter is over, and it was a tough one.
1:03 The market started the year with a nice
1:06 January, the market was up a bit over 1%
1:09 by the end of January. However, largely
1:11 because of the war, but also because of
1:13 fears about the impact of AI and private
1:16 credit, the quarter ended with the S&P
1:20 down 4.6% for the year and NASDAQ down 7.1%.
1:21 7.1%.
1:23 I will have more to say about the
1:25 quarter and the performance of all the
1:27 sectors and important subsectors on next
1:30 week's rap. But on this wrap, we will
1:33 discuss the following. One, while the
1:35 war in Iran continues to grab headlines,
1:37 we need to keep focusing on the
1:40 underlying economic issues at play. Two,
1:43 more bad news about private credit.
1:46 Three, the psychology and herd mentality
1:49 of hedge funds. Four, the psychology of
1:51 the executives of private credit funds
1:53 and how similar that is to the
1:56 psychology of Wall Street executives pre
1:59 the great financial crisis. And finally,
2:01 five, I answer two questions from
2:04 viewers. So, let's get started. We have
2:06 now entered the fifth week of the war.
2:08 Over the weekend, President Trump
2:10 threatened to destroy Iran's energy
2:13 infrastructure and Car Island unless the
2:15 Iranians negotiate and reopen the
2:17 straight of Hormuz. Like I have said
2:20 before, we are now in an environment
2:22 where there is only one variable that
2:25 matters, the war. On Monday, the market
2:27 attempted to rally but ended down on day
2:29 after the publication of certain
2:31 negative headlines. But on Tuesday, the
2:33 market was up strong on a Wall Street
2:36 Journal article which stated that
2:38 President Trump told aids that he is
2:40 willing to end the war without reopening
2:42 the straight of Hormuz. After our
2:44 interview with Steven Cook of the
2:45 Council of Foreign Relations, which we
2:48 posted on Monday of this week, I must
2:51 say that that headline does not sound
2:53 right. On the other hand, on the same
2:56 Tuesday morning, President Trump put out
2:59 a scathing statement on Truth Social. He
3:01 said, quote, "All of those countries
3:03 that can't get jet fuel because of the
3:05 straight of Hormuz, like the United
3:07 Kingdom, which refuse to get involved in
3:09 the decapitation of Iran, I have a
3:12 suggestion for you. Number one, buy from
3:15 the US. We have plenty. And number two,
3:17 build up some delayed courage. Go to the
3:19 straight and just take it. You'll have
3:21 to start learning how to fight for
3:23 yourself. The USA won't be there to help
3:25 you anymore, just like you weren't there
3:28 for us. Iran has been essentially
3:31 decimated. The hard part is done. Go get
3:33 your own oil." unquote. By Tuesday
3:36 morning, after the market soared almost
3:39 3%, President Trump asserted there has
3:41 been a regime change suggesting the war
3:44 is ending. Even given this and the truth
3:46 social statement, I still find it hard
3:48 to believe that President Trump will end
3:51 the war with the straight closed because
3:53 that would be viewed as defeat. But
3:56 that's just my opinion. Clearly making
3:59 any investment decisions right now is
4:01 very difficult given that the markets
4:04 are literally trading headlines. Moving
4:08 on, more bad news on private credit.
4:10 Shocking, I know. Monday morning, the
4:12 Wall Street Journal published a very
4:14 interesting article about private
4:16 credit's exposure to the software
4:19 sector, pointing out that the actual
4:22 level of exposure is considerably higher
4:24 than the 25%
4:26 that has been estimated. By looking
4:28 through the filings of scores of private
4:30 credit funds, some commentators have
4:34 reached that 25% estimate number. They
4:37 say 25% of all direct lending loans are
4:39 to software companies. specifically to
4:41 software companies bought out by private
4:46 equity from 2018 to 2022. The journal
4:48 article suggests that there is leeway
4:51 and how private credit classifies a
4:54 company as being or not being in the
4:57 software sector. I call this data
5:00 massaging. Private credit funds classify
5:03 software companies that service other
5:06 sectors such as health care as being in
5:10 those sectors as opposed to software
5:12 tomato tomato. If that isn't data
5:15 massaging, I don't know what is. The
5:17 journal looked at four private credit
5:19 funds, four major private credit funds,
5:22 and found the following. One, the Blue
5:25 Owl Credit Income Fund, a $34.8 8
5:29 billion fund reported 11.6%
5:32 of its portfolio in software, but the
5:34 journal found its software exposure at
5:38 around 21%. 11.6%
5:41 versus 21%. It's quite a discrepancy.
