On Sept. 15, 2008, a credit crunch turned into a full-blown crisis when New York-based investment bank Lehman Brothers collapsed. The global recession that followed is still too fresh in many people’s memories to be considered history. But 10 years on, the state of the financial system suggests that the crisis has been relegated to the history books for many in the industry.
In 2018, Wall Street is enjoying another heyday. Bonuses for bankers have returned to pre-crisis levels, profits for commercial banks are at a record high, the stock market is in its longest bull run in history, the US economy is humming, and deregulation and tax cuts rule the day in Donald Trump’s administration.
Around the world, regulators and policymakers say that measures taken in recent years have made banks safer than ever, with more capital and targeted oversight informed by mistakes made before Lehman went bust. That said, there are still plenty of potentially dangerous risks brewing in the financial system. Aggressive financial engineering in the pursuit of profit is alive and well. Complacency could lead to trouble, as it always does.
The UK’s Financial Conduct Authority just gave a timely reminder that the onset of a crisis can be sudden. “Most if not all of the firms which failed had been reporting relatively robust financial positions right up to the point when they did fail, with financial statements signed off by their boards and large audit firms,” Charles Randall, chair of the British regulator, said earlier this month.
On the 10th anniversary of Lehman’s bankruptcy, these are the things that market watchers believe could cause the next crisis.
Global non-financial corporate debt more than doubled in the past decade, to $66 trillion in the middle of last year, according to McKinsey. Two-thirds of this debt has been raised in emerging markets, with the added risk that many of these companies have taken advantage of low interest rates to borrow in US dollars.
As corporate debt has increased, the quality of the credit has declined. Analysts at McKinsey say a quarter of corporate issues in emerging markets are at risk of default today, a figure that could quickly increase with a sharp rise in interest rates. US interest rates and the dollar are rising as record amounts of the debts come due.
The current turmoil in Turkey is an example of what can go wrong. The Turkish lira is in freefall against the dollar, and investors are increasingly unsure as to whether Turkish companies will be able to pay their dollar-denominated debt with the rapidly depreciating liras they generate in revenue. Some European banks have loaned heavily to Turkish companies, putting them on the hook in the event of cascading defaults.
There are also worries about China’s debt binge, which has left the world’s second-largest economy with a corporate debt pile worth about 160% of GDP, the highest in the world. The ability of the Chinese government to prop up growth, stabilize its over-leveraged economy, and fight a trade war with the US will be tested, and any slip will reverberate across the global economy.
These sound eerily similar to the collateralized debt obligations (CDOs) that caused so much chaos during the 2008 crisis. These assets are another example of securitization in which leveraged business loans (meaning debt from companies with sub-investment grade ratings) are pooled together and then divided into tranches. There are other similarities to pre-crisis securitization practices: CLO documentation is long and complex and each CLO usually has more than 100 issuers bundled into one product, according to Bloomberg.
For the most part, people think that CLOs are pretty safe. Even during the worst of the last crisis, the top tranches never defaulted. The argument is that this time is different because the company loans aren’t as vulnerable to changes in interest rates as the subprime mortgages underlying CDOs. But the same amount of confidence can’t be applied to the lower-rated CLOs that are becoming popular because of the high returns on offer. Bloomberg warns that the boom in the market may have gone too far now that CLOs are being targeted at individual retail investors.
Issuance of CLOs has “rocketed” in Europe and keeps on rising in the US, especially as 2016 deals are refinanced in better market conditions. At the end of the first quarter of this year, the size of the outstanding US CLO market was nearly $550 billion, versus just over $270 billion in 2008, according to the Securities Industry and Financial Markets Association. The European CLO market is smaller than it was in 2009 but rising from a low set in 2015.
Traditional commercial banks have reduced the amount of mortgages they provide, especially to low- and middle-income families, following tougher regulations. Nonbanks have stepped in to fill the gap: In the US, 56% of all mortgage originations come from nonbanks, up from 35% in 2010. For example, Quicken Loans is now the largest home-loan issuer, surpassing Wells Fargo. The change in the landscape warrants scrutiny, as there is evidence that before the crisis nonbank activities contributed to the deterioration of lending standards (pdf).
Speaking of nonbanks, the size of the global shadow banking industry is at least $54 trillion, according to the most conservative estimate by the Financial Stability Board (pdf). It makes up about 13% of the global financial system, but in China shadow banking is more than a quarter of total banking assets. In this industry, companies that aren’t banks and don’t take deposits provide banking-like services and may pose financial stability risks. How so? Because they aren’t banks, they don’t get the same amount of regulation.
