Etai Friedman has been digging deep into the causes behind the widening of the spread in the credit markets. The 2008 crisis was caused by too much mortgage debt and debt in general and the federal Reserve has propagated even more debt this time. The world is not able to service any more debt.
We have replaced sub prime mortgages with sub prime auto loans, these are being repackaged as debt securities and given AAA ratings. Auto loans are being given out to anyone with a heartbeat, history is repeating itself. We are going to have a full blown deleveraging of the debt bubble similar to the 1920's
Commodity prices are at 25 year lows and commodity shipping rates and levels are at all time lows. The Chinese government is censoring financial data so that what is coming out is non-sense. They will not admit if they are in a recession. Money moving into gold and gold stocks seeking a safe haven though the current 6 week uptrend is just a blip on the long term charts. This move however looks like the beginning of a long term trend although there may well be a pullback before the uptrend resumes.
Palisade Radio Host Collin Kettell: Welcome everyone to another show of Palisade Radio. This is your host Collin Kettell. Very, very excited to have a new guest on the program, his name is Etai Friedman. He is the CEO of Eyal Capital Management LP, manages millions and millions of dollars. Etai is what maybe you could characterize as a super, super bear. We are going to have a discussion with him today on a few different topics. We are going to start out here talking about how Etai sees the US stock market developing over the coming months. Etai, welcome to the program.
Eyal Capital Management CEO Etai Friedman: Hi, how are you doing? Thank you for having me.
CK: Yeah, doing great. Thanks for asking. We had a great discussion a couple weeks ago. I was happy to get connected with you. You were talking about some of the other guests that we have had on the program, of course, doom and gloom Marc Faber, Peter Schiff. You said these guys do not even come close to what I see happening with the economy and the bear market we are going to enter into and you provided some very compelling proof as to why you see things unraveling in the way that you do. Give us a high level overview of where you see the economy at right now.
EF: Okay, I will say this just to make it perfectly clear. I am not one of those permabears who has been bearish for a number of years. I did not, in fact, become bearish until July of 2015 and that was prompted by a widening of credit spreads across the spectrum that always catches my attention. They had been pretty tight since 2013 and they started widening significantly over the summer of 2015. That raised a red flag and got me digging into the causes as to what was behind the widening of spreads.
What had happened was I really dug deep into the debt markets and came to the conclusion- I guess I am jumping a little bit ahead, but I came to the conclusion that we are, in fact, at the end of, I guess, here they refer to the commodities cycle, as a super cycle. We are at the end of a debt super cycle in the world, not just in the United States. That means that the world is not able to service any more debt at this time and the amount of debt outstanding in the world is roughly around $225 trillion.
If you go back through history the last crisis we had in '07, '08, '09, the world debt was at around $140 trillion. Now that crisis was caused by too much mortgage debt and too much debt in general.
What you find, if you dig historically, into what the Federal Reserve has been doing over the last 25 years, you find that the Federal Reserve has propagated this debt bubble. They have used debt to get the US economy out of trouble, so to speak, or more specifically not even the economy but the financial market. Whenever we had very severe turbulence in the financial markets the Federal Reserve, starting in 1987, which they had not been doing before then, stepped in and started offering liquidity and stimulus for the banking system to keep the financial markets steady and to prevent systemic financial crisis from overwhelming the financial market.
It started in '87. That was really the year that the Fed put was brought into being. Then in 1998 was long term capital. Once again the Fed intervened. Then in 2000-2001, the Fed intervened again when the tech bubble collapsed. This time they used interest rates to soften the blow of the recession and the stock market collapsed. That was really when the debt creation kicked into overdrive. Because from 2001, 2002 to 2007, I believe $18 trillion in debt was created in the US economy. The whole expansion after the tech bubble was really a debt-fueled binge that came to an end in 2007. Once again the economy faced an existential crisis, actually this time instead of the Fed letting a lot more of the indebted entities collapse and disappear.
The lesson of being over leveraged, being warned by market participants, everyone, except Lehman, was bailed out. The amount of moral hazard that was introduced to the marketplace in 2008, 2009 was really quite tremendous. You can see a lot of it manifested today. For instance, subprime mortgages no longer are all the rage, but subprime auto loans had become all the rage. The similarities between the two are extremely striking being that subprime auto loans are really driving auto sales at the moment and these loans are being packaged up and sold as asset backed securities.
You have some of these loans and, of course, they were all being rated Triple A. But some of these ABS securities- I have let us say 20% of the loans within a given issue do not even have credit scores. I mean if you want to get a car loan right now literally you do not need a credit score. You do not need any credit. You just need to show up and have a heartbeat and you can get a car. Maybe it will have to be a used car, but you will walk off the lot with the car in hand. It will be a 7-year note. You have negative equities as soon as you leave. You have a high interest rate, but it will not require a dime in the bank or any credit whatsoever.
