Oct 21, 2018

Axios Capital

By Felix Salmon
Felix Salmon

Situational awareness: I'm coming to London! I arrive at the end of this week. The schedule is pretty tight, but it would be great to meet some Edge readers.

1 big thing: Dangerous non-banks

Illustration: Lazaro Gamio/Axios

The most likely cause of a future financial crisis isn't the banks, it's the non-banks. They're enormous, they're much less regulated than banks are, and they tend to have much greater leverage.

  • Never forget that when the U.S. financial system fell apart in September 2008, the bank (Lehman Brothers) was deemed small enough to fail. It was the insurance company (AIG) that was too big to fail and needed a $182 billion government bailout.
  • Today, the most systemically dangerous non-bank in America is Prudential, the insurance company. Prudential remained on Treasury's "too big to fail" list of systemically-important financial institutions even after all the other non-banks fell off it: GE Capital, AIG, MetLife.
  • Now, even Prudential is officially considered no longer systemically dangerous. The Financial Stability Oversight Council, under the leadership of Treasury secretary Steven Mnuchin, has officially removed the insurer from the list.
  • “We are pleased with this decision, which affirms our longstanding belief that Prudential never met the standard for designation," said Prudential in a statement. "Prudential’s approach resulted in the Council’s appropriate conclusion that Prudential does not pose systemic risk."

The official explanation for why Prudential fell off the list is not very helpful, since a lot of important numbers have been redacted. But the numbers that remain are scarily large.

  • Prudential is not huge by conventional stock-market standards: Its market capitalization is just $42 billion, and its book value (assets minus liabilities) is $48 billion.
  • But those assets and liabilities are truly enormous: According to the FSOC report, Prudential has $832 billion of assets, and $778 billion of liabilities. Compare its rival Berkshire Hathaway, which has $702 billion in assets but a much more modest $350 billion in liabilities.
  • Prudential also has an eye-popping $1.4 trillion in financial assets under management.
  • The biggest number of all: Prudential has $3.7 trillion of life insurance. That's about 20% of U.S. GDP.

The weirdest part about the FSOC's decision is that they all but say explicitly that Prudential is systemically important. A couple of quotes:

The Council therefore determined that the negative effects of Prudential’s material financial distress could be transmitted to other financial firms and markets through the exposure channel, which could cause an impairment of financial intermediation or financial market functioning sufficiently severe to impose significant damage on the broader economy.
The Council concluded that such a forced liquidation of assets could cause significant disruptions to key markets, including corporate debt and asset-backed securities markets, particularly during a period of overall stress in the financial services industry and in a weak macroeconomic environment.

Why it matters: Expect further migration of risk from banks to non-banks now that the FSOC has made it clear that it has no interest in regulating the latter.

Insurance companies are regulated primarily at the state level — which, in Prudential's case, means New Jersey. They can also be inherently extremely dangerous.

  • Prudential's entire market capitalization could be wiped out with $42 billion of unexpected losses on its life insurance portfolio. That's just 1.1% of its portfolio.
  • Can such a thing happen? Yes. Look at the number of healthy men, in their prime earning years, who dropped dead during the AIDS epidemic of the 1990s. Most of those men didn't have life insurance. But if they had, a lot of insurers would have become insolvent.

If a large unexpected mortality event saddled Prudential with a lot of claims, its massive life-insurance claims would only be the beginning of its — and the country's — problems.

  • Millions of policyholders would start moving their life insurance somewhere more stable, precipitating the insurance equivalent of a run on the bank.

The bottom line: Prudential could be forced to start liquidating its assets at fire-sale prices, which could set off a chain reaction in the rest of the financial markets and even the economy as a whole.

2. How the anti-Saudi movement snowballed

Illustration: Aïda Amer/Axios

High-level CEO conferences are self-fulfilling. Important people attend them because important people attend them. It's a mechanism that works just as effectively in reverse.

  • The genius of the "Davos in the Desert" conference, as unveiled last year, was that a large number of CEOs would feel compelled to attend, just to maintain their relationships with the king and the crown prince. That core group then created enough critical mass to attract everybody else.
  • The most successful conferences tend to be multi-day affairs in remote locations (Davos, Aspen, that kind of thing). That format maximizes the probability of serendipitous interactions. And, for a while there, it looked like it could work in Riyadh.
  • But, but: No one wants to feel uncomfortable at such things, or hypocritical. And they certainly don't want to feel that they have to watch everything they say, for fear of offending their hosts.

CEOs are human too, and feel real revulsion at the idea of a Washington Post journalist being tortured and killed.

  • The business leaders who waited before they pulled out of the Saudi conference desperately wanted some kind of Saudi signal that their concerns were being taken seriously.
  • The Saudis didn't (or couldn't) provide what the CEOs needed. All of the Saudi messaging has been literally unbelievable.