5:44 The Blackstone Private Credit Fund, aka
5:48 Bred, an 82.5 billion fund, reported 25.7%
5:50 25.7%
5:52 in software, but the journal found 33%
5:57 exposure. Three, Aries Capital Corp. A
6:01 29.5 billion fund reported 23.8%
6:04 exposure, but the journal found nearly
6:07 30% exposure. And finally, Apollo Debt
6:10 Solution Fund $25.1 billion fund
6:14 reported 13.6% software exposure, but
6:17 the journal found 16% exposure. What
6:20 conclusion should we draw from this?
6:22 It's pretty simple. Private credit's
6:25 exposure to software is so large that
6:27 the industry wants to massage the data
6:30 to make it seem smaller. If and when the
6:31 software industry suffers massive
6:34 problems because of AI, this will have a
6:36 huge and negative impact on private
6:38 credit. Losses could be ugly. Now, do we
6:40 care if a few private credit funds
6:43 suffer huge losses? Yes, if it impacts
6:46 the banks who may or may not be involved
6:48 in financing either the equity or the
6:50 credit behind these deals take huge
6:52 writedowns and if pension funds across
6:54 the country are invested and take a
6:56 large hit and if other entities with
6:58 retail exposure like life insurance
7:01 companies are invested and take a large
7:04 hit as well. The impact will be felt but
7:06 more importantly any sense of trust,
7:08 safety and security will be seriously
7:11 eroded. Once the trust is broken, it's
7:14 hard to restore. One more point. This
7:16 software classification story is one
7:18 more aspect of the opakqueness of
7:21 private credit. We now know that private
7:24 credit understates its software
7:27 exposure. Also, the marks on its
7:29 portfolio, the value of the loans is
7:32 priced by the private credit funds
7:35 themselves. Now, how reliable is that?
7:37 There is opakquakeness in this industry
7:40 everywhere you look and that is part of
7:42 the problem. Investors always fear what
7:45 they don't know and here we don't know a
7:48 lot. The role of psychology is a topic
7:50 that does not get enough examination.
7:52 The most you hear about it is when
7:55 business news reports panic selling or
7:58 sometimes panic buying of stocks.
8:00 However, psychology plays a much larger
8:02 role if you know where to look. We're
8:04 going to discuss first the occasional
8:07 herd mentality of hedge funds and then
8:08 the role of arrogance in the realm of
8:10 private credit. Let's first look at the
8:12 herd mentality of hedge funds. The hedge
8:14 fund industry likes to think of
8:16 themselves as the smartest people in the
8:18 room, the independent thinkers, the
8:21 risktakers. And that is sometimes true.
8:23 Here's what is also true. Hedge fund
8:26 managers and analysts know each other.
8:28 They see each other at conferences. They
8:31 go to idea dinners where they share long
8:33 and short ideas. It can create a herd
8:36 mentality in certain trades. And we can
8:39 see that in the strange price movements
8:42 of certain asset classes since the war
8:44 in Iran began. Since the beginning of
8:47 the war, oil prices and interest rates
8:50 are up, but gold prices are down. Now,
8:53 oil prices rising makes perfect sense.
8:56 Interest rates rising is less intuitive.