History is repeating itself quite simply because of the moral hazard that the Fed introduced. Long story short we have reached the point where the world cannot service anymore debt, and I say that because if interest rates in Europe and Japan have gone negative, in the US they are close to zero. I expect them to go negative within the next 12 to 24 months. Negative interest rates send a very powerful message which is no one has the ability or the inclination to take on more leverage. Just like when very high interest rates indicate high inflation, very low to negative interest rates indicate deflation, indicate the slowing of velocity of money, indicate that people do not want leverage. When we go into our next recession, which I believe we are headed into as we speak, the tools that the Fed has grown quite accustomed to using which is inducing the public and businesses to create debt or to take on more debt is not going to happen this time around.
We are actually going to have a full blown deleveraging like we had in the '20s and '30s. I guess from the perspective of the severity of the situation, a deleveraging of a debt bubble is pretty much the most horrific thing you can experience in the economy because it leads to outright deflation. It leads to wealth destruction. It leads to lower incomes. It leads to much higher unemployment and the Federal Reserve is powerless to stop it. That is kind of the summary of my thesis and where I am coming from and how I am looking at the markets.
CK: Well, thank you for that. I am going to actually read off of an online profile I found of you which outlines, I guess, a very short version of your thesis. It reads: "Global markets and economies are at the end of a super cycle in debt that had global debt at $200 trillion in 2014, $60 trillion higher than in 2007. This debt bubble is created by central banks namely the Federal Reserve and their response to every financial crisis since 1998.
The Fed fulfilling its mandate for full employment lowered interest rates during every financial crisis since LCTM failed. By lowering rates, the Fed encouraged people and businesses to take on debt to stimulate the economy. This came to a head in '07 but once again the Fed intervened by dropping rates to zero and by purchasing debt securities in open market to push down long term interest rates."
This is a great summary you put together here. At the end it says, "At the moment the US high yield debt, a $1.2 trillion dollar market, is imploding." My question for you is we are in uncharted territory. This has not really happened before, but you are comparing it to kind of the deflationary crash that we had in the Great Depression back in the '30s. On our call a couple weeks ago you pointed to some indicators such as Tobin's Q of why today is so bad and why we have hit call it the top, why the crash is imminent. Why do you think that the crash is imminent right now?
EF: I think it is imminent because first of all I do not accept the consensus belief that China is growing at 4%, 5%, or 6%. It does not matter. There is absolutely no evidence to suggest that there is any growth in their economy whatsoever. I would point to first and foremost the commodities market seeing as China is the biggest consumer of commodities in the world. The fact that commodity prices are at 25-year lows is a major red flag.
Another red flag is commodity shipping prices are actually half the level they were the month after Lehman collapsed in 2008. That is pretty startling and astounding because it does not feel like the month after Lehman in the rest of the world, but in the commodity shipping market basically the commodity shipping market is dead right now. There is over supply. There are huge ships cape size ships that are sitting, idling in port in Singapore and around the world that have no cargo whatsoever to carry. When they do have orders and cargo to carry the prices they are charging are rock bottom. They are record lows, 31-year lows.
It is just in my mind it is impossible to conclude that China is growing and at the same time there are no commodities being shipped to and from China at the moment. It does not make sense despite the fact that they are making a transition from an industrial economy to a more service-oriented economy. They are a very heavily industrial economy and by all measures and anecdotal evidence the industrial part of their economy is at a standstill. There is actually a Purchasing Managers' Index that was being done privately in China, Caixin PMI. The last reading of the Caixin PMI was in the 42 to 43 range, with, of course, anything under 50 indicating a contraction.
Now 42 to 43 will correspond to the US economy in the second and third quarter of 2008 and the best part about this survey is that the Chinese government about six weeks ago came out and suspended it. They literally stopped it from being published. Now the only thing that is coming out of China is the official government data which everyone knows is complete non-sense. It does not mean anything. Their government data is simply what they want the world and their public to think their economy is doing. No part is based on reality.
I do not even know why services like Bloomberg report China's economic data because it is nonsense. I mean the Caixin PMI is at 42, but the Chinese government, their official Chinese government data, says their PMI is at 50.2 or 50.3. I mean they are never going to admit that they are in a recession. Ever.
CK: Yeah, well, that is a very good point that you bring up. You are quite modest in your previous discussion of the subprime auto loan catastrophe that you see happening. You are actually quite possibly the very only person in the world to have done a trade against the subprime auto loans in its very recent trade. It is a pretty funny story and that you are not really allowed to talk too much about it, but what can you tell us about the trade that you are in there?
