Written by the BullBear Analytics team
The following information is not meant to be sensationalist or fear-mongering. We are only looking at the data in front of us and combining it with a narrative that we believe will play out in the next 12 to 18 months. We’ve spent a lot of time talking about the dollar bull market – how it affects the global economic environment, how it affects the emerging market debt burden, etc. Well, we are not done yet. We believe there are several black swan type events lurking in the shadows that could come out to play if the dollar climbs higher. We’ve already talked about China and other emerging markets, so now let’s look at one that’s a little closer to home – the U.S. pension system.
The Regulatory Twilight Zone
After the 2009 financial crisis, our always-late-to-the-action government officials did us the great civic duty of enacting a law known colloquially as “Dodd-Frank.” I’ll spare you a treatise on the 10,000+ page act, but suffice it to say that it was designed in an effort to prevent a widespread economic collapse from happening. A certain provision in the Act known as “The Volcker Rule” prohibits banks from “engaging in short-term proprietary trading of securities, derivatives, commodity futures, and options on these instruments under the premise that these activities do not benefit banks’ customers.”[1]
Call us cynical, but we operate from the default position that most government laws have the opposite of their intended effect. We count Dodd-Frank among the laws that will go on to have an effect that is opposite of what it is intended to achieve. Conversely, we believe that Dodd-Frank could in fact be a major catalyst for the next financial crisis.
Market Making Made Illegal
Market makers play a vital role in the financial markets (understatement of the year award goes to me). Market makers rely upon each other to be able to unwind large positions of various types of investments. This is referred to as a “network effect.” The efficacy of any market is heavily reliant upon there being a large number of market-making participants.
Market makers are essentially liquidity providers. They are there to buy or sell financial instruments with immediacy where one could otherwise have to wait a longer time period or buy or sell at a non-advantageous price. A large network of market makers would serve to provide liquidity in a time of systemic distress. This last point is important when we look at the market-maker-market through the lens of the Volcker Rule.
The table below provides you with insight into the liquidity providers that are affected by the Volcker Rule.
What was once a large, diversified network of market makers / liquidity providers has been effectively whittled down to half the number of players as before the implementation of Dodd-Frank and the Volcker Rule. Before Dodd-Frank, banks played a huge role in providing liquidity to the market with their willingness to buy or sell large amounts of various financial instruments when no one else was willing. Now, banks are basically banned from participating in this type of trading. This law that is designed to decrease systemic risk in the banking and finance sector could actually lead to a catastrophic liquidity crisis.
Who would be the victims of this liquidity crisis? Pensioners.
Locked Away for Life in the Pension System
It’s pretty well known that the entire pension system in the aggregate is struggling to fulfill its liabilities. The gap between funded and unfunded pension liabilities is growing. Some states have been able to close their respective gaps, but this was due more to market performance than any reforms or retrenchment from their absurd state employee pension “guarantees.” You can see the growing gap between funding and liability in the chart below.
That’s the crux of the issue. Relying upon market performance to meet these guaranteed liabilities is like relying on tarot cards to predict your future.
Most of the pension system is locked up in annuities.” An annuity is a contractual financial product sold by financial institutions that is designed to accept and grow funds from an individual and then, upon annuitization, pay out a stream of payments to the individual at a later point in time.”[3] These annuities guarantee some sort of interest rate return which can vary depending on the structure of the annuity.
Companies selling annuities rely mainly upon market performance to lock in these returns. So what happens if there is a major market downturn? These companies will likely have to liquidate huge chunks of stock to fill funding gaps.
Raoul Pal and Grant Williams – co-founders of video investment publication RealVision TV – recently sat down to have a conversation about this very topic. Raoul sums up his fear:
“The illiquid assets in the system have gone to only very few liquidity providers, and that’s (Blackstone), Carlisle, Fortress, Apollo, etc. Those guys now own all the illiquid assets. They’ve taken what the banks were doing before, and concentrated even more so – and that terrifies me, because the liquidity situation has changed dramatically. This is probably the worst liquidity situation I have ever seen.
“(There are) huge air pockets, because there are no natural buyers of assets right now. We’ve got the sovereign wealth funds who are natural sellers of assets. They were the big provider of liquidity. The pension system is going to get into true trouble. It’s going to have to sell assets to realize anything, otherwise they’ve got funding black holes. They are net seller of assets. Demographically they are too. The banks who are liquidity providers – that was their job in the system – and they’re not there.
“The only guys who provide liquidity are basically funds that are subject to the same liquidity that’s coming out of the sovereign wealth funds. So if the pension system and sovereign wealth system start trying to liquidate BlackStone there is no buyer of those assets in the world. So, this terrifies the hell out of me.”
So there you have it – a beautifully laid out disaster scenario that is by no means improbable. Let’s look at how it could it happen.
Phase One
Since these pension plans are desperate for returns in order to close the gaps between their funding and their liabilities, they have likely taken too much risk in equities and do not own enough bonds.
A really quick rewind - we’ve previously mentioned that we think U.S. bond yields will drop out of the sky soon. The dollar bull market is consolidating nicely (the cup and handle pattern below is indicative of a consolidation period), and we believe it is getting ready for round two of a massive upward move. This would send emerging markets into a debt default spiral, which sends investors into safe haven assets. That’s one of many reasons we believe U.S. bond yields will drop drastically soon.
If bond yields are falling dramatically, we’d be willing to bet that the stock markets will be going through a major correction as well.
Phase Two
While bond yields are falling, these pension plans will need to buy U.S. bonds to lock in their returns. They’ll quickly realize that there are no buyers for their huge chunks of assets. This could really spur a panic sell-off at deeply discounted prices. Remember, the liquidity providers that once existed – the same ones that would otherwise be willing to purchase these large chunks of stock – have been forced out of the market by Dodd-Frank and the Volcker Rule.
Phase Three
Here’s where things get really fuzzy. Who will buy all these stocks? Could we actually see the U.S. Federal Reserve step in as the market maker? We’ve already seen the IMF come out in support of central banks being the buyers of last resort during periods of mass market sell-off.[4]
Think about that for a moment – it’s not entirely unusual. We’ve seen China, Japan, and Taiwan do it. Where would that leave us? The U.S. government could own half the companies out there paid for with printed money. Could we see hyperinflation as a result? What will happen to gold and bitcoin? Are they safe havens or just mirages?
We’ll leave the conclusions up to your imagination because obviously there is no real way to know, but what is clear to us is that the U.S. pension system is edging extremely close to a precarious precipice, and Dodd-Frank could be the finger that pokes it over the edge.
[1] http://www.investopedia.com/terms/v/volcker-rule.asp
[2] https://www.uschamber.com/sites/default/files/legacy/reports/17612_CCMC%20Volcker%20Rule2.pdf
[3] http://www.investopedia.com/terms/a/annuity.asp
[4] http://www.reuters.com/article/imf-markets-vinals-idUSL5N0Z43QT20150618
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Disclaimer: Please always do your own due diligence, and consult your financial advisor. Author owns and trades bitcoins and other financial markets mentioned in this communication. We never provide actual trading recommendations. Trading remains at your own risk. BullBear Analytics publications are meant for entertainment purposes only. Never invest unless you can afford to lose your entire investment. Please read our full terms of service and financial disclaimer at BBA Disclaimers & Policies.