8:58 Normally in a crisis, investors will
9:00 flock to US treasuries, thereby driving
9:03 yields lower. This time, however, rates
9:06 are up because higher oil prices have
9:08 tapped into investor fears about
9:12 inflation. Fair enough. Gold going down
9:14 makes no sense. Gold is viewed as a
9:16 hedge against the demise of fiat
9:20 currencies, rising inflation, and an
9:24 increase in overall risk. So, normally
9:26 gold prices go up during a war. The
9:28 combination of a war with rising
9:30 inflation expectations should cause gold
9:33 to skyrocket. Here we have a war and
9:35 fears of inflation and yet gold has
9:38 declined about 10% since the war began.
9:40 What explains this negative move in
9:44 gold? Answer her mentality. Apparently,
9:46 a bunch of major hedge funds from Caxton
9:48 to PIMCO to Citadel to Millennium and
9:51 Balazni all had similar trades where
9:52 they were betting on lower interest
9:54 rates and higher commodity prices,
9:57 including gold. When the war began,
9:58 their interest rate bets went badly
10:00 against them. All of the funds in these
10:02 trades have suffered fairly significant
10:04 losses since the war began. And I'm
10:07 guessing that the risk managers of these
10:09 firms ordered all the portfolio managers
10:12 with these trades on to reduce risk.
10:15 That meant selling bonds and gold and
10:17 that's why gold prices are down when
10:19 they should be up. It also could explain
10:21 why interest rates have gone up so
10:23 quickly. Now, let's turn to the world of
10:25 private credit. When I watch business
10:27 news and see interviews of the
10:29 executives of private credit, I'm struck
10:32 by how almost universally they defend
10:34 the industry. The defense is not
10:37 surprising, but the tone somewhat is.
10:39 Most of these executives are arguing
10:42 that there is nothing wrong, just bad
10:44 publicity. Since there is obviously
10:45 something wrong, the question is whether
10:47 they actually believe what they are
10:50 saying. I'm convinced that they do. They
10:51 actually believe that there is nothing
10:53 wrong. There is an arrogance to their
10:57 presentation and that arrogance feels
10:59 like the same arrogance Wall Street
11:01 executives displayed before the great
11:03 financial crisis. History does not
11:06 necessarily repeat, but it sure can
11:08 rhyme. And here's the rhyme. Prior to
11:10 the great financial crisis, Wall Street
11:12 executives suffered from one of the
11:14 worst cases of arrogance in business
11:16 history. And that requires an
11:18 explanation. I'm creating a master class
11:20 on how to analyze banks and lending
11:22 companies. And I'll go into all of this
11:25 in much more detail there. But here's a
11:28 quick version. Banks make money with
11:30 leverage. As long as they are making
11:32 money, the more leverage, the more they
11:35 make. The formula to understand is that
11:38 return on equity equals return on assets
11:40 times leverage. Imagine two banks each
11:43 with a 1% return on assets. If bank one
11:46 is levered 10 times, its ROE is 10%. If
11:49 bank 2 is levered 40 times, its ROE is
11:52 40%. From an economic perspective, both
11:54 banks are equally profitable because
11:56 they had the same exact return on
11:58 assets. The only difference is the
12:01 leverage. Historical footnote. Between
12:04 1997 and 2007, leverage in the banks
12:07 more than tripled, but the ROAS stayed
12:10 flat. It was the leverage that caused
12:12 Wall Street profits to explode. And you
12:14 don't need to be a genius to take on
12:17 more leverage. You just have to borrow.
