Prices have never been higher.
Every single asset class is expensive. Nothing is safe.
Not stocks, bonds, or even real estate.
But before we figure out how to invest in
this mess, we need to understand how we got
here, to a place where everything seems inflated.
Allow me to introduce you to
the United States Federal Reserve.
A central bank unlike any other in
the world, a crazy Frankenstein combo that's
part private bank and part government agency.
The Federal Reserve was created in the early 20th
century after a series of financial panics led to
an attempt at central control of the monetary system.
In challenging economic times, it takes a
person with an unusual and diverse background
to run the Federal Reserve effectively and
not torpedo an already ailing economy.
Enter Jerome Powell.
Who is Jerome Powell and how did he
get to the head of the Fed? For that,
we have to go back a couple of decades.
During the global financial crisis of 2008,
the Fed squashed short-term interest rates to
help stimulate the US economy.
Lower interest rates are meant to
encourage borrowing and stimulate economic activity.
But with already low rates, the Fed had to push
them lower than ever before, down to essentially zero
for the first time in history.
Economists call this 0% interest rate, the zero-bound
because it was believed you couldn't go below zero.
That is, until one man, Ben Bernanke, then the
head of the Federal Reserve, decided to put the
economy into creative mode and perform a radical experiment.
What would happen if you
pushed interest rates below zero?
The math may not have made sense, but Bernanke
thought the theory did, at least on paper.
But someone saw the dangers and knew that
if nothing was done, the United States economy
could eventually collapse on itself, taking the entire
world's monetary system with it.
His name? Jerome Powell.
[Music]
Ben Bernanke was at the helm of the Federal
Reserve in 2008 when he suggested his bold zero
interest plan to battle the financial crisis.
His plan was to use a technique called
quantitative easing, or QE, for short to increase
the available money supply and encourage lending.
Now, quantitative easing is basically a fancy way of
saying that the Fed is going to buy a
bunch of assets to artificially increase the money available
for lending and thereby stimulate the entire economy.
As far as Bernanke was concerned, all you had to do
was make the money available and the activity would come.
But let's not forget about Jerome.
Unlike Bernanke, Powell was worried.
He thought that QE should only
be used in absolute emergencies.
The consequences of using it too much for too
long were unknown at the time, and it was
possible that this kind of stimulation was addictive.
Once the economy got hooked on the
juice, it would keep needing its fix.
Was he right?
Telling you would spoil the entire story.
Bernanke's plan definitely had fans
in the private sector.
Obviously, free money was just fine
with the rich and powerful.
Speaking of rich, Richard Fisher, the Dallas Fed
president, shared a story about Texas Instruments.
- The company was borrowing $1.5 billion in cheap
debt but didn't plan to use it to build
a single factory, invest in research, or hire workers.
Instead, the company used the money
to buy back their own shares.
I spoke with him and he told me, I'm not
going to use this money to create a single job.
- TI was bragging about their plunder, all while the
system that Bernanke had designed was actually crushing the
same people it was meant to serve.
But Bernanke wasn't concerned. His response?
- Thanks, but I wouldn't worry
too much about his opinion.
I don't want you to overweight the
macroeconomic opinion of private sector people who
are not trained in economics.
- See, this was Bernanke's problem, his indifference to morals
or ideals, and his absolute faith in theory.
He was so in love with the
intellectual discipline of economics that he discounted
anyone who wasn't an elite economist.
Another person who wasn't an elite economist, in
Bernanke's mind, was Jerome Powell, who watched with
concern as huge amounts of available money began
to distort and twist and change the economy.
Bernanke had basically turned on the money printer
and let it run, creating an economic monster
that might be impossible to stop.
So if he wasn't an elite
economist, who was Jerome Powell?
And why was he so worried? For that,
we'll have to go back even a few decades further.
[Music]
Jerome "Jay" Powell grew up in Washington, DC, the scion
of a long line of prominent legal figures.
He went to Georgetown Prep, a
strict, expensive, and prestigious prep school.
He also earned a BA from Princeton
and a law degree from Georgetown.
