The decade of ultra-low-interest-rate Bernankeism in the 2010s, which produced ziggurats of misguided investment, has left a huge amount of overhang in the worldwide debt markets, which must at some stage deflate and be written off. Big-city real estate and tech stocks form a large part of this overhang. However, the largest element, most dangerous because it is almost or completely invisible to ordinary investors and analysts, is that created by the insidious techniques of financial engineering. Financial engineering structures are driven by the desire to hide leverage, by which they enable its increase, to an inordinate extent. They are inherently opaque and should be severely frowned upon by the regulators or even prohibited altogether. The recent increase in interest rates, especially that in real interest rates, is causing this hidden tower of funny-money Babel to totter; its collapse is probably only weeks away.

First, an apology. In the early days of the profession, I was a “financial engineer” managing a “financial arbitrage division” most of whose operations tended in one way or another to hide leverage and allow leverage to increase through risk management. Of course, the market for financial engineering was both small and undeveloped at that stage. Interestingly, some projects my division rejected as impracticable because of the risk exposure involved and the arbitrariness of its determination, notably the credit default swap, were subsequently taken up by those with more employer risk tolerance and/or less scruple.

The most immediate danger appears to lie in the private credit sector. This has arisen because of the tight restrictions on banks applied by the 2010 Dodd-Frank Act and the easy money that the Fed has allowed the banks to earn by borrowing at relatively high interest rates from them to bloat its balance sheet. Those two changes have led banks to be very wary of private sector credit exposure on their balance sheet, but enthusiastic for the bonus-enhancing front end fees that could be earned on large syndications, especially where they involved high risks in which the banks only modestly participated. Given the huge amounts of money seeking places to go under the decade of Bernankeism, private credit funds were formed to supply the debt financing that banks no longer would.

Since private credit funds achieved their own returns through leverage, financing themselves from the banking system (which could report those loans as low-risk, since they were taking only the top slice of risk from a financial institution’s portfolio), some of them became (as “Business Development Companies”, BDCs) almost the only source of medium-term financing available for small businesses, as the banks were no longer lending much. As the only source of funding for businesses that needed the money, BDCs were able to raise the interest rate “spreads” above Treasuries on their lending much higher than did the banks. This became still easier with ultra-low rates, since even with bloated spreads, the final borrowing cost was still relatively affordable by the small business incurring it.

Everybody involved rewarded themselves with large up-front fees and paid themselves equivalently large bonuses. Much of the BDC’s equity was raised from income-seeking retail investors, who did not realize – poor saps – that the juicy dividend yields on BDCs were achieved by giving retail investors all the credit losses on leveraged small business lending, so that the net asset value of their shares degenerated, often at a higher annual rate than their dividend yields. As always with financial engineering, somebody at the end of the chain is the sucker, and retail investors are very often that somebody. The same will apply to retail investors who invest in private equity; they are the parties in those transactions with the least political or financial pull, so will inevitably get the worst deals and the most disgraceful treatment.

Since 2022, interest rates have returned closer to market levels, with the U.S. government now paying a modest margin over the rate of inflation for its money, and yields on Treasury Inflation Protected Securities rising temporarily above 3%, an unheard-of rate since their inception in the late 1990s. Naturally, this is producing severe stress in the private credit sector. Small businesses are finding it more difficult to service their debt and, while private credit lenders will allow considerable optimism in business projections seeking debt renegotiations (which of course involve extra fees) there are limits to this, especially when the renegotiation is the second or third such confrontation for a particular borrower. Of course, each renegotiation has extracted substantial fees, so after multiple renegotiations the borrowing company may well be fatally wounded by its lenders’ repeated greed.

Private credit loan losses appear to be soaring and given the concentration of these loans in relatively few industries, the whole sector could soon come crashing down, in a similar way to the subprime mortgage sector in 2008.

There are other vulnerabilities resulting from financial engineering. Almost all public companies have engaged in exorbitant stock buybacks, benefiting their top management with stock options, but rendering their cash flows and balance sheets very unstable indeed. While interest rates were near zero, this was not especially problematic, indeed it was encouraged – companies were borrowing at low cost to invest in a higher-return asset, their own stock. The motivation for this activity was of course a derivative scam – top executives’ holdings of stock options, which benefited directly from the buybacks. These had been issued in wild profusion, without proper accounting of their costs to shareholders, after a truly idiotic 1993 piece of legislation that made base salaries above $1 million (a number that has not been indexed) not tax-deductible for companies, while allowing full deductibility of “Incentive Compensation” such as bonuses and stock options.

However, higher interest rates make stock buybacks much more of a problem and the ongoing destruction of balance sheets may in many cases have made further borrowing to stave off disaster impossible. At that point, there will be only one recourse: an emergency share issue, at a price far below that at which stock was repurchased. As always, retail investors will pay the price of this in further dilution of their holdings, while management simply reprices its stock options. Some substantial percentage of these disasters will declare bankruptcy, wiping out large amounts of debt and equity; the recent stresses in bond markets suggest we may be very close to that outcome.

Another derivatives usage that is likely to cause trouble is the use by “hyperscaler” tech companies such as Meta, Oracle and Alphabet of off-balance-sheet financing to fund their data centers. They create a shell “special purpose vehicle” which finances itself with 90% debt from private credit funds (which have fewer leverage restrictions than banks) and the other 10% by equity, albeit only say 20% of that equity from the hyperscaler itself, the rest typically from private equity funds. Credit support is given by an offtake agreement or a residual value guarantee (which is very likely indeed to run into trouble, given the glut of data centers being built currently). This allows the hyperscalers to retain essentially all of the risk of the data center without disclosing that risk on their balance sheets. The total volume of these deals outstanding is believed to run around $800 billion in total financial support currently and is growing very fast. For the historically minded, this is a structure similar to that used by Enron to finance its assets off-balance-sheet, and we know how that ended.
(Disclosure: I have a modest holding of Oracle put options.)

Leopold Aschenbrenner’s hedge fund Situational Awareness LP, which collapsed during the month of July from a value of $45 billion to under $10 billion, was sold to Citadel in a fire sale and cost the trading house Jane Street an estimated $15 billion in the same month. Its implosion indicates both the size and the potential speed of collapse of these hidden “financial engineering” structures.

With a grown-up now at the Fed in Kevin Warsh, but children still pretending to control the U.S. budget deficit, adding to it by unnecessary wars and utterly irresponsible Supreme Court decisions on tariffs, a near-term collapse is almost inevitable. After all, Silicon Valley Bank, the 16th largest bank in the U.S. collapsed in 2023 because of a simple holding of U.S. Treasuries in a period of gently rising interest rates. My guess would be October for the cataclysm’s occurrence — historically a very good month for financial disasters because of the seasonal monetary tightness at the Northern hemisphere harvest time.

Let me make it entirely clear, however. If a crash comes and proves painful, as is likely, the principal blame should be placed not on current policymakers, certainly not on the estimable Kevin Warsh, but on former Fed Chairman Ben Bernanke, who inaugurated the regime of negative real interest rates. Yes, he left the Fed after 2013, but in Shakespeare’s words attributed to Mark Antony: “The evil that men do lives after them.” As a result of his activities, we have owed a vast debt to sound financing since around 2010; that debt is finally coming due.

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(The Bear’s Lair is a weekly column that is intended to appear each Monday, an appropriately gloomy day of the week. Its rationale is that the proportion of “sell” recommendations put out by Wall Street houses remains far below that of “buy” recommendations. Accordingly, investors have an excess of positive information and very little negative information. The column thus takes the ursine view of life and the market, in the hope that it may be usefully different from what investors see elsewhere.)