CHAPTER 2

Lehman Squared

West Side Story and Romeo and Juliet

“Feels like watching West Side Story when you’ve already seen Romeo and Juliet. Two stories that at first sight may look totally unrelated but to me are, in essence, the same story.” That is how I feel about the Global Financial Crisis that shocked the world in 2008, which I call “Lehman 1.0” and the next crisis ahead, which I call “Lehman Squared.”

Most people are quick to rightfully point at the differences. “Diego, one of the stories takes place in Italy, the other one in New York City. One took place centuries ago, and the other one just a few decades ago. One confronts two noble families, and the other one two gangs. How can this be the same story?” they argue.

To me, beyond the surface, the essence, whereby girl and boy from enemy groups fall in love, and live an impossible love story, complicated by the death of her brother by the boy in question, and the drama and dynamics around it are virtually an identical plot.

To, beyond the surface, the essence of the dynamics that led to the Global Financial Crisis of 2008 has clear similarities with today’s global macroeconomic situation. We are dealing with extraordinarily complex and interrelated dynamics across economics, politics, and financial markets, most of which are not well enough understood even by market professionals, let alone non-professionals, which is why I will use a movie analogy, based on plots and principal characters that are easily understood. I will provide the more technical discussion and rationale for all these arguments throughout the rest of the book.

The goal of this exercise is to learn from past mistakes and try to anticipate and prevent future mistakes from happening. We can control our investment decisions. We cannot control the outcomes.

Remember, we are presenting a series of investment thesis, dynamic hypothesis based on assumptions, asymmetric probabilities and outcomes that are path dependent and change over time along with new information and events. Our investment thesis need to be validated, adapted, accepted, or rejected with new information. Therefore, my investment thesis should not be viewed as static frameworks or absolute truths, simply because they don’t exist in the financial markets.

Lessons from Lehman 1.0

The Global Financial Crisis of 2008, also known as the Lehman crisis, caught most people by surprise. Today, with the benefit of hindsight, we have a very good understanding of our mistakes, some of which in my view we are repeating.

Why Lehman Squared

I have called my investment thesis Lehman Squared for two simple reasons.

First, because the next crisis will be a “sequel” of the previous movie, I mean crisis.

Second, because the potential size and implications are much larger than for Lehman 1.0, and thus the “Squared” instead of Lehman 2.0.

A Premortem Analysis

With the benefit of hindsight, we have developed a very comprehensive “postmortem” analysis of the causes that led to Lehman 1.0. The goal is now to develop bridges of competence that will help us develop a “premortem” analysis of what the next global crisis may look like.

Let’s review the plot and the principal characters of both movies, one by one.

The Miracle Technology

We love miracles. And we love technology. So, a movie with a miracle technology sounds promising. But, as we know, technologies tend to have two sides: a good side and a dark side.

Look at the nuclear technology for example. On the one hand, nuclear technology has played an important positive role in medicine and the generation of electricity, among others. On the other hand, however, nuclear has a dark side of nuclear accidents and bombs.

Or look at the Internet, another transformational technology. On the one hand, the Internet has transformed the way we communicate, learn, and live our lives. On the other hand, it has created challenges we did not have before, such as cybercrime or bad use and abuse of the Internet.

The Lehman 1.0 miracle technology was called securitization, another case of transformational technology with positive and negative applications. On the positive side, securitization has provided great benefits to both borrowers and lenders. On the negative side, viewed as a “miracle technology,” securitization was pushed beyond its limits with massive volumes of all kinds of yield-seeking assets (including subprime mortgages) magically converted into tranches with credit ratings ranging from AAA-rated (risk-free) to “equity” (risky residue) that arbitraged the models and inputs. A miracle of alchemy that would transform lead or copper into gold.

The Lehman 1.0 accident, like in most action movies, was the result of a chain of parallel and sequential errors. With the benefit of hindsight, we can assign roles and characters to the key principal players.

The Greedy Arranger

One of the baddies of Lehman 1.0 were the investment banks that played the role of greedy arrangers. With the benefit of hindsight, it is obvious that the banks were conveniently arbitraging models and that the assumptions used by investment banks were flawed.

The banks also inadvertently played the role of naive lender, as they accumulated enormous risk on their balance sheet that they believed to be risk-free but turned out to be risky. A clear case of “believing their own… lies.”

The Partner in Crime

Another key baddie of Lehman 1.0 were the rating agencies (in particular the main three, S&P, Moody’s, and Fitch), which validated the process with theirs that gave credibility to the process and the rating agencies (playing the role of the “partner in crime”) underestimated the risk of extreme events.

The Naive Lender

The role of the victim is played by the naive lender. Naive (trusted someone) is a kind generalization, as many lenders were simply greedy (tried to make some easy money) and careless (did not do their homework). In all cases, they conveniently believed the miracle of earning high spreads for lower credit risk.

The Greedy Borrower

The role of the greedy borrower during Lehman 1.0 was played by those who embarked in cheap debt beyond their limits. Many tried to plead ignorance, but all of them were trying to take advantage of the cheap and abundant credit.

