What stock’s trading volume has increased the most in the last 30 days for Robinhood day traders? It’s not bankrupt Hertz or Tesla, but Genius Brands (GNUS), a children’s entertainment company which got noticed when its Kartoon Channel digital network was picked up by Amazon Prime, Apple TV and Comcast. Shares soared 995% on the news since the announcement on May 5.

Day traders are doing what day traders do, and when markets are up they are pretty cocky. It is well documented now that many sports betters have turned their attention (or addiction) to the stock market and are playing their hands there. Many have flipped their stimulus checks. Some have gambled it all in options and some have lost is all shorting the market.

Some may be fascinated by the short term run up in stocks like Hertz but if you zoom out of the present, you can see that the interest from Robinhood is inverse to the actual long term value of the company, which is the ultimate judge of where the price falls.

The unofficial “captain” of these new age style day traders is Dave Portnoy, the founder of Barstool Sports, an entertainment and gambling site synonymous with the “bro” frat culture. Portnoy has 1.5 million Twitter followers and has made pronouncements that have made significant impacts in stocks like InspireMD Inc and the airline ETF JETS. Penn National Gaming bought a stake in Barstool Sports for $163 million in January contributing to a net worth for Portnoy which he estimates being around $100 million. Having only claimed to have bought a stock once in his life before the pandemic, he decided to gamble $3 million in the market in March and claims to have seen a 400% return since then.

Source: CNBC

The above stats don’t reflect his claim to have a 400% return and at the end of the day, he has a platform that allows him to say whatever he wants. Despite that, it’s not implausible in this type of market, taking speculative bets on worthless or risky stocks, to see a return like this in a short amount of time.

However, all of this day trading is going to be a short lived phenomenon. Portnoy himself admitted on CNBC that once sports is back, he would likely stop speculating on stocks and return to gambling on sports. This is welcome news to long term investors because the longer that uninformed retail investors stay in the “game” the higher the likelihood that many will get burned and want to blame someone else. Then the lawyers show up and sue, the lawsuits spawn legislation which ends up getting passed which becomes annoying rules and regulations that regular market participants have to deal with long after the punters leave the market.

For all of you messaging me and asking me how to start making returns like these, my message is consistent: I don’t speculate in stocks like Hertz, Chesapeake Energy or Genius Brands. I am a long term investor that understands most people and even most professionals do not beat the market over long periods of time. For this reason I keep most of my money diversified among index funds and the few direct real estate investments I manage. I keep a small portion for “fun” investing, my macro bets, options, shorting, leveraged bets, single company bets etc. I recommend to most people who want to start actively following the market and investing to start with the index funds as a base and then invest no more than 5% to 10% of your portfolio in the active or “fun” portion. The reason for this being that this will keep you actively engaged in the market but a big loss will not blow up your portfolio. In all likelihood, the “active” portion of your portfolio will trail the market over a long enough time horizon but it serves an emotional purpose in the sense that it keeps you engaged and feeling like you have some control over how your investments perform.

Notice that Portnoy is an entertainer and entrepreneur, he likely made most of his money from that Penn National investment and now only plays with 3% of his purported portfolio on these risky bets. This should be a warning sign for those of you betting your stimulus checks and year’s worth of savings on these gambles and throwing a significant chunk of your net worth at the latest shiny thing, you are likely being played by the real rich folks. Check out my last post to understand more.

On to the CLO’s

I want to depart from my recent discussions on bro and Robinhood traders to return to a topic where I have some more technical expertise: banks and their balance sheets. Collateralized Loan Obligations, or CLO’s are the latest hot incarnation of risk transformation in the securitization space. Essentially, these are securities that gather up leveraged loans which are risky, high interest loans to indebted borrowers or private equity funds, slice them up into tranches of varying risk and dole them out to everyone based on their risk appetite. Hedge funds and asset managers get the risky portions to make their bets and hedges, while banks and insurance companies get the AAA rated portions which give them a margin boost to the loans on their books for income.

