This is Evercore's Flow of Funds with Glenn Schorr, sharp perspective on private markets, wealth, and the forces driving change.
Hi, everybody. Welcome to Flow of Funds here at Evercore with Glenn Schorr. I'm happy to have Steve Eisman with me today. Steve has had a really big impact on my career at different points. I mean, I love the way he processes information. I love the way he sees the forest through the trees, and of course, I love the way he speaks his mind at all times. You cannot control him. I'm sure you know Steve from his days of analyzing and identifying the collapse of the US housing market and the Global Financial Crisis. And if you don't know, you should know he has this amazing podcast right now called The Real Eisman Playbook, which you should subscribe and listen to. It's truly excellent. So, I like to talk about the goal of today's conversation. The goal is to use a couple of points in time that I remember from Steve's career and some historical big calls that he's made—what he was thinking, what he saw then that the market, that the world didn't—and then try to bring it into today's reality of everything related to direct lending and private credit, and what he thinks is the same and what he thinks is different. And as always, Steve's like, "Go ahead, ask. No prep. We'll talk off the mind, and it'll be a little unfiltered, which is the best way to consume Steve Eisman."
So anyway, I'm not the hugest fan of fluff and history, but in this case, we're going to use a couple of things from history because it actually sets the stage for today's conversation. So let's start with number one. It goes all the way back to the late '90s and then early 2000s. And I remember I was actually on the buy side when this started as a fixed income guy, like reading your research and key events. And this was a key event that got me actually transitioning to sell-side equity research, kind of inspired by your work. So it was a report you wrote in like 1997-ish, and you said, "Glass-Steagall is going to come down, and banks are going to buy brokers, and it's going to be a big deal, and you should buy the brokers." So, he was dead right. A ton of M&A happened actually before Glass-Steagall came down. So Steve, why don't you talk to us about why you thought that, why you were the only person on Wall Street that was saying that, how you knew it would happen, and what gave you that courage? Because that was like that was my first real Steve Eisman 101 introduction.
Well, that takes me back. So first of all, thanks for having me.
So I actually remember that report very well because it's kind of a funny story. So, I can't remember what year I actually wrote it, but it was at least—I actually wrote the report at least a year before I published it.
And what happened was I had this like epiphany that Glass-Steagall comes down, there's obvious—obviously it seemed to me a whole bunch of these mid-sized firms like an Alex. Brown, which you know, takes you way back—
That just seemed obvious to me. And even if they didn't all get bought out, they'll all get revalued anyway because as soon as one of them gets bought out, everybody will assume they'll all get bought out. So I went on a tour, and I met with basically every one of these mid-sized firms that I wasn't covering. And I remember the first meeting was with the CEO of Alex. Brown, who—who's amusingly—this was a guy who had worked for the CIA, and then after Alex. Brown got bought out, he went back to work for the CIA. He was adamant that Alex. Brown would not sell, and it turned out he sold first. So I went and basically toured all these companies, and I wrote a report, and I stuck it in a drawer. I literally took the report and put it in my top drawer because nothing had happened yet. And I left it there. And then when it became very, very clear that the regulations were going to change, even pre-Glass-Steagall coming down, I took the report out of my drawer. I updated all the earnings stuff, and I put it out. And that's the origin of that report.
What is amazing about that is, you know, we've known each other for 30 years or almost, and I don't know if I've told you all the pieces of this, but what's amazing is, so that report came out at the time when I was happy but underpaid, frustrated junior municipal bond portfolio manager. And I decided, "I got to get to the equity side. It's just cooler. It's more interesting." And I determined that lots of Wall Street research firms covered the banks, but nobody covered the brokers because no one wanted to write bad things about brokers because then you would be left out of deals or whatever, right? And so I was like, "Ooh, this is my entree." I went to the sell side with kind of your report idea and said, "Listen, this is going to happen. You should be covering the brokers." And it worked. I—
At Gruntal Securities, which is no longer around.
