The next crisis is still lurking in the financial system: ‘We never addressed the root cause’

WEF chairman: We haven’t learned enough from Lehman collapse
WEF chairman: We haven’t learned enough from Lehman collapse

In a world swimming in debt, the next crisis is likely to bear at least a passing resemblance to the last one. The good news is that day seems to be a ways off. Not that anyone’s in a hurry, but there are few obvious signs of a situation akin to the 2008 meltdown on the horizon. The financial system is well-capitalized and operating with lower leverage and risk-taking than in at least generation or two. Economic pillars remain strong, the health of corporate America has rarely been better and new buffers put in place have been effective at absorbing shocks.

In fact, if anything it’s too quiet. That almost always has been the recipe for a good crisis.

“There was abundant liquidity in the system in 2006, too,” said Danielle DiMartino Booth, CEO and director of intelligence for Quill Intelligence, a research and analytics firm. She also served as advisor to former Dallas Federal Reserve president Richard Fisher during the financial crisis, so she had a front-row seat to how it unfolded. Indeed, before collapsing investment bank Bear Stearns had consistently ranked among Forbes’ best-run businesses. Lehman Brothers had $275 billion in assets under management prior to the crisis and had generated $3.1 billion in revenue in 2007, the year before it too capsized.

For DiMartino Booth, the exotic financial instruments that helped cause the calamity a decade ago and brought down those two venerable institutions, along with many more, are still lurking in the system, threatening a deadly repeat unless the issue is corralled.

“We never addressed the root cause of derivatives in the first place,” she said in an interview. “We still kind of operate in the dark as it pertains to the transmission mechanism of derivatives.” Derivatives refer to instruments that package bonds into blocks that are then sold off to investors. Warren Buffett famously called them “weapons of financial destruction.” In theory, they actually were meant to reduce risk by hedging exposure to any one security failing, sort of like the way exchange-traded funds combine entire sectors to alleviate exposure to a single company whose shares might slump. In practice, things were quite a bit different. Wall Street traders, in response to demand for yield from their clients, put together exotic bundles of mortgages, many tied to unqualified buyers who defaulted. Their structure was so opaque that many banks couldn’t even value what they held, creating a crisis of confidence on Wall Street that took out some of the financial world’s biggest names.

The market for some products, particularly collateralized debt obligations and leveraged loans, has increased dramatically in recent days. CLO volume was up 51 percent year-over-year in the first half, according to Dealogic, while Thomson Reuters reports that volume for loans used in leveraged buyouts has surged 33 percent.

Covenants, or protections for investors in bonds, particularly high-yield junk, are close to record lows, according to Moody’s Investors Services. Meanwhile, the federal government keeps ringing up more and more debt — $21.4 trillion and counting — and interest rates are on the rise. In an investing world that continues to clamor for yield, the debt bomb is always ticking.

“The search for yield has been spread across the globe once again, and now we’re seeing it crop up again in different countries every week,” DiMartino Booth said. “You wake up and wonder who blew up today.”

Indeed, a series of mini-explosions has been happening around the world, in countries like Turkey, the Philippines and India. Currency trading has gotten increasingly volatile, sparking worries that the U.S. may import its next crisis. “I’m concerned about the transmission mechanism,” DiMartino Booth said. “Even if the initial catalyst to set off the next downturn does not come from within the U.S. financial system, that does not mean that the U.S. financial system is not just as vulnerable as it was before to be the conduit to spread systemic risk.” Tightening financial conditions, the Fed continuing to raise rates and the sheer volume of debt instruments rising almost certainly means that while an earthquake may not be looming along the financial system’s many fault lines, tremors are almost certain.

“A lot of markets are going to reprice, but it won’t be systemic,” said Christopher Whalen, head of Whalen Global Advisors, an investment bank consultancy. “A lot of illusions will get broken, but spreads are still quite tight in the credit markets.”

In the interim, warnings about looming crises likely will get treated like the rantings of so many Chicken Littles who have been proven wrong time and again during the nine-year economic recovery. Few really believe in crises until they actually hit.’

“When we talk about leveraged loans and CLOs today, sure there’s obviously a problem. Until you see a sponsor fail and file bankruptcy, then people will start to believe it, but not yet,” Whalen said. “There is a significant mispricing of risk. That will come along soon. You’re going to see prices fall a lot.

“A shock turns into a crisis when the system is unprepared for it. The system is often at its most vulnerable near the end of the global economic cycle when excesses have built up and managing risks may have been neglected,” Kleintop said in a recent report looking at the source of the next crisis. “The global economic, financial and market system now seems better prepared to manage the shocks of the past were they to repeat in the future.”

Politics, the rise of index investing and higher interest rates that will make all that debt more expensive are the big ones investors will need to watch out for. “Vulnerabilities have shifted which may make the shocks that pose the greatest risk of a crisis somewhat different than those of the past,” Kleintop wrote. “Of these, the potential risk posed by a shock from higher interest rates coupled with a stronger U.S. dollar may pose the greatest threat to a vulnerable financial and economic system.”