21 SEPTEMBER 2018
A NEW CRISIS IS BREWING 10 YEARS AFTER THE LAST ONE, AND IT'S NOT A SURPRISE
by Raul Elizalde
This article also appeared on Forbes.com.
The financial crisis of 2008-2009 was no ordinary crisis. It brought the U.S. banking system to its knees, destroyed millions of jobs, and nearly caused the break-up of the Eurozone. And this is just a short list of the damage it caused. Given how bad it was, it may have been reasonable to expect that we would now have a system in place to prevent another debacle. But ten years have passed and the idea that we have learned our lessons seems at best quaint and at worst laughable.
One of the most basic lessons not learned is that a massive buildup of debt tends to end in a serious financial crisis. Even a small liquidity event that gets in the way of rolling over higher and higher amounts of debt eventually brings down the whole edifice.
This is not a revelation. Even the Tulip Mania of the 1630s that ended up in a crash was fueled by a huge increase in leverage created by tulip “futures.” Most recent debacles such as the 1982 Latin American debt crisis, the 1990 Savings & Loan crisis, the 1990 Japan crash and the 1997 Asian crisis can all be traced to out-of-control credit growth. And, of course, the 2008 crisis had at its core an exponential chain of leverage built around mortgage derivatives.
In the aftermath of the 2008 crisis, a river of ink was spilled to condemn the runaway debt spiral that led to it. It is remarkably ironic, then, that as we crawl out of ten painful years of struggle and recovery, even the most outspoken fiscal hawks of that time now seem unconcerned that debt is growing apace once more.
This is, alas, not surprising. As Prof. Richard Kindleberger from MIT put it in his 1978 classic book "Manias, Panics and Crashes" some time has to pass after a crisis “before investors have sufficiently recovered from their losses and disillusionment to be willing to take a flyer again.” Ten years, it seems, qualifies as enough time for the party to resume.
Despite an economy that by all measures has recovered well, if not spectacularly, the U.S. has just decided to unleash a large and most likely unnecessary fiscal stimulus that will bloat public debt and fiscal deficits. But government is not alone in abandoning prudence. The private sector, spurred by rock-bottom interest rates, has gorged on debt. This is true not only in the U.S. but also across the globe.
Three areas, in particular, point to areas where credit expansion may be growing at unhealthy rates.
The Congressional Budget Office projects the fiscal deficit to double to 5% of GDP from 2015 levels, and federal debt, as a result, to grow to nearly 100 percent of GDP by 2028 from the current 75%. And these are just projections the actual deficit numbers for this year are looking even worse. Indeed, the 2018 FY projection (which ends in September) is for a deficit of $804BN, but we already racked up $898BN in the eleven months that ended in August.
U.S.Treasury debt held by the public is growing and
fiscal deficits are deepening according to CBO
Corporations everywhere took advantage of interest rates at all-time lows, borrowing as much as they could in the last few years. Many companies in the U.S. used the proceeds to buy back their own stocks.
The amounts are staggering. According to a report by the McKinsey Global Institute, corporate bonds around the world issued by non-financial companies have almost tripled since 2007 from $4.7 TN to $11.7TN. Of particular concern is that the largest credit category of overall corporate debt (loans, bonds and credit lines) and the one that grew the fastest is BBB, sitting just above the edge of “junk.”
Most of the outstanding corporate debt instruments (Includes bonds, loans, and revolving credit facilities rated by S&P Global Ratings from financial and non-financial issuers) are at the bottom of the investment grade tier.
Higher interest rates or a slower economy may affect the ability of any given company to service, roll over or repay that debt, which then leads to a downgrade into the “non-investment grade” (i.e. junk) category. This, in turn, forces some bondholders to liquidate their holdings. If this goes beyond an isolated event, the risk of downgrades snowballing into a liquidity crisis becomes real.
The 1929 stock market crash was driven, in part, by a speculative mania that relied heavily on borrowed funds to buy stocks. While today’s margin debt levels are a far cry from those heady days when it reached more than 8% of GDP, it is now at its highest level in decades.
Debit balances in customers' securities margin accounts tend to peak at stock market peaks.
History shows that beyond a certain level, debt burdens become too heavy to
bear. It is not clear what that level might be, when it will happen, or how
severe a crisis could get.
There are some mitigating factors today, such as a less-interconnected global
economy (yes, there is an upside to less globalization) that limits avenues of
contagion, and a better-capitalized banking system that seems better prepared
to deal with a systemic crisis.
In addition, the relatively fast economic growth that the U.S. is experiencing, although brought about by the same fiscal expansion that is bloating debt levels, offers a good opportunity to get serious and put in place policies that can help us deal better with future crises. This is to say that it is not yet too late for investors and their financial advisors to avert a repeat of the 2008 disaster – if only they embrace the lessons of the past.