Over the past decade, it’s hard to think of another area of finance that has grown as quickly with as much hype as exchange-traded funds (ETFs). They have all sorts of great features: you can track the performance of an index, commodity, or bond, and trade the fund on an exchange like you would a stock. There are ETFs for almost everything, from biblically responsible baskets of companies to indexes that focus on gender equality. They have supposedly democratized investing by making it cheaper to invest in passive funds. The global ETF market is now worth about $5.1 trillion, up from $700 billion a decade ago. By 2020, EY expects global ETF assets to total $7.6 trillion (pdf).
But ETF growth has been bolstered by a long bull market. What happens when this ends? There are some concerns about synthetic ETFs, which don’t actually hold the underlying securities but instead try to replicate the index using swaps and derivatives. In the event of a crisis it’s hard to be sure what would happen to these ETF if the counterparty in that agreement, usually an investment bank, failed.
There are also concerns that ETFs are inflating the value of stocks (paywall). And there is evidence that ETFs also make flash crashes, which are becoming more common, worse. Evaluating big US flash crashes in 2010 and 2015, the Securities and Exchange Commission found that ETFs experienced “more severe volatility” than ordinary stocks.
Michael Lewis brought CDOs and credit default swaps into the common vernacular with The Big Short, exposing the greed and stupidity on Wall Street in the run-up to the financial crisis. In 2014, Lewis published Flash Boys, a book about high frequency trading (HFT), focusing on a small set of firms that were using technical savvy to generate profits by sending trades faster than usual. The amount of HFT being done today is less than in 2009, and the firms are struggling to generate profits as central bank stimulus after the crisis calmed markets and reduced volatility.
But it hasn’t gone away entirely and still is a cause of concern. The German Bundesbank has warned that HFT aggravates market swings in times of stress. Researchers at Goldman Sachs have said that HFT would make sell-offs worse because the firms would withdraw liquidity from the market at the worst moment. They said that flash crashes were a sign that something is probably not right with the current state of trading and HFT could also be contributing to “market fragility.”
There has been a rapid increase in the number of nonbank financial technology firms with better user experience than traditional banks but without the same regulation (pdf). More and more fintech companies are extending credit or facilitating loans for their customers. For example, in the US, personal loans have skyrocketed thanks to fintech companies. There’s about $120 billion in fintech-linked debt outstanding, compared with $72 billion a decade ago. Fintech companies such as Lending Club, Prosper, and Avant account for about a third of this lending, up from less than 1% in 2010. These loans are not collaterialized and can lead to heavy losses for companies if customers default in an economic downturn, especially as they are often used by borrowers with lower credit scores and to refinance other types of debt.
The US fracking industry has boomed so much that America is producing enough oil that the country is now a formidable player in the global market. But Bethany McLean, the author of Saudi America: The Truth About Fracking and How It’s Changing the World, says financial risks are lurking beneath the surface. The US fracking industry was able to grow so quickly on the back of ultra-low interest rates. This is unsustainable, she says, because interest rates are rising and fracking companies have hundreds of billions of dollars of debt. It’s made even worse because for many of them, the cost of operations is more than they are bringing in from production. McLean compares it to the dot-com bubble that burst at the start of the century. “As long as investors were willing to believe that profits were coming, it all worked — until it didn’t,” she wrote.
For over a year, the Republican-led US Congress has been working to loosen bank rules and dismantle the Dodd-Frank Act, the landmark legislation enforcing stricter regulation after the 2008 crisis. Earlier this year, thousands of small and medium-sized lenders were made exempt from parts of Dodd-Frank. The Federal Reserve and other regulators are considering easing limits on how much the biggest banks can borrow, changing annual stress tests, and changing the Volcker Rule that limits proprietary trading. Meanwhile, the Consumer Financial Protection Bureau, which is being run by one of its harshest critics, is halting new investigations, freezing hires, and preventing some data collection from banks.
Research by the IMF shows that deregulation usually marks the start of a crisis. For 300 years, there has been a perpetual cycle of booms followed by deregulation, crises, and re-regulation.
Crises are hard to predict. While there are lots of risks people are aware of, there is still a good chance that the next crisis will emerge from where few people are looking. The assurances that banks are stronger than before and the financial system is less globally intertwined is little comfort in the face of other facts: Between 1970 and 2011, there have been 147 banking crises, 218 currency crises, and 66 sovereign crises. More will follow.