From his upbringing, he became well versed
in how to behave in the company
of the world's most powerful people.
And it led to a career at the
intersection of private equity and public government.
Even though he hadn't planned it that way.
Paul initially thought that he would follow his
father's footsteps and become a corporate lawyer, but
was lured away by the promise of adventure
in the world of corporate debt at a
rapidly rising firm called Dillon, Read & Co.
Dillon, Read & Co. was more like an elite club than an investment firm.
It was exclusive, snobby, and painfully rich.
During his time there, Powell learned the
fine art of corporate debt creation.
While most civilians consider debt to be a bad thing,
corporate debt has become a way for Wall Streeters with
high IQs and low morals to make an absolute killing.
Basically, there are two kinds of corporate debt,
corporate bonds and leveraged loans.
Both of them can be exploited.
A corporate bond is like a standard
bank loan, except there's a kicker.
Most companies almost never intend to pay them off.
Instead, they roll the loan by hiring a
bank to sell the debt before it's due.
The company selling the debt gets a smaller amount
of cash for it because they think there's a
good chance that they wouldn't have been repaid anyways.
And the buyer is gambling that they'll get paid back
eventually for much more than they took the debt for.
A leveraged loan, on the other hand, is
kind of like a mortgage for a business.
Companies might use them to refinance
or buy back their own shares.
Jay Powell mastered the art of perfectly engineering
both of these new forms of leverage while
at Dillon Read and used them to fuel
corporate takeovers, mergers, and acquisitions.
This required extreme precision because these loans could
blow up at any time, and Powell became
very good at it and also became known
for his sense of calm under pressure.
But he was just getting started.
[Music]
In 1998, Dillon Read's chairman Nicholas Brady was recruited
by Ronald Reagan to become Treasury Secretary, and he
took rising star Jay Powell with him as deputy.
Powell accepted the position and did just what Reagan
and Brady asked, calmly, running things like clockwork, until
one day he found himself facing a new group
of villains, a rowdy group of young, testosterone fueled Wall
Street Bros from Salomon Brothers, who unironically called themselves
"The Big Swinging Dicks"
As despicable as their name implied, the Big
Swinging Dicks had quietly employed a fraudulent scheme
to buy up treasury bills through a shell
company in attempt to gain a monopoly on
the treasury bill market, and they succeeded.
By the middle of 1991, they held
94% of the T bill supply.
The only thing was that this was totally illegal.
Fearing criminal charges and massive fines, the higher
ups at Salomon, including the now legendary Warren
Buffett, found out about the scheme and wanted
to make a deal with the Feds.
The Feds, for their part, knew that if Salomon went down,
this could take all of Wall Street down with them.
So they sent Jerome Powell to negotiate a deal.
And negotiate he did.
In fact, Powell did such a good job
that he was promoted for his efforts.
But Powell's success didn't just earn
the approval of the Feds.
It also attracted the attention of a shadowy
but powerful group who'd been watching it all
unfold, an organization called the Carlyle Group.
[Music]
The Carlyle Group was no ordinary finance company.
Not only were they one of the largest private
equity firms in the world, but their questionable investment
history included ties to CIA cover ups, secret arms
deals, and possibly even the 9/11 attacks.
In fact, Shafiq bin Laden was
at Carlyle's annual investor conference while
the September 11th attacks were occurring.
And those attacks proved very profitable for
the Carlyle Group and their subsidiary, United
Defense, as defense spending soared post 9/11.
Unlike most firms, which were in New York, Carlyle Group
was based in Washington, DC, and for good reason.
Leveraging the connections of Washington insiders was
the core of their business strategy.
Their roster included the cast of political heavy hitters
that even X-Files writers couldn't have dreamed up.
But Carlyle's influence was nothing without the
second component to their business plan, corporate
debt and a lot of it.
Once they convinced debt expert Powell to join their
team, Carlyle became unstoppable, and Powell helped them to
execute one of the biggest deals in their history.
[Music]
One day, Jerome Powell was seated at his desk
at Carlyle, flipping through a catalog, when he found
something interesting, an industrial conglomerate called Rexnord.
