We were supposed to be in a recession by now, at least if you listened to mainstream economists. The exact opposite happened: Unemployment is down near a half-century low, consumers keep spending, and residential real estate demand remains insatiable. The dire forecasts started in mid-2022 and reached a fever pitch at the start of 2023, when 40 out of 44 respondents in a Bloomberg survey of economists said a recession would hit that year.
Executives fretted on TV news about a slowdown. Stock market strategists cranked out pessimistic calls. Investors who listened too closely could have made a costly mistake, missing out on a technology stock rebound and a 24% gain in the S&P 500 index in 2023. In January of this year, the S&P 500 notched an all-time high.
Things could still turn ugly from here. But the difficulties that economists, traders and corporate leaders have had in divining the near future say a lot about the times we’ve been through. Everyone knows how the Covid-19 pandemic scrambled expectations, but for financial decision-makers the roughly two-year period since March 2022 has been its own kind of chaos. As soon as Federal Reserve Chair Jerome Powell began lifting the benchmark interest rate off near-zero, in an effort to tamp down the fastest spurt of inflation in a generation, crystal balls cracked and playbooks were thrown out the window. Here’s a look back at some of the notable miscues, mistimings, head fakes and outright flops since the end of the easy-money era. —Katia Dmitrieva
Economic Forecasts—What Are They Good For?
Brett Ryan, senior US economist at Deutsche Bank AG, was among those on Wall Street who saw a recession forming last year. He’s still worried, and now he expects growth to contract slightly this quarter and next. “Everybody’s had to eat a large piece of humble pie—there are plenty of opportunities as economists in forecasting to embarrass oneself,” he says. “But the utility is this: It’s more about how the risks are evolving than it is about nailing the forecast most accurately.”
Ryan echoes other economists in arguing that the point of forecasts is really to help make contingency plans and put weightings on uncertain outcomes. “Forecasting is essential—we do it every day ourselves,” says David Andolfatto, chair of the economics department of the University of Miami and a former researcher at the Federal Reserve Bank of St. Louis.
Some of the earliest economic forecasters were ancient Egyptians, who built tall stone columns with markings to gauge the water level of the Nile. The technique, strictly performed by priests and rulers, would help farmers to gauge harvests and officials to plan taxes. Today the public has better access to the tools economists use. There are more than 50 widely followed indicators in the US, including payrolls, the consumer price index and manufacturing output. Outside variables and risks such as the Fed’s approach or regional conflicts also play a role in forecasting. Many economists feed these data into some version of a probit—short for probability and unit—that also relies on Treasury yield curves. There’s also the Bayesian vector autoregression, named after the 18th century Presbyterian minister and statistician Thomas Bayes, whose work now forms the basis of modern-day models of chance.
The pandemic and its aftermath made some of the data economists work with more volatile. The Fed, which both responds to economic data and creates its own as it manages interest rates, arguably became harder to predict as it tried to be flexible. Still, some critics of mainstream economists are less than forgiving of failed prognostications. “It’s a waste of time,” says writer and independent economist Steve Keen, who’s on a short list of those who forecast the 2008 financial crisis, “because they leave out the fundamental, cyclical drivers of the economy and then try to predict where the economy’s going to go.” Keen argues that observing private credit is a better predictor.
The 2023 recession call wasn’t the biggest miss in economics: That title may go to analysts about a century ago, who failed to foresee the Great Depression. (Granted, the industry was then in its infancy.) Or perhaps to those who failed to see the dot-com or the 2008 credit crisis. Economists tend to struggle with big turning points in the economy such as recessions or credit shocks, according to the late Victor Zarnowitz, who made a career of studying business cycles. It makes sense: A shock is what happens when most people wake up in the morning to discover they were wrong. If nothing else, economists’ public predictions are useful for knowing where the consensus is, and whether you’re betting on it or against it. “You will almost always get the numbers wrong,” Morgan Stanley chief US economist Ellen Zentner recalls a colleague telling her. “But it’s important that the narrative is right.” —K.D., with Alexandre Tanzi
The Fed Was Wrong But Still Did It Right
Right now there’s hope the Federal Reserve has pulled off what many thought impossible: cooling inflation without a recession, and doing so even though its economic forecasts have been wrong. At the start of 2023, the Fed’s economists predicted that the economy would barely grow and that its preferred inflation gauge would keep running hot.