At the extreme, unemployed people were taking mortgages to buy houses they could not afford. The result, the mortgage subprime (nice euphemism), which contributed to the bubble in the housing markets.

The Acronyms

The role of “weapon” by which the miracle technology does the damage is played by the “acronyms,” instruments named by their initials that everyone used but few truly understood.

The acronyms of the Lehman 1.0. crisis were the ABS, CDO, CLO, and other more funky versions such as the synthetic CDO square, an obscure way to add leverage and risk.

Now, in simple terms, what does an acronym do? What is it, in a sense? Well, I like to define as a mechanism, a vehicle, by which “we lend a lot of money, to the wrong people, in the wrong size, at the wrong price, and arguably, at the wrong time.” That’s really what all those obscure instruments were doing: lending.

The Sleeping Policemen

The role of the “sleeping policeman” in Lehman 1.0 was played by the Central Bank and regulators. It was only with the benefit of hindsight that they realized the excesses and the lack of regulation. Despite the warnings, it is fair to say that central banks were genuinely caught by surprise.

Now, if you fast forward to where we are today, we can draw some clear parallels.

The New Miracle Technology

The role of miracle technology is played by monetary policy. Solving problems is as easy as cutting interest rates, printing money, and why not, tax people for holding that cash.

The role of miracle technology is also indirectly played via fiscal policy. The nonsense has reached an extreme that governments are now paid for borrowing (OMG), which incentivizes the wrong behavior (the more you borrow, the more interest you get paid). A dynamic that we will discuss in detail later, under the “prudent imprudence” chapter.

The New Acronyms

The role of the weapon is once again played by acronyms. In this case QE (Quantitative Easing), QQE (Quantiative and Qualitative Easing), LTRO (Long Term Repurchase Obligations), or YCC (Yield Curve Control), among others. What do they do? Very easy. They are “lending a lot of money, to the wrong people, in the wrong size, at the wrong price, at the wrong time.” Sounds familiar.

The New Partner in Crime

The role of the “partner in crime” (previously played by the rating agencies, which enabled and validated the acronyms) is now played by the Central Bank. Monetary policy without limits is incentivizing—or rather forcing—investors to lend for longer and longer and to weaker and weaker credits. A desperate effort to fight deflation, they argue, but that once again incentivizes the wrong behavior.

Who Polices the Police?

A twist of the current situation, deeply concerning to me, is that supervision is one of the key core competences of Central Banks. As a result, there seems to be a duality, a conflict, which makes me wonder who polices the police, or quis custodiet ipsos custodes, as they say in Latin.

In the movies, it is quite common to have policemen who looked like goodies but turned out to be baddies. Time will tell if Central Banks will go down in history as heroes or villains.

The New Greedy Arranger

The role of the greedy arranger played by the Investment Bank in the Lehman 1.0 crisis is unfortunately also played by the Central Bank, which is the one that is incentivizing volume. In this case, given the massive stakes, superheroes or supervillains.

In addition, there is also a role of passive arranger played by the Benchmarks that is contributing to the vicious cycle. Many institutional allocators have strategic allocations to bonds, which means they are expected to stay invested under neutral market conditions. In practical terms, it acts as a leash that is taking the institutional investors for a dangerous stroll around “bubble park.”

Those allocators that have taken “underweight” positions have been penalized by underperformance as the bubbles carry on. A dynamic that has forced them to cut losses and go back to neutral. Some others, embracing the bubble, have gone overweight. The entry door is pretty large. The exit door probably not. Liquidity, as discussed, a major risk and consideration that is building in the system.

The New Naïve Borrower

The role of the greedy borrower is once again played by those borrowing beyond their limits. Governments are the greatest beneficiaries, as their cost of refinancing is dropping beyond the imaginable, at negative interest rates.

Corporates have been major beneficiaries of the monetary snowball and the credit steamroller, which is crushing borrowing costs beyond the imaginable. With the expansion of QE to high-grade credit, many corporates are now able to borrow at negative rates. Total nonsense in a ZIRP constrained world, but a new reality.

The greatest beneficiaries are however the weakest credits, such as high yield and emerging markets. The bull market has spurred also record issuance. A borrowing party.

Building Bubbles

History tells us that lending too much money, to the wrong people, at the wrong price is likely to end in speculation and bubbles.

During the Lehman 1.0. crisis, the wall of money went principally into real estate and fixed investments. It was large, but somewhat contained and channeled.

Unfortunately, this time around, the vast amounts of money that are flowing into government bonds, thanks to central banks’ monetary policy without limits, is having a spillover effect into many, many more markets, in a much more global way, much more spread, and much bigger, which is, obviously, much harder to control.

The corollary of inflating synchronous bubbles is that they are also likely to deflate synchronously.

The Complacency Phase

I believe we are currently in the complacency phase of the bubble, supported by the belief that Central Banks are in full control. We have had some scares, such as the “taper tantrum” of September 2014, or the “CNY mini-devaluation crisis” of January 2015 following the first hike by the Federal Reserve, which have reinforced the perception of infallibility and control.

