In the first installment of this series, I reviewed my history in the credit markets, to provide context for the planned series. The intent of the second installment was to lay the groundwork for our “Fulcrum Index”, an index that calculates the cumulative value of CDS Insurance on a basket of G-20 Sovereign nations multiplied by their respective funded and unfunded obligations. This dynamic calculation could form the basis of a current valuation for bitcoin (the anti-Fiat).
The second part was dry, detailed, and academic. Hopefully, there was some interesting stuff. At the end of the day though, math is typically not a strong subject for most. And, as for Bond Math, most people would rather chew glass. Too bad.
Bond and credit markets make the capitalist world function. However, when we socialize losses and reward the risk-takers with government-funded bailouts, the self-correcting mechanism of capitalism – creative destruction – is jeopardized.
I asked my wife to read the second installment. When she was halfway through reading she stopped and said, “Two things. First, I never knew Fabozzi (Editor of the Journal of Portfolio Management”) gave you crap for submitting your article to two Journals at the same time. And second, you are a turbo-geek.” With that as valuable feedback, I apologize if I geeked out on bond markets and bond math. I hope I didn’t bore too many readers. This stuff is important and our leaders and kids need to understand the implications of credit, how to properly price credit, and ultimately the COST of crony-capitalism. The penalty for mispricing credit needs to be write-downs, not continual bailouts.
In this installment, I will expand on our base footing, and take the first cut at the Fulcrum Index calculation. I will also talk about other bitcoin valuation methodologies. The culmination of this installment, therefore, details why I believe Bitcoin is the best asymmetric trade I have seen in my 32yrs of trading, and why I believe EVERY fixed income investor needs exposure to Bitcoin in order to reduce portfolio risk.
In the summer of 2007, the credit markets were starting to exhibit typical stresses in the system indicating that the “plumbing” wasn’t working properly. Equity markets were largely unaware of the true nature of the problems except that they were being flung around as credit hedgies reached for protection in the CDS and equity volatility markets. It was a time of preliminary contagion. The beginning of the Global Financial Crisis (GFC).
The non-bank asset-backed commercial paper (ABCP) market in Canada had seized after the CDPQ (C$160B in assets at the time), the pension arm of the Province of Quebec, had refused to “roll” their short term paper. Concerns on sub-prime mortgage exposure within the financial system were rampant and CDPQ was one of the first major players to pull the emergency brake. They had C$16B exposure, or 10% of their assets in ABCP, a financially engineered alchemy. The paper quickly went no bid and a total of C$32B in leveraged super senior assets fell ten points on no trade. (It would ultimately trade down in price almost 80%)
Two Bear Stearns hedge Funds were rumored to be in big trouble due to subprime exposure, and Lehman Brothers were in a precarious spot in the funding markets. Market participants at the time will no doubt remember the famous “Jim Cramer Rant”, when on a sunny afternoon in early August 2007, Cramer lost his patience and called out the Fed and Ben Bernanke for being clueless to the stresses. “THEY know NOTHING!”
Watch the video here: https://www.cnbc.com/video/2017/08/03/watch-the-full-rant-cramers-they-know-nothing.html
There is a lot in here. Note the outset, “As goes Bear Stearns (Bear Stock at $109/hr), so goes the Dow.” “In the fixed income markets, we have Armageddon”. And, in the end, ”they could save us with a rate cut”.
Well, the Fed did cut rates and equities rallied to all-time highs in October 2007 as credit guys who were purchasing various forms of protection reversed course and covered, thus pushing up stocks. Remember, credit is a dog, and equity markets are its tail. Equities can get whipped around with reckless abandon because the credit markets are much larger and credit has a priority of claim over the equity.
However, reality soon returned. Bear Stearns stock traded down to $2/share in March of 2008 when it was acquired by JPM. Subprime mortgage exposure was the culprit in the collapse of many structured products and in September 2008, the Lehman Brothers (LB) was allowed to fail.
My fear was that the system truly was on the brink of collapse. I was not the only one. From January through March 2009, it got really ugly. I rode the train every morning in the new year of 2009 wondering if “it was over”. Our Fund was hedged and wedged but we had counterparty risk exposure in the markets. It was a blessing that our investors had agreed to a lockup period and could not redeem their investments. Our performance was actually very good, however, sometimes that is a curse because investors are apt to “sell their winners”.
We calculated and managed our risk exposure on a minute by minute basis but things were moving around so fast. There was true FEAR in the markets. Any stabilization was only a pause before confidence and prices took another leg lower. We added to our hedges as the market tanked. This is an unfortunate result of “delta” hedging. I won’t even start with the “gamma” component. Suffice to say it becomes circular. Contagion builds on itself.