The lesson: In enormously uncertain times, it’s best to stay flexible. With the waning of the Covid-19 pandemic, Fed Chair Powell and his fellow policymakers have faced one unknown after another. How will supply chains heal? Can the financial system handle the end of near-zero interest rates? How will consumers respond to the end of stimulus? And so on. Instead of rigidly following so-called forward guidance, they relied on real-time data in making policy decisions. After initially misjudging the pandemic-led price surge as “transitory,” the Fed raised rates quickly and did a better job than most expected in restoring price stability. Then it surprised markets again late in 2023 by signaling that rates had peaked.
“I would give it an A, honestly,” says Ed Al-Hussainy, an interest-rate strategist at Columbia Threadneedle Investments, of the Fed’s performance. “They said: ‘Look, we just don’t believe the forecast anymore. We’re just going to become very data—dependent.’ ” Of course, it’s still too early to declare that Powell and his colleagues have achieved a rare soft landing. The last time the Fed did that was in 1995, a feat that helped cement then-Chair Alan Greenspan’s reputation as the Maestro.
Alan Detmeister, an economist at UBS Investment Bank, points out that historically it often looks like the economy is heading toward a soft landing before a recession hits. “To get from point A to point B—from a really tight market to a recession—you have to go through this period that looks really good, and I think we’re likely to be seeing that right now and in the next handful of months,” he says. “So, becoming too cozy and thinking we’re moving immediately back to a low-volatility period would be a mistake.”
One risk, says Tim Duy, chief US economist at SGH Macro Advisors LLC and a veteran Fed watcher, is that the Fed keeps rates too high for too long. “Inflation has fallen more quickly than they expected, and by their own models,” Duy says. “They would have to adjust for that, and they haven’t adjusted for that yet. That’s why I’m not entirely sure we can evaluate whether mistakes have been made or not.” —Ye Xie and Matthew Boesler
Bonds Kept Surprising Almost Everyone
Bond investors have been tested by false dawns and volatile shifts in the past couple of years. Few anticipated just how brutal 2022 would turn out to be—the Bloomberg US Aggregate Bond Index lost 13%—and even some of the most successful money managers in fixed income say it was hard to get the timing of the rebound right. “We were very constructive on the outlook for 2023 a year ago, and there were times where that looked smart and then silly,” says Gene Tannuzzo, global head of fixed income at Columbia Threadneedle Investments. “And then in the last two months, it suddenly looked smart again.”
Bulls are optimistic that yields have recorded their highs for this cycle: above 5% in October for the benchmark 10-year Treasury. In December the Federal Reserve signaled increasing potential for interest-rate cuts in 2024 as inflation cools and economic growth glides down to the much-hoped-for soft landing. (Bond prices rise as rates and yields fall.) That shift spared the market from what could have been a third straight negative year of returns in 2023.
Still, bond managers are war-gaming the potential for surprises from here. “A soft landing was October’s trade,” says Stephen Bartolini, a fixed-income portfolio manager at T. Rowe Price. “We’re already there, and you need to start thinking about what’s going to happen in the next six months.” He says two less likely but very real possibilities must be considered: The soft landing could turn into a recession, or the economy could reaccelerate, which could put pressure on the Fed to keep interest rates high.
A silver lining from the biggest bond rout in generations is that Treasury yields remain high by recent historical standards. Should the economy falter, a bond market priced for a soft landing would find more buyers, since yields would be seen as a port in the storm for equity investors and asset allocators. “While bonds at 4% are not as high as they were in October, they are still elevated in the post-financial-crisis regime,” says Roger Hallam, global head of rates at Vanguard Group Inc.
It’s a point that investors—who’ve parked nearly $6 trillion of cash in money-market funds, enjoying a 5%-plus return for now—ought to consider as the year unfolds. Unlike with bonds, those yields aren’t locked in. “Staying in cash implies significant reinvestment risk, at a time when short-term yields are likely to trend lower,” says Sinead Colton Grant, chief investment officer at BNY Mellon Wealth Management. —Michael MacKenzie
Stock Strategists Missed the Mark
Consider this losing streak for Wall Street strategists: In 2021 the S&P 500 closed 18% above their average estimate. The year after that, the index tanked 22% below the consensus. In 2023 the stock market defied the odds once again, delivering double-digit returns despite a regional bank meltdown, recession fears, higher interest rates and bearish forecasts.