Source: BIS, note that FO = Family Office, MF = Mutual Funds, SCF = Structured Credit Funds, HF = Hedge Funds

The Bank for International Settlements or BIS, notes that CLO’s seem to share a lot of similarities with a dirty acronym from the financial crisis: the Collateralized Debt Obligation, or CDO. CDO’s were like securitizations of securitizations and many blew up during the crisis and almost brought the entire global financial system down along with mortgage securities. They sat on the balance sheets of banks and pension funds. They destroyed the capital of those banks and caused irreparable damage to some of those same pension funds, the consequences of which we are still feeling today.

A recent article in The Atlantic written by a former CLO structurer and current law professor, the author claims that CLO’s are little different from CDO’s and Dodd-Frank has done almost nothing to keep banks away from these type of investments. As having spent some time early in my career working in securitization, I have some basic knowledge of the topic around the products and he has some fair points.

• The first being that the claim that CLO’s are diversified are bunk. They are diversified if you assume a typical downturn where some industries suffer more than others but in this Covid downturn, all physical industries have suffered which is unprecedented.
• The other being that some of these assets are held in offshore Variable Interest Entities (VIE’s) of which investors have little to no visibility on the actual underlying assets and how they are performing.
• Finally he has a strong argument that bankruptcies this time will be different. With large names like Hertz, JCPenny and Neiman Marcus declaring bankruptcy, the courts are going to be overwhelmed and have a backlog of cases which will likely have an effect on the timing and recovery value of the debt held by creditors. Past defaults of leveraged loans assume a 70% recovery rate in the worst case scenarios but again, we aren’t in a typical downturn.

The BIS published a table showcasing the difference between CDO’s and CLO’s and there are a lot if worrying similarities.

The market size and the underwriting standards are worryingly similar. The savings glut of cash has been so desperate for returns in the past few years, borrowers have used this to their advantage to demand covenant light loans that barely enforce any check on their performance by lenders if things go awry.

Indeed, worrying signs started to already show up last year in the market as the whale buyer in the market, Norinchukin Bank, a Japanese cooperative bank that manages the deposits of Japanese farmers and fishermen, stopped buying CLO’s after it experienced a $3.7 billion loss on its $71 billion portfolio of CLO’s, which constitutes 10% of the market. The bank owns only the safest portion of those CLO’s or the AAA tranches so just like in the crisis, a loss like this is not something that should have happened. Worryingly enough, banks like JP Morgan and Wells Fargo didn’t report any losses on their $30 billion holdings in CLO’s, likely just due to reporting standards and accounting differences between the US and Japan.

The key difference with CLO’s compared to CDO’s which is also worth noting is many of the CDO’s were attached to assets that had monthly payments, like mortgages, car loans and credit cards. The CLO’s are attached to assets that have quarterly payments, which is why we may not start to see the cracks in the securities until the highly indebted companies that pay out to these CLO’s like Party City and JCPenny either have long run out of cash or have a slowdown in their restructuring due to the backlogs in the bankruptcy courts.

Not All Bad?

A mild rebuttal to the Atlantic article was published in Bloomberg today with some valid points. It mostly dealt with the probability of actual default on highly rated tranches. Default rates would have to reach levels of 70% to 80% before even the AA tranches started to see losses assuming a 60% recovery rate. The author also notes that the Atlantic article uses absolute numbers for impact, $30 billion dollars on the balance sheet of Wells Fargo is 1.5% of assets.

Although this is true, markets are sometimes based on perception and as Norinchukin found out, even if the securities will still pay, if the market drops 5% and Wells is forced to mark to market those securities, that would represent a $1.5 billion loss which would have to be recognized in their quarterly statements. This is not an insignificant amount considering the fourth quarter of 2019 for Wells brought in $2.87 billion. This is also at a time when provisions will likely be increased for bad loans and further impacting profitability. Bad news on top of bad news is never good for banks with memories of the crisis not far away in the minds of investors.

Then again, maybe the Fed and day traders will come to the rescue and flip perceptions on their head, it wouldn’t be odd to see at this point given all that has happened so far this year, and we are only halfway through.

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