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Good afternoon,

The S&P 500 is back above its key 4,000 mark, no thanks to the tech sector putting in its worst earnings slump since 2016. The NYSE saw and said to hold its beer, sending markets into mayhem this morning after an "unusual" number of halts at market open.

Spotify and Google are laying off, while Microsoft is making it rain on uncomfortably human AI.

Let's dive in.

Bottom Line Up Front

• Ex-Deutsche Bank traders rejected by Supreme Court in “spoof” case (BBG)

• Exxon prepares to start up $2B Texas oil refinery expansion (Reuters)

• Citadel posts $16B in 2022 profits, the largest annual gain ever by a hedge fund (WSJ)

• Microsoft announces new multibillion-dollar investment in ChatGPT-maker OpenAI (CNBC)

• Lagarde says ECB will “stay the course” to return inflation to 2% (CNBC)

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Deep Dive: Bill Ackman's $2.6B Debt Bet

US debt just hit its ceiling. The last time a trader made billions on default bets, he turned $27M into $2.6B in 30 days.

It was none other than Bill Ackman. Let’s dive in.

Ackman, that billionaire hedge-fund manager from your second favorite finance movie, had an intuition that the coronavirus-driven market meltdown would have a greater impact than investors expected.

That led him to mint a multibillion-dollar profit in March 2020, turning a $27M position into a $2.6 billion windfall through defensive hedge bets as the coronavirus outbreak threatened a deep economic recession.

Ackman's bet that the debt bubble would burst was based on a hunch that investors would cast aside riskier securities in bond indexes as the coronavirus spread across the world.

Background on the Ack Man

Bill Ackman is the founder and manager of Pershing Square Capital Management, a hedge fund based in New York City. The hedge fund has around $18.5B assets under management (as of December 31, 2022).

You may know him for his famous battle against Herbalife, where he took a huge short position due to his conviction that the company is a pyramid scheme. You may also know Ackman for his famous activist moves in companies like Canadian Pacific Railway, Wendy’s, and JCPenney. He has outperformed the market by over 600% between 2004-2020.

This debt bet was odd because it wasn’t Ackman’s usual terrain. Professional investors fall into two camps: “macroeconomic” traders who use bonds, currencies and commodities to bet on global economic shifts, and stock pickers like Ackman.

Despite it not being his strategy, Ackman’s macro plays are where his street cred and recognition come from. Ackman dabbled profitably in macroeconomic trends once before. So successfully, it meant Steve Carell played him in The Big Short.

In 2007, Ackman predicted a crash in subprime credit and began betting against the debt of two big bond insurers. Traditionally and today, however, investors give him money to dig into the story of a single company and nudge it down a more profitable path, sometimes through pressure campaigns or public fights for board seats.

Insight into the Trade

In late February 2020, Ackman was growing increasingly worried about the virus. So he did what all rational spenders would: bought instruments that would pay off if corporate bonds fell in value. He said at the time he figured they would offset losses in Pershing Square’s stockholdings, which were tanking along with the rest of the equity market.

Ackman paid $27M for the position and sold it a few weeks later for $2.6B after investors woke up to the risk that pandemic-battered companies might not be able to pay their debts. He used the profits to boost stakes in Hilton Worldwide Holdings Inc., Lowe’s Cos. and the owner of Burger King restaurants – all at fire-sale prices.

Ackman assumed the reopening would unleash a flood of consumer spending, sparking inflation not seen for decades. Then, the Fed would be forced to intervene. After all, higher interest rates can cool an overheated economy by making borrowing more expensive.

Ackman’s Analysis: COVID Stress in Treasury Markets

The world looked different by the end of 2020. Vaccines were coming. Consumers were weary of lockdowns and flush with savings after a year of government stimulus and nowhere to spend it. The Federal Reserve had kept interest rates near zero since the start of the pandemic to keep credit flowing and protect the economy.

The rough sketch is that a lot of people wanted cash, so a ton of investors — mutual funds, hedge funds, central banks — were all trying to sell Treasuries at once. So, in some corners of the Treasury market, there were really massive price differences between how much sellers wanted to get for treasuries and what buyers were offering to pay.

Think of it like having a bunch of diamonds that you need to sell quickly to pay off a debt. People are probably going to want to buy the diamonds, but because you want to get rid of them so urgently and a bunch of other people are also trying to sell diamonds, people are offering to buy them for much less than they would normally be worth.

What actually happened was much more complicated than that, but that’s the basic idea.