Over almost a quarter century of data, there’s essentially zero correlation between equity strategists’ year-ahead predictions and what US stocks have actually done, according to a Bloomberg analysis. And yet setting a target for the S&P is a hardy annual ritual for analysts at big banks as well as niche investment firms. Some say the exercise is a tool for sharpening their thinking. It also gives investors a benchmark, so they can compare a stock’s expected performance with that of the broader market. “People tend to gravitate toward the number,” says David Kostin, chief US equity strategist at Goldman Sachs Group Inc. “The outside world sees that number, and they kind of think it’s just a number, but there are a lot of things that go behind it.”
The targets are also a kind of vibe meter. Rather than taking the numbers at face value, investors should read them as a signal of whether an analyst sees more risk or opportunity ahead, says Savita Subramanian, head of US equity and quantitative strategy at Bank of America Corp. “I think it’s probably the least important number that we publish, but it’s the number we’re all judged on,” she says. “Having a point-in-time number target is a spurious level of precision we’re probably not going to hit.”
Many investors stick to broad asset allocation plans, and seeing a bearish or bullish number may only change their strategy around the edges. Some strategists take the same approach themselves. Morgan Stanley’s chief US equity strategist, Mike Wilson, predicted throughout 2023 that the S&P 500 would end at 3,900—it closed out at roughly 4,770—and he remains bearish for 2024. Yet he told Bloomberg Television in September that the asset allocation model used for the firm’s wealth management business was only slightly underweighted in equities.
Trivariate Research LP founder and Chief Executive Officer Adam Parker, who was once in Wilson’s shoes as Morgan Stanley’s top US equity strategist, says market calls fall into a two-by-two grid—bullish, bearish, right and wrong—and analysts who stay in the role long enough will eventually land in all four quadrants. Parker says that most institutional investors know S&P 500 targets are going to be off and that lots of factors and surprising news can blow up a forecast. “At least they can understand the logic you bring to bear and the distribution of outcomes you see as likely, and what probabilities you assign to them,” he says.
But why put out such a specific number that you are bound to miss and that few people take seriously? Maybe just that tradition is hard to change. “We’re always debating whether or not we should continue to do it because it gets lost,” says Michael Kantrowitz, chief investment strategist at Piper Sandler & Co. Kantrowitz entered 2023 with the lowest expectation for the US stock benchmark among his peers, at 3,225. The S&P 500 closed 48% above that level. “The value we provide for our clients is not what the S&P is going to do,” he says. —Alexandra Semenova
A Bank Bungled
Banks borrow from depositors for a short time and lend to others for a long time at a higher rate. That’s inherently risky, which is why the industry is heavily regulated. The failure of Silicon Valley Bank—the second biggest since 2008—was a reminder that it’s possible to mess up the formula even without making particularly risky loans. You just have to misunderstand your depositors and the Federal Reserve badly enough.
SVB catered to the Bay Area tech elite, and its deposits more than tripled during the easy-money era, when startups and founders were drowning in money from venture capital. Many parked such large sums that the vast majority of the bank’s deposits didn’t qualify for insurance. Although those deposits could be withdrawn on a moment’s notice, SVB jammed the money into securities that wouldn’t mature for years in pursuit of extra earnings. These weren’t toxic mortgages; the credit quality was sound.
But when the Fed began hiking rates in early 2022, the value of SVB’s securities dropped as higher-yielding alternatives became available. Meanwhile, startup funding was drying up, and many of SVB’s clients were spending down their deposits. These factors put the bank in a sticky spot: The demand for ready cash from its customer base exceeded what it had on hand.
It’s not as if no one saw this coming. Three months before SVB failed, its chief financial officer, Dan Beck, was interviewed at an industry conference run by Goldman Sachs Group Inc. Analyst Ryan Nash pressed Beck on the cash burn among SVB clients, the bank’s deposit levels and its asset-liability management. But Beck appeared confident. “We’ve designed the balance sheet to be able to sustain pretty significant stress,” Beck said at the time.
