Passive index investing is the new mortgage crisis?

[nooby_mcnoob]

This is just rambling, feel free to ignore.

I'm trying to figure out where the next catalyst will be. I think the market sees some catalyst forthcoming. But in order for there to be a breakdown in the market, the normal people have to feel the brunt.

Normal people are not as overleveraged as they were during the GFC, but normal people who invest are generally putting their money into passive investing.

AIG/Lehman Brothers/Bear Sterns (I believe) had their situations not because of mortgage defaults, but because of margin calls caused by remarking to market or good old bank runs. i.e., not actual problems. Am I wrong?

Normal people don't invest in leveraged SPY, they just buy SPY. So where is the leverage? Where will the margin calls come from?

The options as far as I can see are (NOT AUTO LOANS): the USG defaults, or some huge fund is shown to be overleveraged when it wasn't declared as such causing a massive selloff when they are marked to market.

Fuck it's driving me nuts. GS types will be looking for people to margin call soon. You can bet they are happy to cause these margin calls (c.f. Tesla - sell the bond, then short the stock the next day)

 

[gaussian]

AIG/Lehman Brothers/Bear Sterns (I believe) had their situations not because of mortgage defaults,

They were crushed after using huge leverage provided by CDOs on what they thought were riskless assets (mortgages). Side pot bets on much larger bets levered up to the tits.

Where will the margin calls come from?

Can't have a margin call with no margin.

But addressing your main point the problem isn't margin. The average investor, and even the average index fund doesn't provide life altering leverage. The crisis you are referring to has been well known since at least the second edition of The Intelligent Investor.

Passive indexing works great until it doesn't. The problem is people are not buying stocks of good companies. They are indexing, and as such, as basically entirely tied to the market's average movement. When it goes down, a lot of people will lose a ton of money because, after being told for years by bogleheads indexing is the short path to riches, they bought their 3 fund portfolio without considering it's correlation to the market or even what they are buying.

If you want a true margin call scenario, look no further than the student loan crisis. In 5-6 years when the last batch of boomers retire (thank God...) we will see large swathes of capital removed out of indexes. There will be a massive vacuum left that can't be filled by the incumbent generation (Gen X, Millennials, early gen Z) due to massive student loan debt. The market will continue to plummet and in order to save the economy either the PPT steps in or the government makes student loans dischargable via bankruptcy. If that happens, suddenly a trillion dollars of paper value will vaporize in a fraction of a second and we'll be right back to 2007.

 

[nooby_mcnoob]

Can't have a margin call with no margin.

But addressing your main point the problem isn't margin. The average investor, and even the average index fund doesn't provide life altering leverage. The crisis you are referring to has been well known since at least the second edition of The Intelligent Investor.

Passive indexing works great until it doesn't. The problem is people are not buying stocks of good companies. They are indexing, and as such, as basically entirely tied to the market's average movement. When it goes down, a lot of people will lose a ton of money because, after being told for years by bogleheads indexing is the short path to riches, they bought their 3 fund portfolio without considering it's correlation to the market or even what they are buying.

If you want a true margin call scenario, look no further than the student loan crisis. In 5-6 years when the last batch of boomers retire (thank God...) we will see large swathes of capital removed out of indexes. There will be a massive vacuum left that can't be filled by the incumbent generation (Gen X, Millennials, early gen Z) due to massive student loan debt. The market will continue to plummet and in order to save the economy either the PPT steps in or the government makes student loans dischargable via bankruptcy. If that happens, suddenly a trillion dollars of paper value will vaporize in a fraction of a second and we'll be right back to 2007.

Student loans are a different beast because they cannot be discharged, so the value will never be lower than the loaned amount, less some adjustment for likelihood of repayment. So I don't follow how you'll get a cascading margin call-like senario from student loans. They haven't been securitized, have they?

Oh crap:

https://www.investopedia.com/articl...n-assetbacked-securities-safe-or-subprime.asp

I think the moral hazard associated with selling student loans will possibly limit the leverage in this market. Would be good to pay attention to who has these loans on their books. When a sizeable party has sizeable portion of "SLAB"s, that could be interesting, although now I think the rules require marking to market more frequently potentially avoiding this issue from creeping up.

I'm already seeing the baby boomer issue you are citing occurring. In my neighbourhood, two old, rich women have died in the last year and immediately the heirs put the properties up for sale. They still have not been sold. Liquidity will be problematic.

But the kinds of chain reactions I'm looking for are forced liquidations causing other forced liquidations causing other forced liquidations. I don't see SLABs or SPY-inheritances causing chaining forced liquidations. I guess we should be looking at frothy markets where marking to market is somehow being bypassed.

 

[gaussian]

Would be good to pay attention to who has these loans on their books.

If you went through post secondary education in the US:

https://en.wikipedia.org/wiki/Great_Lakes_Higher_Education_Corporation

https://en.wikipedia.org/wiki/Nelnet

https://en.wikipedia.org/wiki/Navient_Corporation

https://en.wikipedia.org/wiki/Pennsylvania_Higher_Education_Assistance_Agency



These crooks will probably end up doing what they did for CDOs in the mortgage crisis. They will just refuse to mark to market until they dump the garbage debt somewhere so we, the taxpayers, are once again left holding the bag. SLABs are just CDOs without a real asset attached to them anywhere. In some respects SLABs are even worse. To your point though, we are probably a decade out from the entire student loan market imploding. You can't support a consumer economy when people can't afford to consume. Something will have to be done in the next decade - the second generation millennials (1989-1994ish) are entering the accumulation phase (~30 years of age) with almost no ability to contribute to the economy. It'll take 10 years before economists realize whats going to happen.