And but I convinced them, "Hey, you should cover the brokers and like hire me." You know, I was an older associate because I had already had a buy-side career, and I said, "But this is what I want to do." And so somebody said yes.
So what's interesting is that's the first time that you had a big impact on my life because I transitioned over. So that brings me to question number two and point number two in your life. So now I'm on the sell side as junior associate and helping a woman cover—she covered a lot of things, including the consumer finance companies. And so now this is—I see I got June of '98. So sometime between the second half of '98, early '99, and the analyst I was working for happened to be a big fan of a bunch of these consumer finance companies. And I knew nothing. I was brand new. I was a fixed income guy now trying to do equity research. Again, I come across a Steve Eisman report.
The opposite of what the analyst I was working for said. Yeah, you said all these companies are going to go bankrupt.
And you had literally a zero-dollar price target on almost all of them. And I remember going home to my wife, and like, "I'm in a little weird bind because I work for this firm. I work for this analyst. They were nice enough to hire me, and I knew nothing about equity research. I'm trying to learn, and I think that guy's right, but I don't even know enough about what he's saying." So anyway, why don't you just talk about what you saw, because the whole world was a fan of these consumer finance companies, and you were screaming zero from the top of your lungs?
So because I covered specialty finance at Oppenheimer, it allowed Oppenheimer to create an entire investment banking business involving taking specialty finance companies public. It was pretty lucrative for quite a long time.
Probably until you had zero-dollar price targets, but whatever.
Right. And but I was always very cognizant of the fact that I have a reputation, and if it turns out these companies are going to do badly, it's really going to hurt my long-term reputation, which was very precious to me. So all the companies that we would talk about, whether it was subprime auto, subprime mortgage, The Money Store, securitized all their loans. That was really the new thing back in the early '90s, which was prior to securitization, if you were a specialty finance company, you always had issues of how you're going to fund your loans. And once the securitization market came about, it was like a whole new world. And that's why that was the growth in specialty finance, was because of securitization. I found out that for $10,000, Moody's had a database on every single securitization. So I figured, just to protect myself and because I need to know what's going on, I got my firm to pay for the securitization database. At which point, Vincent Daniel came to work for me. And we actually became partners, and we're still friends. And so Vincent was an accountant, and he became working for me as my junior analyst.
From the great school of Binghamton.
Yes, he was from Binghamton, Binghamton, correct. And I said to him, "Vinnie, I'll put you in this office. I need you to create a database of all the securitizations of all the companies that we cover. Don't come out of this room until you're done. I don't want to see you until you're done." It took him months because I mean, today—
Poor Vinnie. He had clawed his way up.
Literally, you know, scrape the data, bing bang boom, and you know, put it into the right form. He literally had to put in every single delinquency. And so what you would look at is you would look at, let's say, what were the prepayment speeds? What were the delinquencies in month six for every single securitization? And what you would want hopefully see was that there was no underwriting deterioration. But if you saw underwriting deterioration, you were in trouble. So, what we saw, it wasn't so much underwriting deterioration. What we were seeing was massive refinancing of all this paper. And unfortunately, the firms used an accounting method of gain on sale, where they present-valued all of the revenue up front. That was what they were required to do back then. The accounting eventually changed. So, you had to make an assumption about how long the loans would last. And if the loans were lasting literally half the duration of what you assumed, you were going to have massive write-offs. So, we put out a report. It was the first report of its kind on Wall Street where we put out—we literally took the database, and we put it into a report, and we showed all the data on the prepayment speeds. And we said, "Look, this data is very, very clear. The massive write-offs are coming. You got to get out of here." And that's that. You know, my investment bankers were not pleased, but I didn't care because I knew this was going to happen whether I was recommending the stocks or not. So, I might as well be on the right side. So, we downgraded the whole group. Yeah, that's what happened.
I remember well. Those are two clear cases where you were just off on your own and the rest of the coverage universe was over here. So, that's two. Last thing before we get to today's private credit backdrop is, of course, the Great Financial Crisis. So, I think people have read the book, seen the movie, heard your podcast. We don't have to do the whole thing. By the way, little-known fact, I did make a little cameo on page 173 of the book, and I'm still—
That's what I've been told.
