The dark clouds from the financial crisis in 2008 have never really dissipated completely. Global policymakers, including government officials and central bankers, continue to worry about a repeat performance of the colossal meltdown that transpired in the financial sector more than seven years ago. New legislation has been enacted to prevent a recurrence of the liquidity crunch that froze banking and insurance institutions in their tracks way back when. Doubts persist if these efforts were the correct cure or just more added weight to the process. Until there is a real test, no one will know for sure.
Opinions, both positive and negative, appear in the financial press on a monthly basis and, seemingly, have a similar shelf life until the next counter opinion gathers steam. Each author of doom tries to guess at the “trigger” that will cause another liquidity breakdown, while the optimists choose to believe in the latest study that attests that all systems are go with no threat of a massive crunch. The fact remains that 2008 did constitute a “massive crunch”, but trying to predict the next liquidity event is comparable to forecasting the next “Big One” on the San Andreas fault line in California.
Fear is the common denominator that runs through both sides of the house. Our financial institutions, perhaps the most heavily regulated entities on the planet, fell victim to their own greed, and nearly one decade later, we keep hearing reports that our friendly bankers, the ones that are too big to fail or jail, are back at it again, bending the rules to support their bad habits, drawing overwhelming compensation bonuses, and being found guilty of forex and interest rate fixing scandals on a global scale. Are we headed for another judgment day, of sorts?
What were the mistakes in 2008 that we are trying not to repeat?
There have been countless studies and research performed in order to ascertain the true causes of our banking meltdown in 2008. One fact is certain – this type of systemic collapse does not occur due to some singular event. The causes developed over a long period of time until a “tipping point” was reached. When the dam finally broke, it was the result of many smaller events that had accumulated over time to such an extent that pent up pressures had to find a release. In other words, the then current situation was untenable and had to dramatically shift course in order to find a new equilibrium.
The 2008 financial “earthquake” had been building over two decades. Commercial banks, the ones that take deposits, had shifted their focus to transaction revenue and were salivating for the big fee income streams that funded their investment banking brethren, firms like Goldman Sachs (N:GS). In the late nineties, the banking lobby finally achieved a milestone sought after for years -- the repeal of the Glass-Steagall Act, the last impediment blocking the access to investment banking turf.
Competition for market share heated up, and investment banks did what they had to do to survive – invent new exotic securities to sell and trade, primarily over-the-counter (OTC) derivatives in the real estate arena. Ordinary supply and demand forces did not determine prices in these markets. The securities were thinly traded, at best. Analysts would set prices according to their own risk assessments and by applying academic pricing theory algorithms.
The market for these fixed income securities was enormous. Pension funds across the globe bought these items, sight unseen, and then quickly locked in their returns risk free by buying credit default swaps from the insurance industry, another exotic OTC derivative. Regulators in all jurisdictions had no ideas about the size and systemic risk posed by these markets since nearly all were out of sight in the shadow world of OTC. The shear volume of these markets enticed both commercial and investment banks to buy, sell, and freely trade these instruments for profit in what amounted to a global casino.
Investment banks do not have consumer deposits to borrow against or the ability to borrow from the Fed. Their business model involves leveraging purchased assets, sometimes in excess of 100:1, with borrowed funds from the overnight markets. As long as the assets maintained their value and satisfied collateral requirements for the short-term funding, these bankers had learned how to make big money from “black-box” trading software that could manage hundreds of trades in nanoseconds. Profits were outrageous for quite a few years for firms like Lehman Brothers, until the bubble burst.
The U.S. housing industry peaked in 2004. Easy credit practices helped to support the industry for a while, but the value of mortgage-backed securities began to decline when credit defaults escalated. Unfortunately, the entire financial infrastructure was dependent on the continual rise of housing prices. When they did not, collateral values fell. Margin calls resulted, and highly leveraged firms, along with depository banks, began collapsing. Every entity rushed to liquidate their positions, but there were no buyers. A massive liquidity crunch gripped global banking. Lehman Brothers was the largest entity to fail. The government was forced to step in with bailout packages to support the banking system and restore confidence. Financial accountability was forsaken.
There were several high level reports that were commissioned to determine the direct causes of the global banking meltdown. The causes cited in the U.S. Senate's Levin–Coburn Report were a good summary: "High risk, complex financial products; undisclosed conflicts of interest; the failure of regulators, the credit rating agencies, and the market itself to rein in the excesses of Wall Street." The Dodd-Frank Act and others across the globe attempted to correct many of the system shortcomings, but banking lobbies the world over have fought full implementation every step of the way.
