The year 2008 earned its dubious distinction as the worst year ever for stocks, as the S&P 500 declined 37 percent. Now known as the Great Financial Crisis of 2007-2008, the precipitous slide of asset prices around the globe was catalyzed by several culprits. Newly invented derivative structures called mortgage-backed securities began to circulate through financial markets in the early 2000s. This bundling of private mortgage credit risk allowed banks and mortgage companies to offload newly-issued mortgages almost before the signatures were dry. With this outlet in place, and with government policy overtly in favor of increased home ownership rates, underwriting predictably became looser and the bubble began rapidly inflating. Housing prices shot higher, which spurred an even greater buying frenzy and even lower underwriting standards. Banks, mortgage companies, and investors ended up holding the bag on trillions of dollars of exposure to the housing market.
I closed on my second home in July 2007 right at the peak of the mania. I will never forget the bank encouraging me to consider taking out a second lien mortgage, which would have put my total loan-to-value at 105 percent of the home’s cost. When I asked why anyone would borrow more than the total cost of a home, I was told (with a straight face) that customers usually used the extra funds to purchase furniture for their new house.
As everyone now knows well, the housing bubble eventually popped, and did so in an exceedingly violent manner. The downward slide in values – in not just housing but almost every other investment asset class as well – lasted the better part of eighteen months between late 2007 and March 2009. At the center of the crisis, and now known as the watershed moment of the period, was the bankruptcy of Lehman Brothers on September 15, 2008. Founded in 1844, Lehman was a bedrock member of a small group of elite Wall Street firms. It had survived calamities including world wars, depressions, and other financial shocks. After being around for 164 years, its market capitalization evaporated from $46 billion to zero in a single year. It was a major shock to the financial system then, and remains by far the largest bankruptcy in history when measured by total assets.
A type of digital currency in which a record of transactions is maintained and new units of currency are generated by the computational solution of mathematical problems, and which operates independently of a central bank.
a system in which a record of transactions made in bitcoin or another cryptocurrency are maintained across several computers that are linked in a peer-to-peer network.
Decentralized finance, also known as DeFi, uses cryptocurrency and blockchain technology to manage financial transactions. DeFi aims to democratize finance by replacing legacy, centralized institutions with peer-to-peer relationships that can provide a full spectrum of financial services, from everyday banking, loans and mortgages, to complicated contractual relationships and asset trading.
A non-fungible token (NFT) is a unit of data stored on a digital ledger, called a blockchain, that certifies a digital asset to be unique and therefore not interchangeable. NFTs can be used to represent items such as photos, videos, audio, and other types of digital files. Access to any copy of the original file, however, is not restricted to the buyer of the NFT. While copies of these digital items are available for anyone to obtain, NFTs are tracked on blockchains to provide the owner with a proof of ownership that is separate from copyright.
The NFT market value tripled in 2020, reaching more than $250 million. During the first quarter of 2021, NFT sales exceeded $2 billion.
Fast forward to 2021. In two months between mid-April and June 20, a previously obscure digital currency called Dogecoin – known primarily for its dog mascot and various internet memes – made, and then lost, about $60 billion in market value. The company has no assets, performs no services, and was founded in 2013 primarily as a joke. In a separate case, AMC Entertainment Holdings (NYSE:AMC), the operator of movie theaters around the country, came perilously close to bankruptcy in the depths of the COVID environment in 2020. In 2021 its stock price rose from $2 to over $60 on the back of retail investor mania. It has since fallen nearly 50 percent from highs and the company’s future is yet to be written. Similarly, the stock of GameStop (NYSE:GME) began the year below $20 and has seen highs over $300 before dropping back into the mid-100’s in July.
While the investment stories of names like Dogecoin, AMC and GME may or may not be familiar to the average client of True North, everyone under 35 can name friends and peers who have been participating in the ups and downs of these and other financial assets in 2021. Among just the three, over $100 billion in valuation swings have occurred within the past several months as day-traders’ retail capital sloshes around the markets. One could argue that the lack of entertainment options for Americans when it came to how to spend their well-earned dollars during Covid (and those dollars that were handed out during the crisis) provided much of the fuel for this frenzy. Regardless, today’s markets contain as much speculation and outright absurdity as anything we saw in recent booms like the 2005-2007 housing bubble and the internet bubble of 1998-2000. Repercussions might not be as dangerous right now, because the specter of a movie theater chain’s potential bankruptcy does not imply the same magnitude of market ramifications as that of Lehman Brothers, but the sheer number of dollars being made and lost in this market make for paying attention to.Dogecoin is one of many cryptocurrencies in circulation today. More famous and much more valuable is the elder statesman of the cryptocurrency universe, Bitcoin. Invented in 2008 and made public through an anonymous white paper circulated on the internet, Bitcoin’s value fluctuates wildly over the short term, but overall has steadily risen over the past decade. Its market capitalization, even though it is down about one-third from the all-time highs reached in May 2021, stands well over half a trillion U.S. dollars. Why does a made-up digital currency, less than fifteen years old and owned by a tiny fraction of the world’s investors, command the same market capitalization as Coca Cola and Nike combined?