12:19 And anybody can do that. Wall Street
12:22 executives are compensated not on return
12:24 on assets, but on a combination of net
12:27 income and return on equity. Wall Street
12:30 executives got paid tens of millions
12:33 largely because they took on more
12:36 leverage. An entire generation of Wall
12:39 Street executives mistook leverage for
12:42 genius. And the resulting arrogance was
12:44 on full display precrisis as executive
12:48 after executive got on business news and
12:51 claimed nothing was wrong when in fact
12:53 everything was wrong. Something similar
12:54 has happened in the world of private
12:56 credit. But the arrogance is not from
12:58 leverage. Most private credit funds can
13:01 only be leveraged 2:1. The thing to
13:03 focus on here is the lack of a credit
13:06 cycle. Since the GFC, the level of
13:09 losses in virtually all asset classes
13:12 has been consistently low, almost
13:14 subterranean. It's been a great time to
13:17 be a lender. What makes lending a unique
13:19 business is that the cost of goods sold
13:22 is unknown at point of sale. In the case
13:24 of lending, the cost of goods sold is
13:27 losses, and those losses always occur
13:30 sometime in the future. When a lender
13:32 makes loans, they underwrite those loans
13:34 with a level of losses in mind. If
13:36 losses come in lower, that creates
13:40 excess profits. It's been 17 years since
13:42 there has been losses in the United
13:45 States, and private credit, as a result,
13:48 has generated excess returns throughout.
13:51 The lesson here is that an entire
13:52 generation of private credit executives
13:55 have mistaken a lack of a credit cycle
13:58 for genius. And that's why private
13:59 executives believe that nothing is
14:02 wrong. Why? Because times have been good
14:04 for so long that they have forgotten
14:06 what it's like to experience serious
14:09 levels of losses. It's been so long that
14:12 it seems unimaginable. When private
14:14 credit eventually blows up, it's going
14:16 to be a shock to the industry's
14:18 executives. Just like the GFC was a
14:20 shock to Wall Street executives, it's
14:23 not going to be pretty. Now, I'm going
14:25 to address two questions from viewers.
14:27 First question is from McCormack, who
14:29 says, "Hi, Steve. Massive fan of the
14:31 show and the way that you conduct
14:32 interviews, breaking down extremely
14:34 complex information is into something
14:37 that even someone from a non- finance
14:39 background can digest. I, however, have
14:41 probably one of the dumbest questions
14:44 you will receive. is GameStop, symbol
14:46 GME, at its current price, which is
14:49 around 22, a value stock. I am not one
14:51 of the people that would invest looking
14:53 for short squeezes or other nonsense,
14:55 but in this current environment where
14:57 private credit is threatening the US
14:59 economy, I see a stock with a massive
15:02 stockpile of cash and wonder if it would
15:04 be worth investing in. I know that
15:06 Michael Bur has mentioned that he sees
15:08 some value in the stock, particularly if
15:10 they use their cash to acquire other
15:12 businesses with more upside and revenue.
15:14 Thanks again for doing this show and
15:17 being open to receiving questions. My
15:19 response, without question, this is not
15:21 a dumb question at all. Let's review a
15:24 little history. GameStop operates a
15:26 declining business. It sells video games
15:28 and retail stores, but the entire
15:32 business has moved online. In 2021, GME
15:35 was a heavily heavily shorted stock, but
15:37 then became a meme stock. Leaders of
15:39 Reddit boards told their followers to
15:42 engineer a short squeeze by buying GME,
15:45 and the stock soared multiple times and
15:46 wiped out the hedge funds who were
15:49 short. Literally wiped them out. That's
15:51 the danger of being involved in a
15:53 heavily shorted stock. Believe me, I
15:55 know you can be right on the
15:58 fundamentals and still lose money.