Regulators charged with overseeing SVB were also concerned about its balance sheet. Its rapid growth during the pandemic earned it more senior team examiners at the Federal Reserve Bank of San Francisco, who quickly slammed the bank with a series of formal warnings including, crucially, a demand that it improve how it handled interest-rate risk.
The situation got increasingly dire, and SVB was left with no choice but to sell some of its securities at a loss. When it rolled out a plan to do so, depositors got spooked and tried to pull $42 billion in one day—a quarter of SVB’s total deposits from the week before. With that, regulators stepped in to shut the bank down. (SVB now operates as a unit of First Citizens BancShares Inc., which bought it in a government-led auction.)
SVB was by no means the only bank squeezed by spiking interest rates. What made it uniquely vulnerable was its popularity with early-stage companies, which take marching orders from their VC backers. On SVB’s last day in business, when a cadre of VC funds advised their portfolio companies to move their deposits as a precaution, the anxious entrepreneurs listened—and ignored Greg Becker, then SVB’s chief executive officer, when he beseeched clients to “stay calm” and support the bank as it had supported them over the years. —Hannah Levitt
The Magnificent Seven Returned
Coming into 2023, the Nasdaq-100 index had just suffered its worst annual performance in 15 years, corporate profits were shrinking, and tighter money was making risk-taking expensive again. A recession seemed imminent, and the pandemic-era you-only-live-once mood had faded. Betting on technology-driven growth giants such as Apple Inc. and Meta Platforms Inc. seemed like a failure to read the room.
In hindsight, that’s exactly what traders should have done. The seven most valuable companies in the S&P 500 index— Alphabet, Amazon.com, Apple, Meta, Microsoft, Nvidia and Tesla—soared thanks to cost-cutting that drove profits higher and an unexpected artificial intelligence boom. The group added more than $5 trillion in total market value and delivered roughly two-thirds of the benchmark’s gains for the year. “I was late to the rally,” says James Abate, chief investment officer at Centre Asset Management LLC. Nvidia Corp.’s bullish sales forecast in May “really caught me flat-footed, and it was probably a wake-up call for every fund manager,” he says. It sure was: In January of 2023, hedge funds’ exposure to tech stocks was near a multiyear low as companies worked to improve their profit margins. But by late September, hedge funds’ tech exposure was near peak levels, according to data compiled by Goldman Sachs Group Inc.
The so-called Magnificent Seven have become a proxy not only for Big Tech but for the entire economy, which has averted the downturn that Wall Street expected. “We were in the recession camp, but the economy held up way better than we expected,” says Stephanie Lang, CIO at Homrich Berg. The wealth management firm was underweight in US equities in 2023 and remains so this year in anticipation that higher borrowing costs are still going to take a toll. “Were we wrong, or is a slowdown just delayed?” she asks.
Keith Lerner, co-CIO of Truist Advisory Services, says that even though he missed out on the first five months of the tech rebound last year, he wouldn’t have done anything differently. Truist entered 2023 light on equities, but Lerner changed his tune in June by bumping up US stocks to neutral. “It’s been a humbling experience,” he says. “If you manage money and make a big call that’s wrong, there’s a higher bar compared with strategists on Wall Street who don’t oversee a portfolio. We feel the heat differently, because this is real money on the line—not just a call.” —Jess Menton, Jeran Wittenstein and Ryan Vlastelica
Tiger Cubs Acted Like a Herd
A hedge fund’s job is to spot lucrative trends early and bet before the masses do. But in the rush to ramp up their venture investments in recent years, some created their own crowded trade. These funds—including some firms run by “Tiger Cubs,” alumni of Julian Robertson’s Tiger Management—piled into both startups and later-stage growth companies, battling each other for deals and helping to drive valuations to record highs.