Thus did the 2018 Future Investment Initiative unravel. The exodus started with the media types: Andrew Ross Sorkin of the New York Times, Zanny Minton Beddoes of the Economist, Patrick Soon-Shiong of the Los Angeles Times.

  • Soon there were barely any media sponsors left, as CNN, CNBC, Nikkei (which owns the Financial Times), and Bloomberg all departed in quick succession.
  • Among the media types withdrawing from the Saudi conference was Arianna Huffington, who's also a board member at Uber. Before long, Uber's CEO, Dara Khosrowshahi, was also out, along with World Bank president and Partners In Health co-founder Jim Yong Kim.
  • By early this week, JPMorgan Chase CEO Jamie Dimon, BlackRock CEO Larry Fink, Blackstone CEO Stephen Schwarzman, Ford Chairman Bill Ford, and MasterCard CEO Ajay Banga were all out.

The bank CEO departures were only partially based on moral considerations; after all, they still planned on sending underlings to keep their Saudi relationships alive.

  • Fink gave an uncharacteristically revealing interview to CNBC on Tuesday. He declared himself "a friend" of Saudi Arabia, said that he wanted to preserve his relationships with the country, and outright refused to sever ties even if it was proved that the king or crown prince had ordered Jamal Khashoggi's torture and dismemberment.
  • Fink's reasons for pulling out of the conference center on preserving other relationships, with employees and clients who were horrified at the headlines. "What I wanted to do was have this conference delayed," he said, adding that the Saudis "understand that we have many different constituents that we have to balance out."
  • Fink, by his own admission, wanted the U.S. government to pull out of the conference before him. Instead, it was the other way around: Treasury Secretary Steven Mnuchin finally withdrew on Thursday. Only Fox News was slower to the exit.

How will the Saudis react to the international community ganging up on them so publicly? The fear is that they will weaponize the international oil market. But that's unlikely. Saudi Arabia itself would be the biggest victim of such a move.

  • Saudi Arabia is now accepting responsibility for Khashoggi's death. As such, it's hard for the Saudis to retaliate too hard against people and institutions who blame them for just that.
3. The parallel universe of unicorns

Illustration: Sarah Grillo/Axios

It's big-IPO speculation season. Lyft wants to go public next year, with a sought-after valuation in the $15 billion range, which is flat to its last private round.

  • That Lyft valuation is lower than the valuation of Uber Eats, at least if you take the pitch decks from Goldman Sachs and Morgan Stanley seriously. Uber as a whole, we're told, could be worth as much as $120 billion in an IPO, which maybe explains how it raised $2 billion almost effortlessly in the bond markets this week, despite the fact that it's burning through more than a billion dollars a year.

The bottom line: In Unicornland, everything is always sunny and optimal.

Consider the valuation of Palantir, which somehow is considering going public at a capitalization of $41 billion.

  • That's 55 times its 2018 revenue, a valuation which makes $120 billion for Uber (a mere 11 times this year's revenue) look downright modest.
  • Palantir is 14 years old; it's not a startup any more. And its growth rate of about 25%, while strong, is hardly stratospheric.
  • Morgan Stanley reportedly cut its internal valuation of Palantir by 47% last year. It's hard to see what has happened between now and then that would have reversed that trend so dramatically.

The world of public markets is crueler. Tencent has lost $250 billion of market value in the past nine months.

4. Trump's growing deficit
Expand chart
Data: Factset; Chart: Naema Ahmed/Axios

The most recent U.S. government fiscal year just ended. The budget deficit grew by 17% from the previous year, thanks to Trump's tax cuts.

By the numbers: If you look at the breakdown of Treasury receipts in fiscal 2018, almost every category went up, year-on-year. Individual income tax receipts, for instance, rose by 6%, or $96 billion.

  • The exception: Corporate income taxes. They totaled $297 billion in fiscal 2017, and just $205 billion in fiscal 2018. That's a decline of $92 billion, or 31%.

Trump is acting true to history. Every Republican president since Reagan has left office with a budget deficit higher than the one he inherited. Clinton and Obama, by contrast, left office with smaller deficits.

5. How much are you worth?
Expand chart
Data: FactSet; Chart: Andrew Witherspoon/Axios

Sears filed for bankruptcy this week, and its owner, Eddie Lampert, is warning employees that absent "material progress over the next few months," the fate of the company is going to be "a shutdown and liquidation."

  • Sears hasn't made any visible "material progress" since Lampert took control of the company in 2005. The chances of it doing so now are slim.
  • Lampert is a master of financial engineering, but the way that this bankruptcy plays out is now largely out of his control.
  • Sears could easily go the way of Toys "R" Us: An outright liquidation, with tens of thousands of employees losing their jobs.

The bottom line: There are good bankruptcies, which discharge legacy debts and allow the company to continue anew. And then there are bad bankruptcies, which cut off supply chains and result in outright liquidation. Bad bankruptcies inevitably result in thousands of job losses — and Sears is looking like it's going to be one of them.