You've probably never heard of Rexnord, but
you definitely cross paths with their products.
They make boring industrial stuff that helps
make the world move replacement parts, conveyor
belts, that kind of thing.
Their business model was similar
to razor blade companies.
The razor was cheap, but the replacement
blades were expensive and very profitable.
But all was not well at Rexnor.
Despite a strong business model, they had huge debt.
The year that Powell became interested in them, Rexnord paid
more in interest costs than it earned in profit.
But to Powell, that wasn't necessarily a bad thing.
He saw something in Rexnord that piqued his interest.
They had something that private equity investors valued
above all else - a steady cash flow.
So Powell put together hundreds of millions of dollars
in Carlyle money and outside loans to buy Rexnord.
This acquisition remarked the pinnacle of
Jay Powell's private equity career.
It also provided him with firsthand education on
the uses and risks of corporate debt.
In fact, because of the high level of
debt at Rexnord, soon after the Carlyle acquisition,
Rexnord asked his employees to take an hourly
pay cut to lower the company's expenses.
Meanwhile, none of the money that they
borrowed ever went to creating new jobs
or giving pay raises to working people.
Shades of Texas Instruments.
But for Jay Powell and his team, that didn't matter as
long as there's still room to borrow more.
Once Carlyle Group had made their profit and
Rexnord was swimming in even more debt, Powell
decided it was time to cash out.
He found his buyer, Apollo Management LP.
Like Powell, they weren't afraid of
Rexnord's heavy debt because they believed
that Rexnord could borrow even more.
Apollo's offer was remarkable.
They had raised $1.8 billion, more than twice
what Carlyle had paid just four years earlier.
And the payout to Jay Powell and his team was massive.
People at Carlyle would talk
about the Rexnord deal years later.
While we don't know exactly how much profit Powell
earned from the sale because Carlyle is known for
keeping pretty good secrets, we do know that Rexnord
and their buyout made him oligarch level rich.
As for Rexnord, the company was left behind with
crippling debt, a shell of its former self.
It was no longer a company whose goal was
to build products, but instead to service debt.
In many ways, Jay Powell's big Rexnord deal
marked the end of an era.
Although it was still tantalizingly cheap to borrow,
it was becoming harder and harder to find
companies like Rexnord to suck dry.
And that's when a new product was introduced to
the market - the collateralized loan obligation, or CLO.
Basically, CLOs were packaged bundles of risky corporate
debt that bundled a mixture of low, medium,
and high risk debt all into one product,
kind of like layers in a Taco.
One layer was the frilly lettuce garnish of the
deal, that was the AAA rated and pretty safe.
But then came a middle layer of cheese called
the Mezzanine Group, which was quite a bit riskier.
And finally, the package would include a really risky equity
portion that was like the day old tainted meat.
No one would have wanted this by itself.
But buried among all the Taco ingredients, it was easier
to get someone to swallow it without being put off.
And just like Taco Bell popularized the
Taco for Americans, CLOs made leveraged loans
mainstream for the finance world.
[Music]
After his time in private equity, Powell
was nominated by Barack Obama to the
Federal Reserve Board of Governors.
During his previous stint at the treasury with
Brady and even his first couple years at
the Federal Reserve, Powell had never objected publicly
to Bernanke's zero interest rate policy.
But then, one day at a January 2013
Federal Reserve meeting about interest rates, Jay Powell
abandoned his previous tone of moderation.
Instead, he delivered a prophetic and chilling warning
about the dangers of quantitative easing and the
effects that this artificial lowering of interest rates
and government spending might have on businesses.
Powell said that the Fed was potentially
creating an asset bubble in the markets
for debt like corporate bonds and leveraged loans.
That's government finance guys' speak for
"If we keep doing this, we're in for a *** storm of hurt."
But why was the famously
calm Powell so suddenly disturbed?
It came down to one major concern, CLOs, those
nasty bundled tacos of exotic, risky corporate debt.
Not only did they carry risks that Powell
was immediately familiar with, but they were scarily
similar to the collateralized debt obligations, or CDOs,
that caused the 2008 financial crisis.