EF: Yeah, well, unfortunately, subprime after 2008, 2009 became a four letter word at most banking institutions in the US. There was a lot of negative publicity attached to those people who bet against subprime housing using customized CDS as exemplified by- I forgot his name. The guy who wrote The Big Short and the movie, of course, that came out, The Big Short.
CK: Michael Lewis, yup.
EF: That is right, Michael Lewis, who talked at length about these CDS that were constructed on customized subprime indices by savvy clients who recognized what was going on. This time around the action is not in subprime mortgages because they are basically are not any subprime mortgages being originated. I mean there are but we are talking in the billions, not the hundreds of billions, like they were in '06 and '07.
Now what is going on is the subprime activity is all focused on the auto sector and it is actually driving auto sales. I started reading about what was going into these loans and I also started following the delinquency rates of subprime auto loans. The delinquency rates are exploding. The credit quality of the borrowers is it is a joke. I mean it is really like a copy cat of the subprime mortgage situation in 2007, meaning you have people who should not be getting loans who are getting loans and these people are most assuredly going to default on these loans very soon. But these loans are being bundled up into ABS and sold off with triple A ratings.
It is hard for me to say unsuspecting investors but I guess that is what you have to call it. The opportunity was too good to pass up. The problem was finding a bank to do a trade with. There are some banks - I am not going to mention any names - that if you call them and you mention subprime, just the word subprime they will literally hang up the phone on you.
The bank that I ended up doing my trade with was somebody who I had a long professional working relationship with, over ten years of trading going back to when I was at SAC Capital. We do a lot of business together and they actually did me a favor by helping me construct the trade that I put on in the fall and then I took off in January because I was worried about liquidity. The trade, I cannot say it was a homerun because I did not hold it as long as I wanted to, but I made quite a bit of money on the trade and I was grateful of that. I was able to actually put the trade on. But this is a sector of debt that is- I mean it is going to get decimated. I mean there is really going to be a lot of things that are going to be getting absolutely decimated. But the stuff that they are putting in these loans or I should say into these ABS. It is a joke. I mean 20% of the loans have no credit scores, 20% of the loans have credit scores below 600. It is about as toxic as it gets.
CK: How large is the auto loan business? Is it anything that compares in size to the housing bubble which, of course, crashed an entire economy?
EF: No, subprime mortgage was like $1.2 trillion I believe and subprime auto is in the hundreds of billions. It is definitely much smaller obviously because each individual loan is much smaller than the individual subprime mortgage loans. But it is enough that it is going to cause some waves. But I do not know that you are going to see a breakdown in finance come from this corner of the credit market. I think more broadly you are going to see it come from the junk bond market because there is a lot of debt that was underwritten over the last couple of years that should not have been underwritten. The parallels between subprime mortgages and junk bonds are actually quite strong, and the performance of high yield debt over the last couple of months has proven that.
CK: Yeah, and I wanted to ask you, kind of already answered this, but have you identified an individual basket of debt that is likely to crash the economy? Just said junk bonds but I am thinking student loan junk bonds specifically tied to the oil sector. Is there any individual thing that you have honed in on or is it an unknown because so many things are over levered?
EF: It is a great question. I have been kind of trying to really- it is almost an arrogant exercise to try to figure out what is going to be the inflexion point in the market? What is really going to cause people to reassess the values of financial assets in a dramatic fashion? I think it is either going to come through a major bankruptcy or bankruptcies in, let us say, the energy sector or it is going to come from the Chinese recession manifesting itself somehow.
Right now the consensus believes China is growing so it is not manifesting itself in any way that- well, I should not say that because if you look at the dry bulk shipping industry which is on the verge of going bankrupt in its entirety you can certainly argue that there are places that the Chinese economy's problems are manifesting itself, but not enough to the extent that people are marking down financial assets around the globe.
They started to in January then we had a bit of relief rally. We bounced. I think we were about to start our next leg down. But the catalyst for a big unwind, it is a tough call. I mean I find it hard to believe that it is going to come out of the financial sector because that was where the last crisis started and history seldom repeats itself with such exactitude, another crisis coming from the financial sector. But at the same time banks in Europe and banks exposed to China are seeing their credit defaults swaps trade at financial crisis levels.
You have a bank like Deutsche Bank that has a $2 trillion balance sheet and $66 billion in tangible equity. They do not have a lot of room for error at Deutsche Bank which is very reminiscent to Lehman Brothers. Deutsche Bank CDS is trading higher than it was in the '08, '09 financial crisis which is extremely striking. I say on the one hand I do not see problems emanating from the financial sector or that being the starting point of the collapse. But when you look at a bank like Deutsche Bank and their precarious financial situation it is hard to ignore. Just a slight shift in the value of their assets, of their balance sheet and their equity is going to be wiped out. That is going to be the end of Deutsche Bank.
