Where is the wealth destruction concentrated?

It goes without saying that we are in a massive crash of nearly all assets, except US$, Yen, and US government bonds, but where are most of the losses concentrated?

I'm going to speak from a US-centric point of view. The details differ across countries--for instance, the housing bubbles in China or Ireland have little in common with the subprime and Alt-A problem loans in the US--but the core problems started in USA, and since, contrary to de-coupling theory proponents, USA is the largest and most important country on earth, I don't think my views are too narrowly focused on USA.

Some people mistakenly believe that this is a housing bubble. It is not! Yes, housing in many countries was a bubble waiting to implode. Yes, the Subprime Virus, especially the collapse of two Bear Stearns real estate hedge funds in June of 2007, signalled the beginning of the crash. However, the subprime problem is, believe it or not, quite minor compared to the massive bubbles elsewhere. If subprime mortgages were all there was to it, very few outside the housing industry would be worried. Don't forget that subprime only makes up a small portion of the total mortgage industry. We would simply absorb the trillion dollars (or so) of damage and get on with life. But that's the case at all. The stock market collapse across the world alone has wiped out $30 trillion in wealth. Stocks of companies unrelated to housing would not collapse as much if this was just a housing problem.

The correct view--this is pretty obvious now but was not as recently as 6 months ago--is that we had a global bubble in many different asset classes. Some may disagree with some markets--some still believe commodities were never in a bubble for example--but I think it's hard to argue against reality. Of those that I follow or encountered in the past, the only three that implied we had a global bubble were Stephen Roach (economist at Morgan Stanley,) Marc Faber, and Jeremy Grantham. Roach kept warning about the unsustainable current account deficit in the US and how that was financing bubbles (especially in commodities); Faber was always vague so I don't give him much credit for any particular call, but he did keep saying that we were seeing a unique situation where almost everything (except US$) was rising; Grantham, well, completely nailed the call. I ignored Grantham at the time because his view seemed extreme but anyone influenced by him would have done well. He is a portfolio allocator and not a stockpicker per se, so it's hard to profit off his views but anyone macro-inclinded would do well to at least read some of his views.

One of the issues Grantham wondered about in his prescient It’s Everywhere, In Everything: The First Truly Global Bubble article had to do with the losses from the bubbles (scroll to the middle of this post). Namely, who is going to bear most of the losses?

(The heart of the bubble this time is probably private equity. In 10 years, it may well be described as the private equity bubble just as 2000 is thought of as the internet bubble. You heard it here first!)

I think he is wrong. (I assume he is not referring to hedge funds as private equity.) Private equity will suffer huge losses but it doesn't seem like the amount of assets they own are very large. They may take big losses in percentage terms but their dollar losses will be small. For example, if Chrysler goes bankrupt, Cerberus will lose $7.4 billion (its equity investment) for a 100% loss but that's not a whole lot compared to say the losses being posted in other assets by other investors (such as hedge fund losses on share ownership of oil companies where they are posting a lower percentage loss (say 50%) but the dollar losses are large.)

Let's look at who the potential losers and who may actually bear most of the losses:

Potential losers:
  • Governments/taxpayers
  • Homebuyers
  • Specialist lenders eg. mortgage lenders, credit card lenders, etc
  • Commercial banks
  • Investment banks
  • Public/retail investors
  • Private equity
  • Hedge funds
  • Mutual funds
  • Pension funds
  • Employees/workers
  • Future generations

Looking at that list, everyone will take losses but I think the losses will be catastrophic in hedge funds (often invested in risky assets with leverage), private equity (overpaid for assets,) and commercial/investment banks (those that provided leverage to hedge funds are not going to get paid).

I think the global bubble is more apt to be called a hedge fund bubble. If you look at the chart in this article, you will see the rapid rise in the amount of assets. It seems that hedge funds manage almost $2 trillion. If you apply leverage on top of that, you are looking at several trillion being invested in questionable assets that may never recover--ever! The losses being posted by mutual funds may simply be quotational losses whereas the hedge funds are likely posting real impairments. I think history will look back and notice the rise and fall of hedge funds.

Having said all that, we haven't seen the problems in the various markets resolved so it is possible that the biggest loser may end up being someone else (i.e. not hedge funds.) Just to give an idea, consider derivatives such as CDS (credit default swaps.) So far the CDS market has not blown up (Warren Buffett said a while ago that he is not as concerned about this market) but I am not certain that it won't explode. If some problems develop in the CDS market, you will easily see banks, such as JP Morgan, Citigroup, and others, jump to the top spot and end up with massive losses. The subprime mortgage write-downs will look like a joke if these companies start posting a percentage of losses on their CDS exposure. Remember that AIG was, arguably, the #1 insurer with sizeable assets, brand reputation, and resources, yet it completely collapsed due to their mispricing of their CDS contracts. Admittedly, AIG is an insurer taking a directional bet whereas the banks are just intermediaries so one would assume that the banks would hedge everything. But if their hedges end up not working then even a strong company like JP Morgan will take massive losses.


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