Basically, CLOs were the same type of
Taco as CDOs, but filling it with
sketchy corporate loans instead of sketchy mortgages.
See, when Powell criticized leverage loans like
CLOs, he was actually speaking from experience
from his past life in private equity.
He had spent a good portion of his career engineering exactly
the kind of risky debt he was now afraid of
on a grander scale, the combination of artificially low
interest rates and those tempting tacos of dangerous debt
made for this high-risk combo meal that everyone wanted
a piece of. The industry went from just under
$300 billion in 2010 to $400 billion in 2014
and $ 617 billion in 2018.
[Music]
As demand boomed, the only stop gaps preventing total exploitation
in CLOs were something known as covenants.
Think of them like seatbelts,
meant to protect investors.
Or if we want to stretch the analogy,
maybe like Pepsin, meant to protect investors from
the nasty tacos that they were eating.
A typical Covenant might dictate that a borrower like
Rexnord couldn't immediately go and take out more debt.
But lenders got even more greedy and started
insisting that covenants be left out of deals.
These even riskier loans made up just 10%
of the market in 2010, but by 2019
they accounted for 85% of all leveraged loans.
Years later, it would be easy to point fingers at
the evil bankers who got rich selling this junk.
But financiers were only doing what Bernanke's Federal
Reserve gave them incentive to do, even though
real economic growth wasn't being stimulated.
Asset prices were through the roof, and this
gave company executives the chance to exploit their
stock even further by buying company shares using
the loans that they were getting.
By taking these shares off the market, they
decreased the total number of shares available to
the public and boosted the price of their
own shares, making them even richer.
Speaking of all these tacos, Yum! brands, the
actual owner of Taco Bell, was able to
make some massive profits from this exact scheme,
boosting its debt to absurd levels.
And remember Rexnord, the company where
its employees took pay cuts?
Well, in 2016, the CEO was paid $1.5 million, but
by 2017, when the plant closed, it increased to $12 million.
The Fed knew people were doing it, but
Bernanke believed the prosperity would eventually make its
way down to the common folk through the
wealth effect, so they let it continue.
It was trickle down economics all over again.
[Music]
Between 2007 and 2017, the Fed's balance sheet
nearly quintupled as it used quantitative easing.
Remember QE, to buy up all the assets
it could and flood the economy with money.
Many Wall Street traders saw clearly what
was happening, and they developed a nickname
for this, the everything bubble.
Everything was clearly overpriced.
Both prices and risk tolerance
seemed to increase daily.
But if everything is expensive, how do we invest?
Well, for like Buffett, we can take the needle in
a haystack approach, not worrying about the market, but instead
sitting and waiting to pounce on a high cash flow.
Simple business.
Or we can look at real
assets, something physical and specialized.
Commodities tend to perform exceedingly well
in times of high inflation.
Other options include REITs, or real estate investment
trusts that allow you to purchase a share
of cash flowing real estate with healthy dividends.
You can even go more niche within this.
And look at a REIT that specializes
in farmland like one of Bill Gates
favorite investments or possibly a Timberland REIT.
Or you can invest in publicly traded
airports which are extremely hard to replace.
While nothing is perfectly safe from the
everything bubble, real assets not only offer
additional portfolio diversification and inflation protection, but
also the potential for high yields.
[Music]
On February 5, 2018, with Bernanke and his successor
long gone, Jerome Powell was sworn in to become
the next chairman of the Federal Reserve.
Things have come full circle, but what has
he done with his extensive knowledge of high
risk debt, its benefits and its perils?
Well, since his appointment, the pandemic happened.
The Federal Reserve has doubled its
balance sheet in just four years.
Interest rates are still at near
zero and inflation over 7%.
Now it can be tricky to separate the effects of
the pandemic from things that would have happened anyways.
But it's hard to tell where Jay
Powell stands on handling high risk debt, both
having earned an oligarch's fortune from it and
being made keenly aware of its dangers.
But with inflation soaring and income inequality
on everyone's lips, Powell seems to have
been dead on about one thing.
Once you open the door to QE it's
nearly impossible to close.