What was said on 173? I am unaware.
By the way, it was unbelievable, but I'm pissed that it didn't make the movie, because I think it was an amazing scene. It's when you and I went to meet with the then-CFO of Merrill Lynch as the largest shareholder.
Oh, that is a spectacular scene. It was unbelievable.
It was me at my absolute most obnoxious.
And there were plenty of those moments, believe me. I'm not like that anymore, ladies and gentlemen.
Not even close. Not even close. That was peak Eisman. I loved it. I'll tell anybody the story that wants to call up, but like, long story short is we went to see the CFO during the most perilous times.
August 2007. First week of August.
And the long story short is you asked in a couple of very simple terms about the CDO exposure on their books, and he might as well have answered what he ate for lunch that day. You threw your papers up in the air, landed in the middle of the room with all the largest shareholders, and said, "I'm sorry, you don't know what the blank you own. You guys are blanked." And then five minutes before the meeting ended, you left.
That peak Eisman. That was me at my worst.
The live story is even better. If anybody wants to hear it, call me. But there you go. So the interesting thing is, I just want to get to, because we're trying to paint the case of you seeing the forest through the trees, and then what do you see today? So, this is the last thing. Was it more similar to the subprime consumer finance companies where it was data-related? No one in the world thought housing could go down. What were you looking at that had you among a couple of people on the planet that saw this coming?
You and your team, sorry Vinny.
Me and definitely my partners, for sure. This was not a solo show.
I mean, the report that you mentioned before was very, very important because all those companies actually did go bankrupt. All of them. And what happened was, starting in 2002, the second generation of subprime mortgage companies went public. The funny thing was that many of them were run by the same guys who ran the first generation. They just changed the names to protect the innocent, so to speak. So as early as 2002, me, Vincent, Porter, we all were thinking we saw this play before. It's a play in three acts. Act three is a tragedy. Call me when act three starts. So sometimes you see things because you're actually looking for them. So, we were looking for them. And we subscribed to the same Moody's database. And it's not like I had information that nobody else had. That Moody's database by then was like Moses with the tablets every single month. That data came out over two days mid-month. The entire securitization world would basically stop for two days. They would do like a deep dive in terms of the data, and then they would start trading again. So, the data was bad. It just kept getting worse.
I think the reason why the people in the fixed income world sort of ignored it was, number one, they'd been making so much money for so many years in this paper. It was sort of unimaginable to them that things could get bad. And the other thing was that they were all just data-driven. They actually didn't do any legwork. They didn't go out and figure out that the underwriting standards were really deteriorating. As you know, equity people are story people. That was a story. You had to go out and talk to people. And once you realized that the underwriting standards had deteriorated that badly, all of a sudden it became quite possible that housing prices could go down. I remember we had a meeting with the head of asset-backed research at Bear Stearns of blessed memory. And I remember he said he really believed—he said it in the room that the housing prices in the United States don't go down on a national basis. And I said to him, "Dude, is that like a law of physics?" And he literally thought it was kind of like a law of physics. It was unimaginable. But once you realize how bad the underwriting had gotten, you realized that it could happen. And what was the gong other than the data? The gong was when the Sandlers sold Golden West in May of—I think it was May 2006, or it might have been May of 2007. I don't remember exactly. The Sandlers were these iconic lenders. Fun fact, the Sandlers knew me when I was in diapers because my father's best friend was Herb Sandler's older brother.
So when I got into the business, I got friendly with them, and I realized that if the Sandlers were selling, it's over. It's over. And that was my gong.
It's interesting. Okay, so we're going to transition to today's environment.
Oh, something's going on in today's environment?
And what I've heard is two different things: some of it is behavioral, some of it is digging, some of it is data and underwriting. So all those things will come up through this conversation. So, I'm going to start with a purposely provocative question. So, we haven't really had a credit cycle since the financial crisis.
It's 17 years, which is unbelievable.