My fund owned credit obligations in many of the largest North American banks. We were typically long the credit instruments and short the equity, a term that is referred to as “capital structure arbitrage”. There were relative value anomalies all through the markets. For instance, why was I able to buy TD Bank Pref shares in the US market at 40 cents on the dollar when equivalent debt in the Canadian market was trading at 90 cents? Answer: Because Citibank prefs were trading at 25 cents on the dollar. It is all relative. Americans assumed that TD was baked if Citi was baked. TD had zero sub-prime exposure. No one cared. Long-only accounts could sell TD prefs, and buy Citi prefs, take-out 15 points…where is Canada again?
You may ask why the C$ prefs of TD bank “held in” at such a high price relative to the US$ prefs. The simple answer, Canadian accounts, and retail investors assumed that TD bank was “too-big-to-fail” and that at 90 cents the return was juicy. More importantly, they were unaware of where the US$ prefs were trading as the two markets had little cross-over. To say it was a scary time in the markets with definite pricing inefficiencies is an understatement.
Liquidity is best defined as the ability to sell in a bear market. By that definition, liquidity was non-existent. Some securities would fall 25% on one trade. Who would sell something down 25%? If funds are being redeemed and investors want cash, the fund needs to sell regardless of the price. For that reason, many funds “gated” themselves, meaning redemptions were unilaterally stopped. There was panic and blood in the streets. Just when you thought things couldn’t get worse, they invariably did.
It was called CONTAGION. The system was broken and there was a de facto vote of no confidence. People didn’t sell what they wanted to, they sold what they could. Selling begets selling.
The bankruptcy of LB was a true awakening for all market players. An institution that was deemed by some as “too-big-to-fail” was not rescued by the Government. The cascading credit crisis became even more real as people who had assets custodied at LB as well as players who had purchased CDS protection from LB were suddenly exposed to risks as a major counterparty failed.
LB’s downfall was that it had been the largest player in the mortgage-backed securities (MBS) business and it had a residual portfolio of MBS risk which it was not able to “lay off” on other risk players. This MBS risk had a notional value of US$85Billion. This was equal to FOUR times its book value of equity. Financial market players are very leveraged and equity cushions are surprisingly low relative to the true risks.
It is for this reason that I often say; “Banks are regularly insolvent on a mark to market basis”. My experience in 1988 was being repeated again in 2009.
Commercial banks are typically 25x levered on their lending books. That is to say, for every hundred dollars in loans, they have $4 of equity and $96 of deposits and subordinated debt. How then do they maintain such high credit ratings? The implied government backstops. This is a huge danger. However, these backstops do NOT ensure that a levered institution can continue to “fund itself”. When confidence ebbs, depositors run for the exits, and a “bank run” generally ensures that a weak bank needs to run to the arms of a strong suitor. But what if all potential suitors are themselves dealing with a crisis in confidence?
The GFC just transferred leverage from the financial system on to the balance sheets of sovereign nations. The Troubled Asset Relief Program (TARP) was the beginning of financial acronyms that facilitated this risk transfer. And then in 2020, with the Covid crisis in full swing, more acronyms and the high likelihood that many financial institutions would again be insolvent. But the Fed ran into the market again. This time with the same old QE programs, but also new programs that would purchase corporate credit and even HY bonds.
As stated in section 2.6, the reason that the Fed decided to endorse a credit facility to purchase HY bonds was due to four credits who were (and still are) on the cusp of becoming “fallen Angels”. CONTAGION comes at you in many ways in a crisis of confidence, and this selling pressure would have overwhelmed the HY markets, led to further increases in equity volatility. It was a game of whack-a-mole.
Quantitative Easing QE by central banks (CBs) tends to focus on the “administered” level of interest rates (some call it manipulation), and the shape of the yield curve, using targeted Treasury bond purchases sometimes called “yield Curve Control” or YCC. Under these extreme conditions, it is difficult to get an open market rate for a quasi “risk-free hurdle rate”.
Moreover, due to CB interference, true inflation risks can be compressed as well as true CREDIT risks. For this reason, we implore market participants to follow the CDS rates on sovereign governments for a much better indication of the true risks that are brewing in the system. One glaring example in my mind is the following:
USA (AA+ rated by S&P) 5yr CDS = 14bps
Canada (AAA) = 36bps….(trades like a single-A)
Portugal (BBB) = 40bps….(ECB support!)
Even though Canada has the highest credit rating of the three, the market is telling us otherwise. Do the Canadian politicians and local MMTers have any idea? No way. There is truth in markets. Do not follow subjective credit opinions blindly.