When the subject of Bitcoin comes up in our world, the conversation usually goes in one of three directions. The person on the other end is either 1) mildly amused but largely uninterested, 2) of the strong opinion that Bitcoin is a Ponzi scheme destined for ruin, or 3) of the strong opinion that Bitcoin is an answer to our monetary prayers and the future global reserve currency. But a common discussion point, regardless of stance, revolves around one primary question: What is Bitcoin’s intrinsic value?
That’s an age-old question with an equally age-old answer. Whether the object is an ounce of gold, a Big Mac, a Smith & Wesson revolver, or a single Bitcoin, a thing is worth exactly what someone is willing to pay for it. In economics parlance, this point – where supply equals demand – is known as the market clearing price. Pondering the supply and demand factors that determine the market clearing price of a common good or service is a simple mental exercise, because one can explain what sets the price. It is primarily the input and production costs of the product, weighed against the usefulness of the product in the eyes of its potential buyers.A more difficult mental hurdle is encountered when an asset like Bitcoin is being considered. Because the product has no real utility, demand (and therefore price) is seemingly impossible to predict. In this sense, Bitcoin is most similar to gold. It is largely seen as a store of value in the eyes of its advocates. Similar to gold, its supply is finite. And for the past few years, there have been more buyers than sellers; hence, the upward price movement.
Unlike Bitcoin, other cryptocurrencies such as Ethereum have a greater potential to look and act more like a traditional asset in the future. If that sounds far-fetched, imagine that you purchased an iPhone upon the initial release in 2008. What you had was a portable telephone with internet access and a decent map for navigation, but not much else. At the time, very few people could have predicted the cornucopia of applications that would eventually flood Apple’s iOS software platform. Today with any mobile phone one can manage a company calendar, execute any banking transaction, board an airplane, summon a taxi, watch any film ever made, and of course place an actual phone call. In 2021 it is difficult to predict just what will come of the vast amount of human talent and financial resources that are currently being expended on blockchain-related technologies. A decade from now that will no longer be the case.
As Americans, we are used to thinking of our income, costs, and wealth in terms of U.S. dollars; the notion that a dollar could be worth anything other than a dollar seems ludicrous. But history is littered with regimes whose currencies exhibited drastic volatility at some point. The United States has not suffered such a fate, but that is not to say that the U.S. dollar will be immune from devaluation pressures forever. Over the past decade virtually every country with a central bank has been printing vast quantities of their own currency, so the currency risk seems to be less about American dollars versus the dollars of another regime. Rather, questions for the CEOs of global financial leaders and the heads of central banks now revolve around the possibility that cryptocurrencies might ultimately sit alongside country-specific currencies in the wallets of people across the earth.
Custodians such as Fidelity and Charles Schwab – whose services are provided to True North clients – are devoting hundreds of people to the task of determining how digital assets trading, custody, and services will fit into their platform seamlessly with the existing menu of stocks, bonds, and alternative investments. Extrapolating these types of examples out over the next few years, it would seem that we are still in the early innings of blockchain/DeFi/cryptocurrency conversations as it relates to our investment portfolios.
A wise investor once said “There are no called strikes in investing.” Meaning, you don’t get punished for sitting on the sidelines. The problem with that analogy in 2021 is that investors are not being paid to wait; interest rates are at zero, there is a real and growing threat of inflation eating away at the purchasing power of cash, and for the first time there could be a legitimate alternative to traditional currencies. Strikes might be called in the near future. When it comes to the blockchain and ecosystems that are being developed around it, True North not only needs to determine what investments might make sense over the medium/long term, but also to assess how this new asset class will eventually affect our existing investments. We are diligently researching both angles.
Managing Director, True North Fort Worth