‘Many More Problems’ To Follow SVB Collapse, Dalio Says

[Editor’s note: Ray Dalio occasionally conducts “ask me anything” sessions on social media, Reddit first and then, more recently, on Twitter. Not surprisingly, Dalio’s followers were curious to know his thoughts on the second-largest bank failure in US history. On Wednesday, Ray “consolidated” his public answers to various questions in a short post, found below]

Via Ray Dalio

I think that it is a very classic event in the very classic bubble-bursting part of the short-term debt cycle (which lasts about seven years, give or take about three) in which the tight money to curtail credit growth and inflation leads to a self-reinforcing debt-credit contraction that takes place via a domino-falling-like contagion process that continues until central banks create easy money that negates the debt-credit contraction, thus producing more new credit and debt, which creates the seeds for the next big debt problem until these short-term cycles build up the debt assets and liabilities to the point that they are unsustainable and the whole thing collapses in a debt restructuring and debt monetization (which typically happens about once every 75 years, give or take about 25 years).

While in different cycles the sectors that are in bubbles are different (i.e., in 2008 it was heavily in residential real estate and now it’s in negative-cash-flow venture and private equity companies as well as commercial real estate companies that can’t take the hit of higher interest rates and tighter money), the self-reinforcing contraction dynamic is the same. Based on my understanding of this dynamic and what is now happening (which line up), this bank failure is a “canary in the coal mine” early-sign dynamic that will have knock-on effects in the venture world and well beyond it.

Because one man’s debts are another man’s assets and most people are levered long (i.e., they are holding assets financed by debt), when interest rates rise and money becomes tight, assets fall in value, which hurts debtors, creditors, asset holders and financial intermediaries, which causes a self-reinforcing contraction and contagion because when money is needed, other assets are sold and when creditors are hurt, they curtail lending.

Those financial intermediaries (most importantly banks) that are most leveraged long to the asset bubble that is bursting are particularly affected. It is classic that coming out of an extended period of very low real interest rates and abundant credit, there is an enormous amount of leveraged long holding of assets that are going down due to higher interest rates and tighter money, which is producing this classic dynamic of dominos falling.

Because a) we are in the early stage of the contraction phase of this cycle and b) the amount of leveraged long holding of assets is large, it is likely that this bank failure will be followed by many more problems before the contraction phase of the cycle runs its course.

Before the contraction phase of the cycle ends, history and logic have shown that there will be,

1. Forced sales of assets at very low prices that require big losses to be reported and cause further contractions in lending,
2. Equity dilution, i.e., selling at prices that are at significant discounts to conservative estimates of the present values of their future cash flows,
3. Attractive acquisition prices for strong synergistic companies to buy distressed ones,
4. Credit problems being a negative for markets and the economy, and eventually,
5. The Fed easing and bank regulators providing money, credit and guarantees because the problem becomes system-threatening.

At this turning point into the contraction, it is too early for the Fed to ease, but I will be watching closely what it does as the tradeoffs become tough.

Looking backward rather than ahead, tightening rather than easing seems appropriate. Looking ahead, it’s likely that it won’t be long before the problems pick up, which will eventually lead the Fed and bank regulators to act in a protective way.

So I think we are approaching the turning point from the strong tightening phase into the contraction phase of the short-term credit/debt cycle.