Legendary hedge funder Raoul Pal explains how a 'doom loop' in corporate credit is on the verge of upending the entire pension system

Real Vision Television

• Raoul Pal, former hedge fund manager and founder of Real Vision, sees all hell breaking loose in the US pension system if corporate debt starts to get downgraded due to chain reaction of economic events.
• Pal sees the genesis of the crisis spreading from weakness in Europe, and swiftly permeating into US markets.
• He proposes quantitative easing for the entire pension system to mitigate a potentially cataclysmic upending of the network.
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In financial markets, when one domino falls, others tend to quickly follow. Trouble in one area of the market permeates into others, and the overall contagion effect spreads as investors rush towards the exits.

That's the exact scenario Raoul Pal - the legendary former hedge fund manager and founder of Real Vision - sees happening in the US economy. He's calling for a chain reaction so severe that it could upend the whole pension system in one fell swoop.

Pal calls the situation a "doom loop."

"My theory is this European situation is going to start blowing out credit spreads," Pal said on We Study Billionaires, an investing podcast. "Credit, the corporate credit market in the US and globally - because of the sheer amount of issuance - is getting somewhat problematic. Corporate debt has doubled since 2008."

The graph below depicts the explosion of corporate debt issuance in the US. It's been on a meteoric rise.

Board of Governors of the Federal Reserve System (US)

European weakness fits into the equation because it's dampened the overall outlook for global growth. Pal says the situation overseas has become more pressing of late as data continues to disappoint, and as a calamitous political landscape ramps up anxiety.

We'll call this the first domino.

When investors are worried about the future - and economic activity is expected to deteriorate - credit spreads widen. Pal thinks this will be the straw that breaks the camel's back for debt-laden markets. And he expects the repercussions to slither their way into the pension system, an area which is highly susceptible to debt downgrades.

This is the second domino. Here's how he sees it playing out:

"Everybody has been borrowing money to buyback their shares," Pal said. "That debt is actually bought by the pension system, because the baby boomers are about to retire, and everybody is stampeding for yield."

For context, consider that corporate debt offers higher yields than US Treasurys due to the excess risk involved. But this mounting situation puts the pension system in a precarious position. Those plans and funds are holding a boatload of these securities.

If the global economy continues to slow - which looks like a real possibility - these companies won't be able to issue more debt as free cash flow dries up. In turn, their ability to buy back stock is diminished. And this is where the unwinding begins.

"Those share buybacks are the only source of consistent buying of equities," he said.

What happens next isn't pretty - and this is where Pal sees the potential for a cataclysmic sequence of events taking place.

"What happens is the credit spreads widen, well some of the companies share prices start falling - these triple B shares," he said. "And if they get downgraded to junk, all hell breaks loose."

This is the third domino.

BBB-rated bonds are classified as investment grade, but just barely. If they're downgraded, their classification shifts to junk, and pension funds aren't allowed to hold junk bonds. They'll be forced to sell.

But Pal doesn't think the junk bond market will be able to absorb the deluge of supply. And he thinks the massive shunning of these securities could potentially freeze the entire junk bond market. A recipe for disaster.

But now that we've laid out the stakes, it's time for the solution: Pal thinks there needs to be heavy-handed quantitative easing for the entire pension system.

"The only way out of this doom loop is essentially for the central bank to step in and underwrite the entire pension system - the private sector, and the state sector" he said. "It's basically QE to underwrite the pension system. And that's going to get pretty ugly - and it's going to be huge - but there is no other way out of that."

That's a bold suggestion, and there's no telling what the unintended consequences of such a strategy might be.

Hopefully, we won't have to find out. American citizens aren't in a position where they can stomach yet another massive bailout for excessive risk taking and bad judgement.