Coatue Management, D1 Capital Partners, Lone Pine Capital and Viking Global Investors have taken huge markdowns since the beginning of 2022 on the value of many private companies they backed. But no other hedge fund firm bet as fast or as furiously on venture as Tiger Global Management, founded by Chase Coleman, who started the firm in 2001 with a $25 million investment from Robertson. Since 2019 the firm has raised more than $25 billion from investors, which it put to work backing nearly 900 startups, according to data provider PitchBook. It marked down its private portfolio by 6% last year and about 33% in 2022. Tiger Global’s hedge and long-only portfolios, which invest in tech stocks and make venture bets, each lost more than half their value in 2022. Its hedge portfolio bounced back 28.5% last year, but it still has to return about 90% to recoup its total losses.
It’s harder to get clients to commit money for venture bets now. Although firms have found trading opportunities, the pace of deals has slowed, and their dollar amounts have dwindled. Coatue created a fund that lets clients invest in late-stage startups at better prices and fees, though it had to shutter a European office as it shifted staff to the US. Both Coatue and Viking have raised pools of cash to help startups—including ones they’ve backed—keep going without having to raise money while industry valuations are low. —Hema Parmar
A Housing Giant Tried to Grow Too Fast
No, this isn’t another story about Evergrande and China’s ailing property sector. In Sweden, Samhällsbyggnadsbolaget i Norden AB, better known as SBB, is fighting for survival after a string of credit downgrades and a 90% tumble in its share price. The landlord oversees an unusual $11.5 billion portfolio; its debt-financed properties, including schools, rent-regulated apartments and community centers such as elder-care homes, are tied up with the Nordic nation’s welfare state. Not so long ago, investors thought this was a brilliant idea. SBB was the best performer in the Stoxx 600 index of European stocks, rising 137% in 2021. It was a similar story in the bond markets, where investors rushed to lend the real estate group more than $6 billion in the space of a few years.
SBB was founded in 2016 by Ilija Batljan, who came to Sweden in the 1990s as a refugee of the civil war in his native Yugoslavia. Drawing on his connections from a career in Swedish municipal governments, he amassed a portfolio of more than 2,000 properties. His formula: snap up buildings from cash-strapped local authorities and lease them back, while buying rival property firms.
Stock and bond investors were sold on the idea of steady growth in what Batljan called “the world’s safest real estate asset class,” anchored by reliable, long-term tenants. Batljan even pledged to increase SBB’s dividend for the next 100 years. In 2021 he announced an aggressive plan to build 15,000 apartments over the next five years and more than double the value of the company’s portfolio, to 300 billion kronor ($29.1 billion). Like other property companies in Sweden, SBB relied on short-term bonds to finance most of its business activities. Then borrowing costs surged on the back of interest-rate hikes and concern for the real estate sector’s prospects. In May of last year, Standard & Poor’s downgraded SBB’s credit rating to junk. Batljan stepped down as chief executive officer, though he remains on the company’s board.
SBB stumbled into a pitfall of its own making. Unable to raise more bond debt, it had grown too big for the Nordic loan market. Swedish banks are more exposed to commercial real estate than other lenders in Europe, making them unlikely to provide help for a struggling landlord. SBB said in November it was unable to access unused credit lines of 3.5 billion kronor.
That’s left SBB with two options: It can sell properties or raise more equity. Batljan’s successor, Leiv Synnes, says he won’t offload assets at steep discounts. To attract shareholders, Synnes is planning to break up the company, making housing, school and community assets separate. That might help investors see the assets in a new light. “Good assets get financing one way or another,” Synnes says. “We have an occupancy rate of 96%, with long-term contracts, so the company and its properties will continue to exist.” —Charles Daly
Smacked by SPACs
As a pile of bankruptcies keeps growing, one thing is clear about the SPAC fad: It was built on a lack of understanding. Many starry-eyed corporate executives and retail investors didn’t grasp the costs built into these complex deals to take companies public through the back door.
Special purpose acquisition companies are publicly traded shell corporations that raise money from investors to do just one thing: find a private company to merge with. After the deal, the private business inherits the SPAC’s public stock listing. While “blank check” companies have been around for decades, they soared in popularity in 2020. Retail investors were willing to pay high prices for SPAC shares before deals in hopes of getting in early on a hot new company. The deals were also seen as a way of avoiding some of the regulatory hurdles and costs of a conventional initial public offering.