CK: Okay, well, this is such an enlightening conversation. Unfortunately, time is a restriction. But there is one topic that I would like to discuss today because the sector has started to move in earnest over the last few weeks. We can have broader discussions on our next chat. But the gold space and the gold mining space, we talked about this a bit before we hit record, just how difficult it is for traders who are watching the mining space. It really is convincing that a bottom is in; that this is the safe haven bid of the environment that we are in is gold. But if that is not the case we have just had this huge move and a lot of these companies are up 50 and 100% already. I hate to jump in at the wrong time, right? What is your feeling on gold and gold mining stocks?
EF: Well, about two or three months ago, I will just use the XAU, the Philly Gold/Silver Index was trading at a level that corresponded to $300 an ounce gold. Gold stocks had caught my interest and I did some short term trading of the stocks. I was really just trading in and out of them every couple days, not playing for any big move. I thought that as this crisis unfolds, this massive crisis that is going to dwarf '08, '09, I thought gold is going to have a role to play. The question is is it going to be a safe haven or is its role going to be something that comes later down the line when the central banks figure out a way to actually create a real high rates of inflation which I think they would opt for over really terrible deflation.
It is not entirely clear to me that they can orchestrate that process, but you have guys like Ray Dalio talking about helicopter money right now before much of anything has happened. Gold stocks in the last month have had this tremendous move. Gold has had a tremendous move. It is acting like a safe haven. Now I am starting to- well, I watch it closely every day. I just did not know if it was going to participate in the early round of this unwind or not. The answer appears to be yes.
Now I am forced with chasing what has been a pretty big rally in the last six weeks although if you pull up a five-year chart of gold mining stocks the rally over the last two months was like a blip compared to where they were. If you put it into some perspective the move is not that big. They just are not the screaming bargain that they were two months ago. I literally overlay the XAU over gold prices and the level of the XAU two months ago was exactly where it was when gold was at $300 an ounce in the late '90s. The mining stocks were trading extremely cheap to the commodity. That is no longer the case.
Now it is just a question of do you wait for a pull back? Do you jump on board? Do you chase the rally a bit? For me, personally, it is an extremely tough call. I do not have anything on in this sector. Of course I am a little upset by the fact that I missed out on this beautiful rally that we have had. But I will tell you this I am looking for a pull back to enter the space. But I just have this bad feeling that there may not be any pull back, that this move just may go on without any material breaks.
Gold, high on my radar screen, but I am not really doing anything about it. I mean I do not have the conviction level for gold that I have, let us say, for US treasury bonds, for instance, which I think have already begun to be a homerun. I think we are going to have negative interest rates in the US within the next year or two. Treasury bonds, if you believe that, certainly have ways to go in terms of price.
But, anyway, in reference to gold I think I will get involved. I will just wait for a very serious pull back before getting involved. In case this is a head fake move and this really is not a safe haven after all you do not get burned buying gold mining stocks up 50, 60, 70, 80%. That is about it. It is a missed opportunity for me.
CK: Well, summing up, the great unwind has begun, China not growing at all in your opinion, and another great depression likely ahead with equity prices to come down 60, 70, even 80%. You are the guy who has put on a successful short of the subprime auto loans which nobody is really even talking about, so congratulations there.
Etai, thank you so much for coming on the show. I know you have a busy schedule and lots of money that you are sitting there managing for people. I appreciate you taking the time out of your schedule. Maybe we can get you back on the show to discuss some more actionable trades that you are looking at doing.
EF: Absolutely, absolutely! I appreciate you having me. It was really my pleasure talking about it. I love talking about it. I almost feel like it is my duty to warn people as to what is lurking around the corner. I really do not want to see large groups of people getting hurt by what I think is coming. I would say my conviction level is about as high as it gets.
CK: Yeah, and have you seen The Big Short, Etai?
EF: I read the book. I saw the movie. I actually, in '07, when I was at SAC in June of '07, I convinced Steve Cohen to buy about $80 million worth of VIX futures when the BIX was trading at $15. This was really math. Investment grade credit spreads went from 25 basis points to 100 basis points in about four weeks. It was once in a lifetime opportunity to buy equity volatility. We did. We killed it with the trade. I remember it. I lived it. I traded it. I will say that the book is a hell of a lot better than the movie. But that is just my opinion.
CK: Yeah, okay, well, thanks for that. Etai, thank you again for coming on the show and looking forward to having you back soon.
EF: Thank you very much. Take care.
Etai Friedman is the CEO of Eyal Capital Management, LP and former head of equity-derivatives trading at MKM Partners.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.