Welcome to The Weekly, where our team shares a few thoughts to take you into the weekend. The June 17th weekly is brought to you by Jared Schepis, one of our investment writers.
A comment on contagion
Fourteen years ago, Bear Stearns failed. Overexposed and overleveraged in the infamous subprime mortgage space, Bear Stearns was the first domino to fall in the pending meltdown. There have been countless books and case studies on the causes and subsequent effects of the 2008 financial crisis, analyzing what went wrong and what could have been done differently. In the case of Bear Stearns, the company fundamentally failed because it ran out of money. It was a liquidity crisis, an old-fashioned bank run.
A bank run happens when all depositors want their money back at the same time and the holding entity –the bank – doesn't have enough liquidity or cash to fulfill those redemptions. A run on a bank doesn't always equate to a default. Still, it can be a self-fulfilling prophecy: more panic causes more withdrawals, straining a bank's reserves and leading to insolvency.
Today, the sheer acceleration of crypto's decline is causing widespread panic throughout the nascent industry and drawing parallels to Bear's failure. Crypto lender Celsius, which allegedly held roughly $12 billion in AUM, is freezing withdrawals from clients. Crypto hedge fund Three Arrows Capital went belly up last week, and crypto lending platform BlockFi would have followed if not for the $250 million bailout from crypto exchange FTX.
Any market will have panics and bad actors, but a single sick firm can infect the entire ecosystem. I'm sure Celsius' tentacles stretched far further than the $12 billion it allegedly held under management.
In today's crypto market, borrowers, lenders, and investors facilitate a complex and mutually dependent ecosystem, but their interconnectedness can also break it. Like a virus, one sick firm can infect an otherwise healthy market and bring the whole system down. I will spare you the butterfly effect metaphor, but for Celsius it is as if 12 billion butterflies died. In essence, financial contagion.
Bear Stearns may have been patient zero in the 2008 financial crisis, but Lehman Brothers was the first fatality from the contagion. But, unlike Lehman, Bear Stearns had a backstop: Uncle Sam. The federal government stepped in to nurse the bank back to life, loaning JP Morgan the money needed to buy Bear's bad assets, guaranteeing the sale to JP Morgan.
The government recognized that the threat of complete liquidation was far greater than the $30 billion line of credit it extended to JP Morgan for Bear's assets. At the time, Chairman of the Fed, Ben Bernake, remarked that a Bear Stearns' default could lead to a "chaotic unwinding" of investments across the US market.
Perhaps an even more apt example is that of Long-Term Capital Management, the hedge fund run by Nobel prize-winning economists that blew up in 1998. Its highly leveraged interest-rate swaps swooned investors with eye-popping returns when things were good. But after the 1997 Asian financial crisis, things went monumentally wrong, almost collapsing the global financial system and forcing a government bailout.
Though, in some ways, the Terra, Celsius, and other crypto collapses rival the 2008 meltdown, comparing the crises is like apples and oranges. Not only is there no central bank to bail out the crypto entities, but the space is much smaller and more closely integrated than the big banks.
To elaborate, crypto finance can be divided into two categories: centralized ("CeFi") and decentralized ("DeFi"). In CeFi, trades or transactions occur through an intermediary or entity such as banks or exchanges. In a way, it is very similar to the legacy financial system we are used to, with the assets being cryptos instead of stocks or bonds. In DeFi, transactions are peer-to-peer on the blockchain and enforced by smart contracts.
The most recent crypto collapse and subsequent contagion is primarily concentrated in the CeFi sphere and has less to do with the underlying crypto technology and more with the entities that broker transactions across the crypto market.
Unlike DeFi, where smart contracts manage transactions with clear liquidity requirements and loan-to-value ratios, in the CeFi realm, there are no standard capital requirements. As a result, institutions operating in the Cefi sphere can make deals and lever at their own discretion. Sometimes, as in Celsius' and Blockfi’s case, to their demise.
To some extent, contagion in financial markets is inevitable. If history is any indication, there will always be bad actors and delinquent institutions. What differentiates the dramatic crypto collapse from others is how young, unregulated, and intertwined it is. As crypto continues to mature, it is necessary that the exchanges, lenders, and other participants of the market institute stringent guardrails to prevent one renegade firm from wreaking havoc on the entire ecosystem.
As with all investments, we hope that crypto will yield a risk premium for long-term investors and that patient investors may be compensated for bearing the risk. For those who can withstand the turbulent times, winners may undoubtedly emerge. But for the nascent market's health, we hope past lessons can help heed the trailblazers in this dramatic new space.
An aside on interests
Primarily, we speak from the point of view of shareholders, but other stakeholders are affected by the company's people own. Sometimes, shareholders' interests diverge from the consumer’s best interests. With the price of a barrel of crude oil at its highest in nearly a decade, we might be at that point.
It's been quite a rebound for energy companies when the price of a future barrel of oil sat in negative territory just two years ago. Today with oil prices soaring, energy companies are in a renaissance- seeing meaningful increases to free cash flow.
So what to do with all that extra cash? Usually, companies have four options:
1/ Institute a stock buyback program
2/ Acquire another company
3/ Return the cash to investors in the form of dividends
4/ Invest in capital, R&D, production, or more employees.
For the most part, energy companies are rewarding patient investors with massive dividend increases and instituting share-buyback programs. Chevron is set to buy back $10 billion of its stock, while Exon plans to enact an eye-popping $30 billion share buyback program.
While increasing output could lower prices at the pump, oil companies are contending with the potential for a seismic renewable energy shift in the next 10 years. According to a paper from McKinsey, global oil demand is expected to peak by 2027. How can they justify pouring billions of dollars into a new petroleum project when in 5 years, the rig may be obsolete? We are already seeing the energy giants begin shifting away from oil and natural gas and positioning themselves to lead the renewable energy transition. For example, British Petroleum recently acquired a 40.5% stake in a $36 billion green hydrogen project in Western Australia.
It's not fair to say they aren't drilling more in some places. For example, Exxon is accelerating production in Guyana-the largest oil discovery in the last decade. But, according to Bloomberg, Exxon's first-quarter production was its lowest since 1999.
For shareholders, it's a catch-22. On one hand, we all want lower fuel prices, but increasing oil production today would be a massive misallocation of capital for energy companies in the future. If anything, oil producers are simply acting as proper fiduciaries for their shareholders.
At the end of the day, shareholders want stock prices to go up. The consumer, on the other hand, wants lower gas prices. So it begs the question, whose interests take precedent?
To quote Succession's great Gerri Kellman, "But it doesn't serve my interests…How does it serve my interests?"
In case you missed it
Have a great weekend!
The above content and projections are the opinion of the authors. Any conclusions or takeaways are their own. This should not be considered as investment advice. Investing involves the risk of loss and returns are not guaranteed.
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