But new costs were soon revealed. Executives gave large stakes in their companies to the blank-check sponsors in exchange for arranging the deals but didn’t always raise as much money as they hoped. As part of the SPAC structure, investors in the shell companies—often hedge funds—have the option to take their cash out plus interest before the deal is complete. Target companies in merger negotiations can set a minimum amount of cash that the sponsor must deliver or the deal is called off. For nearly half of the mergers completed in the past two years, the minimums were $10 million or less. Some executives late to the mania were desperate to finalize deals quickly, says David Erickson, a former capital markets banker and a lecturer at the University of Pennsylvania, while others may not have been sophisticated enough to know they were bringing in far less money than they needed.
Retail investors in SPACs, meanwhile, failed to appreciate that the blank-check companies were likely to fall in value after a deal because of the rich compensation for sponsors and early investors. And once the era of ultralow rates ended, money-burning companies that went public via SPAC had a harder time raising additional capital. The typical company that completed a deal after March 2022 has seen nearly three-quarters of its value wiped out.
For the more than 175 SPAC deals that have closed in the last two years, 90% saw investors redeem about three quarters of shares or more, according to SPAC Research data analyzed by Bloomberg. That means a company like Chijet Motor Co. brought in less than $20 million from its SPAC deal, a far cry from the $140 million in potential proceeds it touted in October 2022. The blank-check company it merged with, Jupiter Wellness Acquisition Corp., traded for $10 before the tie-up, but shares in mid-February traded for about 40¢. Hoverbike maker Aerwins Technologies Inc., which was expected to get a cash infusion of more than $110 million from its SPAC deal, reaped just $1.6 million for the company after about 99% of its shares were redeemed. That stock’s gone from $11 premerger to around 10¢. Jupiter and Aerwins didn’t respond to requests for comment. Chijet says that despite setbacks to its financing plans, it is confident that it will be “able to take advantage of other opportunities that are available in the market.”
Bank-check mergers have resulted in roughly two dozen bankrupt companies in the past two years. And about 170 SPAC-spawned stocks will likely need more financing in the next year for the companies to keep operating, according to data compiled by Bloomberg that estimates a company’s cash needs. With that kind of writing on the wall, it’s no wonder that almost 350 blank-check companies have liquidated since 2021 without doing a merger, returning their cash to investors. —Bailey Lipschultz
Why Is It Always Nickel?
In a period of record commodity trading profits, there are still surprising ways to lose money. One of the biggest missteps was made by Trafigura Group, a trading house that revealed last year that it had paid more than $500 million for cargoes of nickel that turned out to contain near-worthless rubble.
It wasn’t the only time nickel hit the headlines. In March 2022 a massive short squeeze in the market almost caused the entire London Metal Exchange to collapse. And last year, JPMorgan Chase & Co. discovered that the material underpinning several nickel contracts it owned on the LME was not, in fact, bags of nickel but bags of stones.
Why is nickel so scandal-prone? One reason is that it’s the most valuable widely traded industrial metal—at $16,000 a metric ton, it’s worth twice as much as copper and seven times aluminum. Unlike silver or gold, it’s transported in ordinary container ships rather than by security vans and jets. And much of the world’s nickel is produced in the form of briquettes that are sealed inside bags. That makes it a little harder to tell whether what’s inside is nickel or just rocks.
There’s also a connection between the LME mess and the Trafigura saga. When nickel prices spiked from $25,000 to $100,000 a ton in just a few days in 2022, it kicked off a chain of events. Citigroup Inc. was financing Trafigura to buy nickel cargoes from companies linked to Indian businessman Prateek Gupta. Gupta’s companies would eventually buy the cargoes back after a period of a few months as part of a “transit financing” deal. But when the price of nickel skyrocketed, so did Citi’s exposure to the trade. And so Citi asked Trafigura to scale the trade back, and the trading house then asked Gupta to buy back some cargoes, according to documents disclosed in Trafigura’s legal battle with Gupta.