The normalization of monetary policy in the United States seems underway. The two consecutive hikes following the U.S. elections are a very important positive development for global markets in my opinion. They are a test to the resilience of global markets. The jury is still out.

The Twilight Phase

The recent scares have casted some doubts into many people, which is leading to a polarization of views across markets participants. Many others remain confident and bullish.

The Burst

Time will tell if this movie will end in disaster, like Lehman 1.0, or will have a happy ending. The future is path dependent, and recent developments such as Brexit or Trump’s presidency complicate things further. This new phase is likely to add fuel to the fire and increase the bets through fiscal expansions.

The Scapegoats

The Lehman 1.0 crisis was followed by a phase of blame and punishment, primarily inflicted upon the Investment Banks.

The current dynamics are different. A growing problem of inequality is emerging from financial inflation, which benefits those with financial assets the most. So far, Central Banks are able to operative at will outside of the radar of blame. The blame for many of the problems is being pointed toward globalization, and the proposed answer is protectionism, as it has become evident in the United Kingdom and the United States with Brexit and the election of Trump.

	Description	Lehman 1.0	Lehman Squared
The plot: A miracle technology	Every technology has good and bad uses. Nuclear power vs. weapons.	Abuse SECURITIZATION: Alchemy of creating AAA tranches from Junk.	Abuse MONETARY POLICY: Print money and incentivize debt.
The weapon: The Acronyms	Vehicles that lend too much money, to the wrong people, at the wrong time, at the wrong price.	ABS, CLO, and CDO, Collateralized Loan and Debt Obligations, and so on.	QE and QQE, Quantitative and Qualitative Easing, LTRO, YCC, …
Partner in crime	Validate the “miracle”	Rating Agencies	Central Banks
Greedy arranger	Benefit from volume	Investment Bank	Central Banks (Monetary Policy)
Naïve lender	Complacent lender	Institutional Investors attracted by higher yield and credit	Duration and Credit bubble via negative rates and benchmarks
Greedy borrower	Take advantage of cheap credit to borrow beyond its means.	Investment Bank	Governments, Corporates
Sleeping policeman	Regulator and Supervisor of Financial Stability should have identified and avoided problem.	Central Bank (Supervision) caught by surprise in a framework of loose regulation.	CB plays dual role Greedy Arranger and Supervisor: “who polices the police”?
Bubble	Excess lending eventually results in gross misallocation of capital.	Housing Market and Infrastructure	Epicenter Government Bonds, but spread to High Yield, Emerging Markets, IG Credit, Equities, ….

A New Beginning

The end of the Lehman 1.0 movie was a period of extraordinary monetary expansion. The beginning of the movie we are still watching. The following chapters of the book will provide a more in-depth analysis of both the causes and potential paths ahead. There are great opportunities and challenges ahead, which will leave major winners and losers, but as always, whatever happens. A financial crisis will not be the end of the world. No matter how the tables turn, the sun will still come out in the morning.

Bridges of Competence

My brain seems to be wired in a way that creates connections, analogies, and parallels all the time. My colleagues and team members know this well, as I am known for making extensive use of sporting analogies during the morning and strategy meetings.

One of those connections was triggered by the Fukushima nuclear accident. A mental bridge that connected the divergence in global natural gas prices with the Internet bubble. A big bridge, I know, but an idea that stayed with me and eventually took form in my first book.

I had read Thomas Friedman’s “The World is Flat” in 2003. The dot. com bubble was still fresh in everyone’s memory, and had left a sour taste to many, but Friedman’s book opened a completely different perspective. An inspirational “post-mortem” analysis about the transformational process that had “Flattened the World,” thanks to a game-changing technology (the Internet), thanks to the large growth in capacity that took place during the boom (which, among others, wired the oceans with broadband), and thanks to the bust of the bubble (which made the technology available in large capacity virtually for free).

As I tried to explain the technical concepts and complex dynamics of the energy markets, my brain somehow created a bridge of competence between the Internet revolution and the energy revolution. The framework of the Flattening of the Energy World applied the lessons learnt from the “post-mortem,” backward-looking, analysis of the Internet revolution to a “pre-mortem,” forward-looking analysis, of the energy revolution that was happening in front of our very eyes.

The framework helped us coin new concepts, such as the “Energy Broadband,” which explained the complex dynamics of the supercycle in Liquified Natural Gas (meaningless to most people) with the wiring of the oceans with “Internet Broadband” (familiar to most people).

In addition to the interdisciplinary bridges of competence, The Energy World is Flat used also historical lessons, or time analogies, such as OPEC’s dilemma in the 1980s, which was applied to the then prevailing circumstances in the chapter called “The Btu that broke OPEC’s back.”

Reflexive Competence

A fascinating feature of the bridges of competence is that they are reflexive. The bridges work in both directions. It was fascinating to see how, once the bridges were built, the analogies prompted us—and many people familiar with the Internet revolution—to ask follow-up questions such as “so if the LNG network is the Internet broadband, the Producers are the Telecoms, right?,” which continued to “the Telecoms suffered enormous losses via asset write-offs during the bust, I guess that overcapacity in LNG will lead to write-offs for the producers, which will hurt their share price, right?” Bingo!