Falsely rated “AAA” credit tranches were a major cause of the unraveling of structured credit products in the GFC. Forced selling due to downgrades of previously “over-rated” structures and their respective credit tranches was contagious. When one structure collapsed others followed. Selling begets selling.
For a complete list of CDS by nation see here: https://www.worldgovernmentbonds.com/sovereign-cds/
The term Fiat is Latin for “let it be done”. In other words, trust the decree of the central banks.
“Fiat money is a government-issued currency that isn't backed by a commodity such as gold. Fiat money gives central banks greater control over the economy because they can control how much money is printed. Most modern paper currencies are fiat currencies” -- Wikipedia
In the GFC of 2008/09, there was a huge amount of debt that was written down, but there was also a huge amount that was bailed out and transferred to Govie books and thus is now Govie obligations.
According to the Institute for International Finance, in 2017, Total global debt / global GDP was 3.3X. Global GDP (then US$67Trillion) has grown a little in the last three years, but Global debt has grown much faster. I now estimate that the debt/GDP ratio is over 4X. At this ratio, a dangerous mathematical certainty emerges. If we assume the average coupon on the debt is 3% (likely low), then the global economy needs to grow at a rate of 12% just to keep the tax base in line with the organically growing (the coupon obligation) debt balance. This does not include the increased deficits that are contemplated for battling the recessionary impacts of the covid crisis.
In a debt/GDP spiral, the Fiat currency becomes the error term. Printing more Fiat is the only solution that balances the growth in the numerator relative to the denominator. When more Fiat is printed, the value of the outstanding Fiat is debased. It is circular. Error terms imply an impurity in the formula.
Therefore, when you lend government money at time zero, you are highly likely to get your money back at time X; however, the value of that money will be debased. That is a mathematical certainty. Assuming there is no contagion that leads to a default, the debt contract has been satisfied. But who is the fool? Moreover, with interest rates at historic lows, the contractual returns on the obligations will certainly not keep pace with the Consumer Price Index (CPI) let alone true inflation as measured by other less manipulated baskets like the Chapwood Index. And notice we have not even mentioned the return that would be required for a fair reward due to the CREDIT risk.
While a default by a G-20 sovereign in the short term is still a lowish probability event, investors still need to be rewarded for the RISK of potential default. That is not currently happening in the environment of manipulated yield curves.
There are over 180 Fiat currencies, and over 100 will likely fail before a G-20 country does. However, CDS rates are likely to continue to widen. Contagion and the domino effect are real risks. Remember the GFC. Investors need to be rewarded for the increased systematic credit risk, as well as idiosyncratic credit risk. How? Own Bitcoin as a hedge to CDS widening in sovereigns.
“Fiats always return to their intrinsic value. Zero.” – Voltaire.
I believe that bitcoin is anti-Fiat. As such, it can be thought of as default insurance on a basket of sovereigns/Fiats. This concept has a value that is fairly easily computed and it will be a dynamic calculation since the input variables are continuously changing.
Let’s use the USA as a sample calculation. The Federal government has over US$25Trillion in outstanding debt. According to Jeffry Gundlach, it also has US$157T of unfunded liabilities in Medicare and Medicaid obligations. These are not contractual obligations, however, anyone who is counting on a semblance of healthcare from the government is counting on this aid and needs to protect themselves should the safety net collapse. So for the USA, the total of funded and unfunded obligations is US$180T.
USA 5yr CDS at 14bps multiplied by the total obligations is US$250B. If CDS widens to 35bps in the 5yr (to match Canada), the value increases to US$630B. This calculation uses a fixed 5yr term. The outstanding weighted-average obligation is longer than 5yrs due to Medicare and Medicaid, consequently, we have decided to use a term of 15yrs for the USA. There is no 15yr CDS market, but we can calculate the implied spread using a tenor calculation. The implied 15yr CDS spread for the USA is 45bps. In other words, just using the USA as ONE component in the G-20 basket, we have a valuation of US$180T * 45bps = US$810Billion.
I am currently constructing the Fulcrum Index with the help of Shaun Cumby. He is an experienced CDS trader who successfully hedged some very large naked long credit positions for a major Canadian bank PRIOR to the GFC. Shaun is a wizard at CDS, tenor calcs, and modeling. Our first cut calculation of the current Fulcrum Index is between US$2Triliion and US$3Trillion for the risk basket. Note that the USA is between one quarter and one-third of that amount.
