Wednesday, December 12, 2018

What Will Be the Trigger?

As financial markets behave erratically, what could be the trigger to push the system into some form of a crisis?

In the financial crisis of a decade ago, economists and historians tend to agree that America's over-dosage on mortgages, mortgage products and securitizations proved to be a trigger that caused global havoc in 2008.

From 2006 into 2007-08, there might have been signals for what was to occur. What eventually occurred was the collapse of Bear Stearns and Lehman Brothers and the disappearance of familiar mortgage banks like Countrywide and Washington Mutual, followed by a debilitating recession.  Scattered mortgage defaults across the country (especially in the sub-prime sectors) led to defaults in mortgage bonds, mortgage securitizations and mortgage structures. Defaults led to losses, not just in the millions, but in billions.

Back then, products (highly rated bonds, securities, and loans) that were popular just a few years before couldn't be traded, sold or touched. What had been modestly liquid turned out to be unbearably illiquid. As the crisis appeared and evolved, risks some financial institutions thought were tolerable or negligible suddenly became overwhelming and insufferable. Losses mounted.  Over time, but firms and banks, one by one, began to fall like a "house of cards," as it so often was later described.

Ten years later, market-watchers and market-forecasters are trying to project the next crisis by trying to identify what might cause it.  What might be the one phenomenon that leads to another that leads to outsize losses that spread like a wildfire around the globe?

Despite low unemployment statistics, increasing job growth, and heretofore glowing prospects for global businesses and the global economy, market players have begun to react as if it's inevitably time for another recession. They speculate whether a slowdown or crisis is imminent, although not in the proportions we endured in 2008-09. 

Check the equity markets the past few months. Or check it one hour and then glance back an hour later. Watch the emotions of the market. Watch how one announcement, one trend, or one hint of how interest rates might behave moves markets by whole-integer percentage points.  

Everybody attempts to figure out the trigger: The Trump presidency, Trump's whims and misguided pronouncements, or a credit and debt bubble (after corporate borrowers have begun to amass almost too much debt). Will it be a economic pause that leads to an aggressive slowdown? Will it be a sudden turnaround in consumer confidence? How about recent-years' mania over crypto-currencies? What about (what we see this month) the bickering over trade policy between China and the White House? 

Economists study inverted yield curves and try to make sense of the implications of short-term interest rates rising above long-term interest rates.

Can market events and uncertain economies in India, Argentina and Turkey lead to mini-crises in Europe and the U.S.? Will a plateau in growth in Silicon Valley result in a collapse of economic activity in Latin America? Will corporates later be haunted by the billions in debt when they struggle to generate cash flow just to meet quarterly interest payments? Or what will happen if a major corporate entity can't roll over what's due within the next six months?

Where are the hotbeds of political and country risk that could seep into financial markets and affect a global economy?

Ten years ago, the crisis was chaotic and evoked angst, stress and widespread concern about the financial system. Some point out the build-up to it was steady, almost methodical, occurring step by step: the euphoria of home ownership, the overflow of mortgage origination, the excess in innovation with newly created mortgage products (CMO's, CDO's, ABX CDS's, synthetic CDO's, re-securitizations, etc.), the mortgage-making and mortgage-securitizing machinery (led by the likes of Lehman and Bear Stearns), the acute demand for more mortgage product, the over-rated AAA ratings on mortgage bonds, the inability to value mortgage securities properly, the collapse of short-term debt markets, and the panic among short-term lenders to financial institutions.

Ten years later, as a rocky, misbehaving stock market suggests something bad is about to happen, what could be the factor, the variable, the phenomenon or the event that sends us back to harsh memories of 2008?

Crude, irrational experts say they know and offer weak conclusions and incomplete warnings. Real experts don't try to predict as much as they remind all that economic downturn and volatile markets are facts of life in finance and market activity. 

Real experts are, too, aware that with interdependent financial markets, one thing can lead to a negative bad thing, which can have detrimental impact on many other things and lead to financial losses of some kind---which leads to diminished confidence and standstills in the marketplace.  Lenders and investors stop lending and investing to other financial institutions and companies.  Traders become hesitant to trade and make markets--at least until confidence turns upward again. And that would be followed by corporations reluctant to spend, hire and invest, followed by consumers too afraid to consume. 

What happens in markets in America surely has impact on markets in Singapore, Brazil, Japan and throughout Europe.  A global bank's loan losses to medium-size enterprises in the Midwest will influence how much risk it's willing to take in Japan or its willingness to make markets in German corporate securities. 

At least this time around, regulators have done their best to ensure that banks big and small can weather the worst cases.  Losses will occur (even big losses), but banks, they project, should be able to absorb them without having to hope the U.S. Treasury will step in and save the day. 

Regulators and supervisors understand how markets and financial institutions are closely interconnected and interdependent.  They have obsessed over how best to manage risks in the financial system, even choosing to implementing stricter capital requirements for financial institutions that appear too powerful or "too important." 

And they, too, perform scenario stress tests on big banks to see how they would fare if, say, equity markets zoomed downward by 30-50%, if real estate values crash, if unemployment surges above 10%, and if the U.S.'s GDP growth rate sags below 2%.

What we do know is that financial markets act in desperate ways and assume the worst when they are engulfed in uncertainty. They calm down when uncertainty is contained. 

Tracy Williams

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