Ooc: obviously, this meme does not explain much. What is going on?

Last month, an auto parts manufacturer called First Brands filed Chapter 11 Bankruptcy. In their bankruptcy filings, they reported somewhere between $10B and $50B debt over $1B to $10B in assets. You are basically betting it all on black when you're that leveraged, and as luck would have it, the ball landed on red.

That seems like a lot of leverage for someone who makes brake pads. How did they convince lenders to give them so much money? It actually happens pretty often. Banks, for instance, routinely have many times their actual assets in loans. Risking money that isn't yours is a great way to multiply returns.

For example, if I buy a $500,000 house with cash (I *wish*) and the house goes up in value to $550,000, my investment has gone up 10% (ignore that I need a place to live, that maintaining and selling a house is expensive, and that taxes exist). But if I buy that same house for $500,000 with a down payment of $50,000 and a $450,000 mortgage, and then the house goes up in value to $550,000, I don't have a 10% return; I have a 100% return. In a world with no transaction costs, I could sell the house, pay off the bank, and walk away with double my money. Clearly, houses are messy and have lots of issues, but the basic idea is that leverage multiplies outcomes. This is also true for bad outcomes: if my $500,000 house goes down in value to $450,000, I would lose 10% of my all-cash investment, but 100% of my leveraged investment (my mortgage). Any more than that, and I'm underwater: it's the bank's house, even though my name is on it.

If I want a loan, I have two options: I can go to a heavily regulated financial institution like a bank, or I can go to people who don't have to play by the same rules (e.g., Uncle Moneybags, hedge funds, guys named Rocco and Knuckles, anyone with money, etc.). The traditional financial institutions will bring out the financial colonoscope to determine whether I am creditworthy and, if so, how creditworthy I am. They want everything. Tax returns, bank statements, proof of income, existing debts, sworn affidavits, balance sheets, etc. If I'm one of the FAANGs, or whatever the acronym for the biggest tech companies is now, banks will agree to give me the cheapest loans possible (up to a point). When they make me a loan, that goes on my balance sheet so that any future investor can see it, understand it, and plan around it.

If I take on enough debt, banks will start to worry that I cannot repay the loans. They're not stupid: they will make me promise to not have too great a debt-to-equity ratio. If I exceed a given ratio, they can make me repay the loan or force me to refinance at rates that reflect the heightened risk.

But not all debts need to be reflected on my balance sheet. Consistent with generally accepted accounting principles, my bigass company can enter into partnerships, create special purpose vehicles, and otherwise sustain relationships where debt that is actually tied to my business doesn't *look* like it's tied to my business. The classic use case here is research and development for pharmaceuticals: drugs are really expensive to make, Pfizer doesn't want to lug around huge millstones of debt, and so they set up a special purpose vehicle to hold the debt. This is technically Pfizer's debt, but it only gets reported in notes, not on balance sheets, and so the specifics are much harder to trace and can easily (or, more easily) get obscured. It feels relevant that a version of this is what brought down Enron.

Banks with their hefty regulatory burdens don't typically get involved here. Private lenders called non-bank financial intermediaries, or NBFIs, do. NBFIs include all kinds of potential lenders who are not technically banks (think: hedge funds) and thus have dramatically fewer regulatory compliance requirements. They can make loans that I don't have to report on my balance sheet. I love this because it won't ratfuck me out of my cheap bank loans by pooching my debt-to-equity ratios as reported on my balance sheet. The downside is, these NBFI loans are a lot more expensive (think 200-300 basis points, or 2-3%, more expensive). But If I need a mountain of capital, far in excess of what traditional banks will give me, it is often worth the deal. I can continue to both get loans from banks and sell equity without investors asking why I'm leveraged to hell and gone. And the NBFI lenders love it because they can charge high rates on extremely safe loans.

[Aside: companies normally like taking on debt instead of issuing equity because debt is cheaper. My creditors can only get what I owe them, but my shareholders have theoretically unlimited upside - if I can, I want to keep that upside. The order of preference is to find money to fund activities from my income and cash on hand, then from secured debts (loans, bonds), then unsecured debts (worse loans, debentures), and only as a last resort by selling shares. As the risk of not getting paid back goes up, the return on investment has to go up. This is why bonds normally have lower returns than stocks: when the bankruptcy lawyers hack apart a failed company's carcass, the scraps go to the secured creditors (the bondholders and lenders) and the shareholders get nothing.]

These NBFI loans aren't a total wild west situation: there are technically limits on off-balance-sheet financing, but it can tip over into illegal territory pretty easily. Regulators and cautious people correctly hate that this is even a thing. When times are good, this stuff doesn't matter. When times are bad, investors get wiped out.

All of this is a long lead up to what happened here: First Brands got an assload of off-balance-sheet financing along with a lot of bank financing, then it shit the bed. Investors did not realize the extent of their risk (because of that whole "off balance sheet" thing) and watched as billions of dollars of loans caught fire, fell over, and exploded. Some of the investors were regional banks (Jeffries, Zions, Western Alliance), whose own investors are now understandably scrambling for the lifeboats.

So fucking what? The company that makes my windshield wipers went bust and a few banks I never heard of are failing. What's the big deal?

The big deal is that private finance is incestuous. A big failure creates a gravity well that can suck in a lot of nearby objects. And when these NBFI lenders are also hip-deep in the data center financing business (a business that, infamously, makes no financial sense and has no articulable pathways to profitability that do not involve magic), the risk is that these smallish failures could build on themselves until they pop the big stupid AI bubble. Jamie Dimon likened the First Brands failure to seeing one cockroach: there are likely a thousand cockroaches you can't see.

How bad will this get? I don't know. Nobody does. But it has potential to get extremely bad. The US economy is, in large part, an AI hype economy. Pop the bubble, and the hype machine breaks down. The hype machine breaks down, and the recession begins. A recession begins, and all hell breaks loose because we really don't have that many great options left for quantitative easing or stimulus spending (remember in April when there was that stark flight away from treasury bonds? Yeah, we can't just print our way out of the next one). And that is why I'm posting banking memes in the middle of the night.

Disclaimer: I'm an idiot and I don't know anything. Nobody should listen to me.