The Masters of the Universe Invent a New Plaything

Remember CDOs? Get ready for CFOs

“Fools and their money are easily parted” is an old adage. But it seems that the world is full of very clever fools whose wisdom falls an algorithm or two short of their own self-assumptions.

It is perhaps no coincidence that the cryptocurrency trading platform FTX, whose collapse has triggered the failure of a number of other houses of crypto cards, was the brainchild of some extremely smart geeky products of Stanford University. Led by the extravagantly named and dressed Sam Bankman-Fried, then in his 20s, this little group united self-support and self-regard for their own trading genius to create a monster of multiple-leveraged debt that caused billions of dollars of losses to those who had faith in the digital currencies which they issued or with which they traded.

Whether dishonesty was involved has yet to be determined. But those who bought into the hype and into something they clearly did not understand have mainly themselves to blame.

None of this would have been possible without the generous cash support of organizations supposed to look after other people’s money, providing both credibility as well as hard cash to what proved an ever more leveraged enterprise. So, what, for instance, was the due diligence done by Singapore’s sovereign wealth fund Temasek? Or was Temasek just a victim of the collective hubris of the Masters of the Universe, the Wall Street elite who make billions by putting other people’s money at risk in the “heads I win tails you lose” situation which took over when risk-sharing investment bank partnerships were replaced by limited liability enterprises.

Of course, funds such as Temasek must invest some of their assets in start-ups and forward-looking ventures. But Temasek does seem to have a particular weakness for the “latest things” out of Silicon Valley, Wall Street and China. The super-smart Singaporeans however may not be a match for their peers in such real rather than derived founts of creativity. Temasek’s write-off of its US$275 million investment in FTX-related assets was a particularly extraordinary plunge into a seemingly lead player in a rapidly growing crypto and fintech world. 

Official Singapore proved too eager to jump into this world as well as trying to cultivate it as the latest thing in financial services, another way to get a jump on Hong Kong. There is little doubt that the backing of names such as Temasek enabled FTX to gain traction and respect that it did not deserve and was soon to bring down a whole host of crypto assets and exchanges.

Not that Hong Kong was entirely uninvolved. Bankman-Fried’s operation was based in Hong Kong until shifting to Bermuda in September 2021. The city’s much-touted recent Fintech week was followed by the collapse this week of a local crypto exchange, Atom Asset Exchange, and there are doubtless many local and mainland investors who are on the receiving end of the losses sustained by the whole sector.

That number will probably never be known. Nor probably will be the beneficiaries of the crypto boom – those behind the currencies, funds, and exchanges who got in early and out in time. For every loser, there is a winner – even if only the purveyors of luxury items acquired by the suddenly rich and their companies.

For those in Singapore in particular the Temasek FTX investment had some echoes of its 2007 investment of SFR 11 billion in the Swiss bank UBS (Union Bank of Switzerland) by its fellow sovereign wealth fund the Government Investment Corporation (GIC) shortly before the 2008 global financial crisis. It ultimately lost about US$4 billion on the deal. That US-driven implosion followed years of excessive loan growth and was exacerbated by new financial instruments which enabled the securitization of loans and the repacking of variable quality debt into higher class assets.

The main – but by no means only – villain of that disaster was the asset class known as Collateralized Debt Obligations (CDOs). These enabled banks and secondary financial institutions to rev up lending by assembling packages of mortgages and various loans which could be bundled as securities and sold in tranches to fund managers and individuals.

In the process, banks avoided some capital requirements and also lowered the apparent risk level of the underlying assets by spreading it widely and cutting it into different levels. CDOs could make sense for individual institutions but on a large scale and in many cases they were secured on assets financed by the issue of short-term commercial paper which proved toxic to a whole system. Hence the collapse of Lehmann Brothers and all that followed in the US and internationally.

With memories of 2008 in the background and the FTX disaster in the foreground, it was interesting to read in the Financial Times on November 28 of Temasek’s major involvement in a newly revived instrument with some characteristics similar to CDOs. This is the Collateralized Fund Obligation (CFO) Instead of being secured on debt, this is essentially leveraged security invested ultimately in a broad range of private equity and buyout situations. As the FT put it: “Stakes in hundreds of companies owned by private equity firms have been bundled into investments with strong credit ratings”.

According to the report, one of the leading issuers of such CFOs is none other than an offshoot of Temasek named Azalea. The CFOs it spawns have access to strong credit ratings and investment in private equity funds run by the likes of Blackstone and KKR and, in turn, are invested in a wide range of what seem like high-risk/high-reward corporate situations. Income from the funds is used to pay bondholders and other creditors and the rest to the originator of the CFO. Why anyone else, say a pension fund, should want to buy a fund where the benefit of leverage goes only to the originator is a mystery.

Insofar as they remain entirely within a closed private sector loop, the CFOs may seem a harmless enough piece of Wall Street entrepreneurship to which the likes of Temasek have attached themselves. In reality, however, there is only a glass curtain between such institutions and the regulated banking system and at a time of rising interest rates, wobbly asset prices after years of rapid growth in low-cost money, casualties are likely.

Azalea is relatively transparent because retail investors can access it, but little is known about the CFO asset class as a group – let alone how much might have been lost by some CFOs in from FTX-related assets. Nor, for that matter, how much has been lost from the crypto crisis by those who contributed to the US$250 billion invested in 2020/21 in those bubble-era classics Special Purpose Acquisition Vehicles (SPACs), black money boxes invented for and on behalf of the investment banking industry.

The crypto boom and bust may have been in a different category from CFOs and SPACs but was as much driven by near-zero interests rates, suspicion of central banks, and entrepreneurs searching for a new way to a quick buck as it was by the technological innovation behind blockchains.

As for booms and busts in general they usually involve frauds at some point – today often dressed up as incompetent accounting. But their genesis lies more in a mix of new and misunderstood instruments and opportunities with human conditioning. The latter at times likes to cast aside reason in favor of dreams, in the hope or expectation of an unstoppable bandwagon of change and prosperity.

In that context, it is worth mentioning how even the cleverest get caught up. The famous mathematician Isaac Newton was involved in the early 18th-century London market boom and bust known as the South Sea Bubble, an event that wiped out the savings of thousands and left an indelible mark on English law and society. A practical person and a mostly-successful investor, Newton bought early into an originally legitimate start-up trading venture, the South Sea Company. It was aiming to profit from the increasing globalization of trade, including slaves. He sold out early on in its rise, based on what proved bogus profits but bought back in again when it was reaching dizzying heights. Momentum investing is fine while it lasts but the music too often stops without warning.