  • Worryingly, there are many other companies which are worth very little on the stock market but which have thousands of employees relying on them to make payroll every month.
  • JC Penney, another troubled retailer, has 98,000 employees and a market value of just $5,600 per employee. Pier 1 is worth only $7,000 per employee.
  • Netflix, by contrast, has a market capitalization of some $27 million per employee, with a workforce of 5,500.
6. The labors of Clegg

Illustration: Rebecca Zisser/Axios

Nick Clegg has a herculean job ahead of him at Facebook as the incoming head of PR and global affairs. It's almost impossible to keep up with the sheer breadth of negative headlines about the company.

  • Most urgently, Clegg has to grapple with a lawsuit close to many journalists' hearts. Facebook, by inflating the number of video views on its platform, precipitated innumerable "pivots to video" wherein people-who-write-things were laid off and video producers were hired (and then fired when the video views never materialized). Expect people-who-write-things (a superset of newsletter writers) to stay on this story like glue.
  • Politicians have greater clout than journalists, however, which means that the bigger problem for Clegg is a shareholder proposal to oust Zuckerberg as chairman of Facebook.
  • Rhode Island, Illinois, Pennsylvania, and New York City have all signed on to the proposal. They don't have the votes to push it through, but there's more to this proposal than counting votes. Part of Clegg's job is to keep important politicians happy, and it's clear what important politicians want, in this case.
  • Recent Silicon Valley history is littered with examples where vote-counting doesn't matter. Consider Elon Musk being ousted as chairman of Tesla, or Travis Kalanick's defenestration at Uber. Consider, even, the way in which Mark Zuckerberg dropped his plans to issue new non-voting shares, despite having the voting power to push the change through. Zuckerberg has enough votes to stay on as chairman. But that doesn't mean he's safe in the job.

The bottom line: Among Facebook’s biggest problems is that it lost a huge amount of public trust and credibility thanks to having been nefariously used in the election of Trump. Clegg, who lost credibility after entering into a coalition with David Cameron that allowed the U.K. Conservative party to attain power, may or may not be the perfect person to help Zuckerberg navigate the consequences.

  • Advice for Clegg from Axios CEO Jim VandeHei: Radically self-regulate, or allow government regulation. Maybe it takes a new FCC of social media to force the same standards as expected from TV stations and newspapers. One thing is for sure: The current self-policing isn't cutting it.
7. The perils of being free
iStock / Getty Images Plus

Free ain't what it used to be. Back in 2009, it was a radical idea, extolled in books by the likes of Wired editor Chris Anderson. Today, it's inherently suspect, on the grounds that if you're not paying, you're the product being sold.

Robinhood made its name by offering free stock trades; now, the backlash has arrived.

  • The scandal concerns the fact that Robinhood gets some 40% of its revenue by selling its customers' order flow to high-frequency traders. All retail brokerages do this.
  • The customers aren't hurt by this; they still get fantastic execution. But high frequency traders have a bad reputation, thanks to the flash crash and a certain Michael Lewis book.
  • I was unimpressed by Lewis's argument, but no one's litigating the merits of high-frequency trading here.
  • The real issue is the lack of transparency at Robinhood. If you're going to give away a service for free, it behooves you to be very clear about how you're making your money. If you're not, your customers are likely to feel misled when they find out.
8. Blockchain quote of the week
iStock / Getty Images Plus
"Blockchain has been heralded as a potential panacea for everything from poverty and famine to cancer. In fact, it is the most overhyped – and least useful — technology in human history ... Far from ushering in a utopia, blockchain has given rise to a familiar form of economic hell."
— Nouriel Roubini, The Big Blockchain Lie
9. This week: Amazon, Alphabet, cannabis

Illustration:Rebecca Zisser/Axios

  • More than 150 S&P 500 companies will release earnings this week, including tech bellwethers Amazon, Alphabet, Microsoft, Twitter, and Snap, writes Axios' Courtenay Brown. Go deeper.
  • Plus we’ll get 3rd quarter GDP. Economists say growth cooled a bit, so it would be a surprise to see another 4.2% annual growth rate (sorry, President Trump).
  • Aurora Cannabis will start to trade on the New York Stock Exchange Tuesday, under the ticker symbol ACB. Until now, its only listing has been in Toronto. Expect volatility.
  • Are you feeling lucky? The $1.6 billion Mega Millions lottery jackpot drawing is happening Tuesday night. It's almost a good investment! The lump sum option is $904 million, and the odds of winning it are 1 in 302,575,350. A pair of "just the jackpot" tickets will set you back $3. Think of it as a consumption purchase: you're buying a dream.
10. Building of the week: A prewar kit home
A Sears kit home in Boston. Photo: Boston Globe / Getty

In the decades before World War II, Sears sold tens of thousands of house kits. Some, like the Magnolia, were extremely grand, but most, like this two-bedroom craftsman-style bungalow in Boston, were much more modest.

Felix Salmon