 

[tommcginnis]

If you went through post secondary education in the US:

https://en.wikipedia.org/wiki/Great_Lakes_Higher_Education_Corporation

https://en.wikipedia.org/wiki/Nelnet

https://en.wikipedia.org/wiki/Navient_Corporation

https://en.wikipedia.org/wiki/Pennsylvania_Higher_Education_Assistance_Agency



These crooks will probably end up doing what they did for CDOs in the mortgage crisis. They will just refuse to mark to market until they dump the garbage debt somewhere so we, the taxpayers, are once again left holding the bag. SLABs are just CDOs without a real asset attached to them anywhere. In some respects SLABs are even worse. To your point though, we are probably a decade out from the entire student loan market imploding. You can't support a consumer economy when people can't afford to consume. Something will have to be done in the next decade - the second generation millennials (1989-1994ish) are entering the accumulation phase (~30 years of age) with almost no ability to contribute to the economy. It'll take 10 years before economists realize whats going to happen.

I think we should dump this mess on the Congressional retirement fund -- this ("student debt") mess was a bi-partisan creation by them, added to by them, compounded by them, and made 'inescapable' by them. Newt Grinchmas, Tipsy O'Neal, signed by Smiling Ron Reagan (a hero of mine, but..."Damn.")

Thems my thoughts.


{"Ooops. We're pretty far from Index investing now, aren't we."}

 

[Nobert]

If that happens, suddenly a trillion dollars of paper value will vaporize in a fraction of a second and we'll be right back to 2007.

Would be good to pay attention to who has these loans on their books.

I find this song fitting :

 

[Specterx]

Events like the GFC are rare. There doesn't always have to be a major crisis / crash lurking around the corner.

The main effect of greater passive investing will IMO be to flatten the distribution of actual returns to investors. 2018-19 could be a good example: indices will spend more time hovering at highs or slowly grinding up, punctuated by occasional brutal selloffs (caused by quant strategies hitting sell thresholds in quick succession) and equally rapid recoveries. Value or discretionary players who are quick on the draw should enjoy fatter edges, as competition for these strategies falls away and capital crowds into cheap, highly scalable systematic or passive spaces.

If there is a "catalyst" coming up, it's going to be some combination of the trade war and the implosion of busted unicorns.

 

[tommcginnis]

Events like the GFC are rare. There doesn't always have to be a major crisis / crash lurking around the corner.
...
If there is a "catalyst" coming up, it's going to be some combination of the trade war and the implosion of busted unicorns.

I agree very much with the first thought -- there is much hand-wringing going on over what is in fact a stable economy.

But I disagree 'very much' on the second thought, and here's why. With a glance at towards Norbert's cites above, student debt is wiping out the ability to own a home right now. That has broad implications for consumer discretionary (ZERO $000!) and consumer durable goods (less-than-ZERO $000) in the near future. (0-10 years) THAT means no retirement funding, either -- right at the point where this cohort looks to step out of the employment pool.

Just like the Great & Recessionary Financial Crisis, lack of liquidity will KILL a vast amount of wealth, and just like the G&RFC, it will cycle itself and spiral down worse.

(And, pardon my loyalties here, but a goodly chunk of this will fall on the colleges and universities who were fed fat & happy by all this, and they will take it out by pruning not the idiotic bloated Administrations, but the poor (figuratively AND literally) faculty.)

At any rate, people who can't afford to buy anything eventually can't afford to buy anything. Housing, goods, services, attendant industries -- will all tumble like dominoes. Sorry.

 

[nooby_mcnoob]

This thread has some great responses that are really making me think, thanks guys. Some things I wanted to point out though:

I agree very much with the first thought -- there is much hand-wringing going on over what is in fact a stable economy.

It's not so much that the economy is unstable, but where will the instability come from? We are somewhat all in agreement that there will be a liquidity problem in the future where the economy will lose an entire generation of consumers to debt slavery before they even hit their 20s.

@Nobert had a good set of data on the current state of student loans. These are rookie numbers: As of recently, the government was on the hook directly for 17-24 billion in loans, let's multiply that by 10 maybe to get the entire exposure in the market: 170-240 billion. How much of that 24 billion is likely to be repaid over 10 years? Quite a huge chunk. So even marking to market will give you, at most, a 50% haircut. And that's a really, really bad case. Nothing like cents on the dollar like with the GFC. I struggle to see this being a major problem in the near future.

These crooks will probably end up doing what they did for CDOs in the mortgage crisis. They will just refuse to mark to market until they dump the garbage debt somewhere so we, the taxpayers, are once again left holding the bag

Yes, and so in a few years, we should look out for the people who have these on their books.

Trade wars and busted unicorns are the potential catalysts. OK then. Who is exposed to unicorns? The fallout of trade wars is likely priced in.

 

[nooby_mcnoob]

Commercial loans could fit the bill in a downturn might be too late already though Dalio was warning about it a few months back