The Profit

According to investor documents, Ackman would have had to pay $27M over 12 months for a total of 5 years. This would amount to $1.62B in total premiums paid if he had held on for 5 years. The total amount of $1.62B would have been discounted to about $1.56B as the treasury rate was 1.5% for 30-year Treasury bonds.

When Ackman entered into this CDS contract, $27M per month represented a 50 bps spread on the notional amount of $64.8B. Essentially, he needed to pay 0.5% of the notional amount he was receiving protection against per year for 5 years. Credit spreads were also at 0.5%, so the CDS contract premiums were more or less equal to the prevailing credit spreads for the bonds being protected against.

But, Ackman bet on credit spreads widening as a result of COVID damaging corporate creditworthiness. In other words, he bet COVID would negatively affect corporate bonds. He was soon right – in a big way. Credit spreads on the corporate bond index increased from 0.5% to 1.35% (or 50 bps to 135 bps).

Why Use Credit Default Swaps

Especially after his ‘08 fun, why would Ackman buy a credit default swap (“CDS”) to profit from his prediction? Because credit default swaps are safer. Losses are limited compared to the possibility of infinite losses when shorting bonds or stocks.

One example is a house that you bet will burn down (maybe don’t admit that out loud), so you buy fire insurance on it. You will have to pay monthly fees on the insurance contract until the house burns down or until the contract time expires. If the house does not burn down during that time period, then you only lose the limited amount of money that you paid on the insurance contracts over that time period. If you directly shorted the house with the hopes of it burning down, then the amounts of money you could lose are unlimited.

This is basically the case with Ackman’s CDS (fire insurance) and the corporate bonds (house). By buying credit default swaps, Ackman could limit his losses to about $1.56B in the worst case scenario.

Ultimately, the best way to think about a CDS is insurance against a bond defaulting. If nothing goes wrong, then you lose what you pay in premiums. If the bond defaults, then you get a payout.

Background on the Current Debt Ceiling Showdown

For markets, it’s a bad time for a debt limit fight.

Congress places a limit on the amount of debt the country can issue, with a simple majority in the House and Senate required to lift it. That cap, currently $31.4 trillion, needs to be adjusted to allow the United States to borrow to pay for obligations it has already committed to, such as funding for social safety net programs, interest on the national debt and salaries for troops.

There’s never a good time for the U.S. government to be unable to pay all of its obligations, but this would be an especially bad year for that.

For one, the place where that debt is traded, the Treasury market, has already been under strain because of the Federal Reserve’s relentless interest-rate-hiking campaign. Rising rates make even recent lower-rated debt less valuable, so there are fewer buyers right now. Also, the market relies on a small number of large dealers to intermediate trading for a huge volume of debt, and they can only hold a finite amount of assets on their books at any one time.

This all means trading and pricing aren’t as smooth as they would ideally be. So, U.S. officials are trying to reform how the market is structured to make it work better.

Since the Fed is still engaged in its battle against high inflation, it might be more hesitant to intervene and buy Treasury bonds to prop up the market, at least as dramatically as it otherwise would. That’s because buying bonds would run at cross-purposes with its efforts to slow down the economy.

Markets have been through these showdowns before – notably in 2011. But this time could prove more dangerous. This time, the Fed is battle-tested.

What Now

Bank of America analysts wrote in a note to clients this week that a default in late summer or early fall is “likely,” while Goldman Sachs called the possibility that the government would not be able to make good on its bills a “greater risk” than at any time since 2011. When the nation approached the brink in that episode, its credit rating was downgraded and wild market movements helped to force lawmakers to blink.

The Fed and Treasury aren’t publicly speaking about what they could do if an outright default were to happen this time. This is in part because the mere suggestion they will bail out feuding politicians could leave lawmakers with less of an incentive to reach a deal. But, they have a series of options — albeit bad ones — for mitigating the disaster if political impasse takes the nation up to or over the brink of default.

Strategists across Wall Street have sent out their own assessments of when the US will exhaust its ability to stay under the debt limit — what is known as the X-date — and how a default might ripple through asset classes.

The Treasury is now being encouraged to consider other alternatives. The most popular is the one you’d expect from politicians too busy running for student government to grind through Econ 101: minting a $1T coin. The proposal would have it deposited at the Fed, exploiting a legal loophole to raise money to keep paying the bills.

But short-term solutions will lead to the short-term volatility we’re now seeing play out in the markets. As investors lose faith in government, it will mean higher financing costs for the rest of the US.

Now only time will tell if politicians get as unnecessarily aggro in the debt limit fight as they did over the House speaker.

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