The businessman dragged his feet, and eventually Citi requested an inspection of the contents of some of the cargoes. The US bank had already pulled out of the arrangement by the time inspectors arrived in Rotterdam in November 2022 and pried open several containers, only to discover the rubble instead. Gupta hasn’t denied that the containers didn’t have nickel in them, but he claims that some of Trafigura’s staff knew of the scheme—something the company denies—so it can’t claim fraud. —Jack Farchy
CoCos Came With a Nasty Surprise Inside
The sudden fall of Credit Suisse Group AG in 2023 caught some investors on the wrong foot, having bet on the bank’s riskiest debt: The “Additional Tier 1” bonds it issued were zeroed out. Among those nursing losses are fund giants Pimco and Invesco, the flagship hedge fund of Caius Capital LLP, and brokerage and wealth management clients of Japan’s Mitsubishi UFJ Financial Group and Mizuho Financial Group.
AT1 bonds—which are more charmingly known as CoCos, for contingent convertible bonds—are a little bit debt and a little bit equity. They give banks an extra capital cushion. When times are good, they pay coupons like other bonds or can be repaid early, but in a crisis they can be transformed into equity or even be written off entirely.
CoCos became popular among European banks after 2014, when the European Central Bank stressed the need for lenders to strengthen their capital. “It was still a delicate time in the European banking crisis, and banks considered it was cheaper for them to issue these instruments than to issue equity,” says David Ramos Muñoz, professor of commercial law at Universidad Carlos III. Investors lined up because yields were good.
When UBS Group AG agreed to take control of Credit Suisse to stave off its collapse, the Swiss financial regulator that brokered the deal said it would trigger a complete write-down of the AT1s. Meanwhile, Credit Suisse’s stockholders would receive 3 billion Swiss francs ($3.5 billion). Shock and outrage followed, because bondholders are typically ahead of stockholders in priority of payment after an insolvency. Credit Suisse didn’t actually go insolvent, but its AT1 documents included an event for loss absorption without there being an insolvency, making this unusual result possible. “You don’t expect this to happen even though it is true it was in the prospectus,” says Ramos Muñoz. (Caius, Invesco, Pimco and Mitsubishi UFJ declined to comment on their AT1 bets. Mizuho didn’t reply to a request for comment.)
Then came another surprise. Some market participants thought the AT1 market was irreparably broken—who would buy these things now? Plenty of investors, it turned out. While the market for new CoCos stalled immediately after the fall of Credit Suisse, issuance ended last year 34% higher than 2022. “The day it happened for us it was a bad bank dying, so it was the natural order of things,” says Jérémie Boudinet, head of investment-grade credit portfolio management at La Française Group. “It was not sufficient to damage the reputation of the product. It was really perceived as an idiosyncratic situation.” —Irene García Pérez
A Pension Bet Almost Broke the UK
Liability-driven investing, or LDI, is a strategy popular with UK defined-benefit pension plans, which guarantee retirees a fixed payout regardless of swings in financial markets. Once an obscure abbreviation known only to market participants, LDI managed to almost wreck the UK government bond market in a matter of days in the fall of 2022.
To match their assets and liabilities, pension plans that use LDI rely on derivatives that gain value when interest rates go down and lose value when they rise. The terms of LDI stipulate that when the value of a derivative falls, the funds have to put up collateral to cover the loss. That worked well for over two decades, thanks to a near-zero interest-rate environment. But in 2022, when rates started to rise, the funds’ cash and liquid holdings dwindled as they started selling them to pay for collateral.
The situation took a turn for the worse when the UK government, then led by Prime Minister Liz Truss, announced a controversial plan of unfunded tax cuts that sent bond yields soaring in a matter of minutes. Panicked pension funds quickly shed any liquid asset they could get their hands on, but they couldn’t do it fast enough to meet margin calls. As a result, they sold government bonds, too, which sent yields even higher, meaning they had to pay more in collateral. After a chaotic 48 hours, the Bank of England stepped in to stop markets from a complete collapse.
When the dust settled, a parliamentary inquiry found that pension funds and LDI providers—including BlackRock Inc. and Legal & General Investment Management—had never stress-tested for such an extreme scenario because they didn’t think it was plausible. Plans are now expected to keep higher cash buffers, and asset managers are required to structure their operations in a way that allows clients to deliver collateral fast. LDI providers have encouraged pension plans to buy in-house mutual funds as a buffer, so if history repeats itself, at least they won’t have to worry about transferring money to meet margin calls. —Loukia Gyftopoulou
What about crypto?
That’s a whole story—or two—on its own.