Why do so many feel that the same shortcomings are forming again today?
Fast forward eight years, and not that much has changed. Banks still bet on the bond casino and trade for their own benefit. While there is some transparency now in the OTC derivatives market, it is not all encompassing. Per one analyst: “This month, G-20 leaders will meet in Antalya, Turkey, for their tenth summit since the 2007 global financial crisis. But, despite all of these meetings – high-profile events involving top decision-makers from the world’s most influential economies – no real progress has been made toward reforming the international financial architecture.”
Progress to build a global financial safety net, especially for emerging market countries has been stalled. Over the past eight years, quantitative easing and zero-interest rate policies have forced investors to go global in search of higher returns. Whereas 5% to 10% used to be a prudent portfolio share for cross-border investments, global securities now can make up as much as 25% to 35% of a pension, institutional, or hedge fund mix. These securities tend to be thinly traded and subject to liquidity constraints.
Emerging market economies comprise 55% of global GDP growth, but the precipitous fall in commodity prices has severely impacted that sector. Capital outflows have been accelerating. Dodd-Frank, the Volcker Rule, Basel III, and other regulatory actions have only disrupted these capital flows, and the “shadow banking” system that has developed to support this global expansion is not highly regulated and does not maintain the necessary reserves or capital to sustain itself, if and when there is a rush for the exits.
According to Bill Gross, the former head of the Pacific Investment Management Co., “Investors and markets have not been tested during a stretch of time when prices go down and policy-makers’ hands are tied to perform their historical function of buyer of last resort. It’s then that liquidity will be tested. The fact is that derivatives on a systemic basis represent increased leverage and therefore increased risk – presenting possible exit and liquidity problems in future months and years.”
What could trigger panic selling and the dreaded liquidity crunch?
Fixed-income managers, central bankers, and government officials have been sounding the liquidity-warning bell since 2010. From their perspective, they have seen the storm clouds forming from on high and have spoken to what might cause the avalanche to start rolling down hill:
- A central banking misstep, the reason many are concerned about the Fed’s desire to speed up interest rate normalization or the withdrawal of economic stimulus in other regions;
- Sharp devaluations or defaults of Euro Zone sovereign bonds, whether in Greece, Portugal, Italy, or Spain;
- Problems in China, whether of their own making or their impact on the economies of their trading partners;
- A growing crisis in emerging markets and their ability to respond to increased capital outflows;
- The impact of geopolitical risks and the actions of terrorist groups;
- The deterioration of the junk bond market has also been cited by many experts as a possible linchpin;
- The great unknown of unknowns, the proverbial straw that breaks the camel’s back.
The IMF and World Bank recently convened in Peru for their semi-annual meeting. Their primary concern was what could start a “vicious cycle of fire sales, redemptions and more volatility. The global financial outlook is clouded by a triad of policy challenges: emerging market vulnerabilities, legacy issues from the crisis in advanced economies, and weak systemic market liquidity.” Gloom and doom were pervasive at this confab.
Concluding Remarks
Is a liquidity crunch looming on the near-term horizon? As far as corporate bonds in the U.S. are concerned, a recent report, issued by New York Fed analysts, claims that this part of the market is alive and well. What about everything else? As long as the present scenario of gradual positive change remains the new normal, then a financial earthquake and subsequent tsunami could possibly be delayed long enough to correct the global financial architecture. History has shown, however, that the situation is always worse than current reporting systems portray. The fuse is burning, so to speak.
If and when the shock arrives, one thing is clear – foreign exchange markets will experience extreme volatility. The structure of the forex market has also radically changed over the past decade, in both volume and breadth of investing participants. As one expert noted, “Daily currency trading volumes denominated in dollars are now over 140 times the size of the dollar value of New York Stock Exchange volumes! In other words, currency markets and their flows are driving all of the other markets.”
If and when panic selling starts, there will be chaos in the foreign exchange market and the opportunity to profit on a large scale, if you are prepared. To be forewarned is to be forearmed!
Risk Statement: Trading Foreign Exchange on margin carries a high level of risk and may not be suitable for all investors. The possibility exists that you could lose more than your initial deposit. The high degree of leverage can work against you as well as for you.
by Tom Cleveland