If we assume that the US$2-3Trillion is a valid benchmark for the value of bitcoin, divide that range by 18.6mm coins and we obtain a value of between US$108k and US$160k per bitcoin. Again, this is a dynamic calculation, somewhat subjective, but a very valid benchmark using other clearly observed CDS markets and disclosures. Also, since there is no counterparty risk with Bitcoin, there is further validation in the calculation. If you are a Fixed income investor with the above-mentioned Fiat risk exposure to contractual sovereign obligations, bitcoin can be viewed as cheap portfolio insurance.
Together with the asymmetric return profile of Bitcoin detailed in section 3.6, the traditional 60/40 equity/bond portfolio can be meaningfully enhanced with an added exposure to bitcoin. Expected portfolio returns are increased while actual portfolio risk is decreased. Furthermore, with YTMs in credit products at historical lows, pension funds with prescribed rates of return that are calculated using more generous return assumptions for fixed income will have large difficulty hitting their return assumptions. Many pension funds will have to examine their funded “status” more closely.
Our Fulcrum index is one of many calculations that should be performed in order to evaluate potential price outcomes for bitcoin. I will advance two others: i) bitcoin versus the market cap of physical gold, and ii) bitcoin as a proportion of total global financial assets including real estate.
The market cap of physical gold is US$10T. If we divide that amount by 21mm coins the result is US$475k per coin.
According to the Institute for International Finance, total global financial assets in 2017 including real estate was US$900T. If bitcoin were to capture 5% of that market, $45T/21mm is $2.14mm per coin. At 10% market share, it is over $4mm per coin.
These are huge numbers. Also, they show the asymmetric return possibilities of the bitcoin price curve. The likelihood is certainly low, but it is not zero. In reality, the probability/price distribution is a continuous distribution bounded at zero with a very long tail to the right.
Expected value analysis has always been a key calculation in my risk management toolbox.
Let’s do a simple analysis using the numbers calculated in sections 3.5 and 3.6. We will formulate a simple distribution that has only five outcomes. Bitcoin worth zero, bitcoin worth $135k/coin, worth $475k/coin, worth $2.1mm/coin, and worth $4mm/coin. For example purposes, we assign arbitrary probabilities to each outcome to reflect a subjective distribution as follows: the price of zero with 75% probability, 135k (mid-point of Fulcrum Index range) with 15% probability, $475k with 7% probability, $2.1mm with 2% probability and $4mm with 1% probability. The expected value outcome of this example is $136k per coin.
Given recent trading levels on bitcoin, if you believed this to be your base case expected value calculation, you would be buying with both hands. For the record, my base case is substantially higher than this. But you must “Do your own research “(DYOR). Always DYOR!
Bitcoin is currently trading under US$40k/coin. It sure looks cheap to my expected value distribution; however, there is no certainty I am right. And this is not financial advice to run out and buy bitcoin. I am presenting a valuation methodology that has served me well in my 32yr career. I have been called a kook many times. I am fine with that. If the facts change, my investing decisions and valuation models change.
Others will argue that bitcoin is too volatile. I quote Bill Miller, “Volatility is the price of return”. No Vol, no return.
And finally, given its asymmetric return distribution I believe “It is riskier to have zero exposure to bitcoin than it is to have a 5% portfolio weight. If you are not long bitcoin, you are irresponsibly short”.
Don’t overthink this. Lower your time preference. Bitcoin is the purest form of monetary energy and is portfolio insurance for all fixed-income investors. In my opinion, it is cheap on most rational expected value outcomes. You can never be 100% certain. The only thing that is a certainty is Fiat debasing in a debt spiral. Hedge the global Fiat Ponzi.
In a debt/GDP spiral, the Fiat currency is the error term. All Fiats are melting ice cubes. The rate of decay is relative, but all Fiats melt. It is only math.
I believe there is a real chance that bitcoin becomes the reserve asset of the world. The tipping point (or Fulcrum point) for that event is when bitcoin is adopted as a global unit of account for the trade of energy products. When oil, natural gas, and electricity are priced in bitcoin, bitcoin will supplant the USD as the world reserve currency/asset. This will be the topic for the next and final installment. For now, I leave you with the following picture from the New York Times in December 1921, and Henry Ford calling for “An energy currency that would stop wars”. Makes you think.
Bitcoin = math + code = truth
In our fourth and final part, we will discuss
4.1 - Energy Priced in Bitcoin
4.2 - Bitcoin Miners, the Banks of the Future? Strategic plans for the energy patch and Nations
4.3 - Indigenous Communities embracing Bitcoin
4.4 - Bringing ASIC chip manufacturing back to North America
Stay Tuned!
Greg Foss
Reach me on Twitter at @fossgregfoss – concerned but Optimistic Canadian