16:00 Topline fundamentals at GameStop have
16:02 not gotten better, but the company has
16:05 cut costs and so is profitable. Also,
16:07 the company was very smart and use the
16:10 price surge to raise capital. Currently,
16:13 GME has 6.3 billion in cash and cash
16:16 equivalents, but 4.1 billion in
16:18 long-term debt. So, it has net cash of
16:21 2.2 billion. The market cap is 10
16:23 billion. In a recent Substack, Michael
16:26 Bur argued that GME has value because
16:28 they could use their cash to acquire
16:31 other businesses. I do not find this
16:33 argument compelling at all. It sounds
16:36 like a pipe dream to me. Buy a stock
16:37 because they could buy something
16:39 worthwhile at a good price. Good luck
16:42 with that. Maybe they buy something good
16:44 and maybe they buy something not so
16:46 good. Maybe they buy something at a good
16:49 price and maybe not. Too many may for
16:51 me. Second question is from Malin who
16:53 says, "Hi Steve, thank you for the great
16:54 coverage of what is happening in the
16:56 private credit markets over the last few
16:58 weeks. It is my understanding that
17:00 within the private lending space,
17:02 broadly speaking, there are two types of
17:05 lending entities. A closed-end fund that
17:07 is publicly listed and retail investors
17:09 can buy and sell at the prevailing
17:11 price. It provides liquidity to retail
17:13 investors and the issuing company is
17:16 insulated from redemption pressure. I am
17:19 talking about companies like OCSL which
17:22 is a public company. The second vehicles
17:24 like Bcrad the Blackstone fund where
17:27 there is no day-to-day price and limited
17:31 5% or so redemption volume can be
17:33 liquidated. However, their portfolio
17:36 size is huge compared to listed BDC's.
17:39 From the issuers's perspective, what is
17:41 the attraction for BCred type non-listed
17:43 vehicles? Is there more fee income in
17:45 it? Why is the entire market not made up
17:49 of companies like OC CSL or OBDC?
17:51 There's a whole list of companies. Great
17:54 question. The answer is all about who is
17:56 investing in the private credit fund.
17:58 Private credit funds, the ones that are
18:01 not public, restrict investors to
18:03 wealthy individuals and institutions by
18:06 operating under exemptions from
18:08 investment company act registration. To
18:12 qualify, they must must restrict
18:14 investors to accredited investors or
18:16 qualified purchasers and limit
18:18 marketing. In other words, to very rich
18:21 people or institutions. This exemption
18:24 allows them to avoid SEC registration as
18:26 investment companies, which means no
18:28 public reporting, no leverage limits
18:31 under the 40 act, and no liquidity
18:33 requirements. The public entities that
18:36 Malin referenced are all public BDC's,
18:39 business development corporations. BDC's
18:41 are a structure Congress created in 1980
18:44 to let retail investors access private
18:47 credit. But in exchange, BDC's must
18:49 register with the SEC, file public
18:51 financials, and operate under leverage
18:55 limits that private funds don't face. So
18:57 BDC's are permitted to use leverage, but
19:00 only up to 2:1. The non-public private
19:02 credit funds do not face these leverage
19:05 restrictions. Also, BDC's must
19:07 distribute at least 90% of income. This
19:10 last Monday, March 30th, we posted an
19:11 interview with Steven Cook of the
19:13 Council of Foreign Relations, who was a
19:15 Mid East expert with deep contacts in
19:18 the region. We discussed the war and how
19:20 it will potentially change the region.
19:22 We also discuss what his contacts are
19:23 telling him about what is really going
19:25 on. So, check it out. This coming
19:27 Monday, we will post an interview with
19:30 Steve Leeman, chief economics reporter
19:34 at CNBC. Steve is a recurring guest. We
19:35 discuss the impact of the war on the
19:38 economy, the Fed, private credit, and a
19:39 bunch of other topics. So, I hope you
19:41 tune in. Be sure to check out our
19:44 website, realismanplaybook.com.
19:46 If you're enjoying these weekly raps in
19:47 our podcast, we kindly ask that you
19:50 support the channel by subscribing to
19:52 our YouTube channel and to our audio
19:55 channels as well. The Real Eyesman
19:57 Playbook. Subscribing is the best way to
19:59 help us expand this community to more
20:00 like-minded individuals such as
20:03 yourselves, and we greatly appreciate
20:07 your support. And that's the wrap. See
20:10 you real soon.
20:12 This podcast is forformational purposes
20:14 only and does not constitute investment
20:16 advice. The hosts and guests may hold
20:18 positions in stocks discussed. Opinions
20:19 expressed are their own and not
20:22 recommendations. Please do your own due
20:23 diligence and consult a licensed
20:25 financial adviser before making any