Unbelievable. If you listen to bank earnings, you will hear about a strong enough consumer, strong enough corporate balance sheets. If you look at these direct lending, private credit portfolios, you will see companies that have 150 to 250 million of EBITDA, good margins, interest rate coverage ratios of 1.5 to 2 times, one turn of leverage when the banks had 20, 30, and 40 times leverage back then.
So it was 40. I ask you opening question: what's all the fuss about if there's all these good companies?
This is not a leverage story. This is not a leverage story. I mean, it's possible there's some stuff in the life insurance sector with hidden leverage, which is very, very hard to figure out.
And I actually had a guest on my podcast who talked about it. And it was very interesting. I'm not 100% sure he's all right, but he certainly raised some very important issues about how life insurance companies reinsure their books internally and whether that creates hidden leverage. It's an important point.
But this is not a leverage story. And nor do I think, despite the fact that the banks do lend to private credit for their leverage—and I think the data that I saw was that there's about 300 billion of this loans to private credit, and there's about 350 billion of unused commitments. Even if private credit gets really bad, which is certainly possible, the banks have never been this well capitalized in their history of being banks.
In the history of the United States. Let us just say categorically, in the history of the United States of America, the US banks have never been this well capitalized. Hard stop.
I think that's a very fair statement, and we owe all that to Daniel Tarullo, who was the first Vice Chair of Financial Supervision, who every single bank cursed when he was doing it, and today they would bow down to him.
Thank goodness he did what he did. Thank God he did what he did. So, this is not a leverage story. So therefore, whatever happens, it certainly could cause a recession. It's not going to cause a systemic meltdown. So let's put that on the table to begin with. I think what we don't know is—well, we do know that private credit has a very large exposure to software. That we do know. We know that it's at least 25%. There was an interesting article in the Journal about classification, so maybe it's more. Let's say it's 30. It's certainly large. Now, these are all pretty—were pretty good companies. The problem is that about 11, 12% of the debt's going to get refinanced next year, and another 20% is going to be refinanced the year after that. And here's the problem: these companies were all bought out in 2018 to 2022, probably at high prices. Multiples were more than double where they are today. Now, what's happened to the software sector, which you can't blame private equity for this because nobody knew about this in 2018 to 2022, is that AI has created a risk to software that has never existed before. And the risk is that they create much cheaper software.
Now, how much inroads AI software is going to make into the software industry is unknown at this point. It's a lot more complicated to be a software company than to just make software. I mean, there's a whole bunch of different things you got to do to actually be a software company. Making the software in some ways is the easiest part. However, the SaaS model for software is kind of like the asset management model in terms of how you would model it, which is you make an estimate about how many seats you're going to grow, you take an average for the quarter, and you multiply that by the average price that you had last quarter, and that's revenue, which is why software stocks used to sell at such huge multiples, because it's so easy to model. And it's recurring. And because the subscription is like a monthly or quarterly service, it makes it kind of easier to raise prices because it's kind of subtle. So, every year you raise the price 5%, 7%, whatever it is, and you move on. I think that the days of raising price are probably over, and then the question becomes what's going to happen to seats. I don't know. Nobody knows. I do know that for the first time in decades, software stocks sell at significantly lower multiples than the market, whereas they used to always sell at significantly higher multiples than the market. So from a—forget about private credit—from a private equity perspective, all the companies that were bought between 2018 and 2022 are worth less than half. I think that's a very fair statement. What private equity is going to do about that? They're stuck. I don't know what you could do about that. I'd be curious what you think they could do about that.
Yeah, so to your point, if you have rolling maturities coming in from now through 2032—
The BDC structure, the retail vehicles that have made a lot of these loans—
They have maturities coming due. They're going to need that money, right? Because right now, if you're in net redemption, 5% a quarter—
Right. That principal back.
You're negative cash flow. Right now, you can add some leverage and draw on your credit facility to pay off some of these redemptions, but eventually the maturities will offset the redemptions. But you need the maturities to happen, which means that specific structure may or may not be the one refinancing these companies.
