The City of London’s most vocal “bear” has warned that the world is heading for a financial crisis as severe as the crash of 2008-09 that could prompt the collapse of the eurozone.
Albert Edwards, strategist at the bank Société Générale, said the west was about to be hit by a wave of deflation from emerging market economies and that central banks were unaware of the disaster about to hit them. His comments came as analysts at Royal Bank of Scotland urged investors to “sell everything” ahead of an imminent stock market crash.
Sources of risk
- Liquidity – Whether enhanced capital and liquidity requirements, and the ban on proprietary trading by banks, have suppressed market maker inventories in relation to the outstanding amount of corporate bonds.
- Non-banks – Whether the next contagion will originate in asset managers and fintech companies who are subject to less prudential regulation but compete with banks in credit intermediation.
- TBTF – Whether post-crisis regulations have encouraged oligopolistic behavior by reinforcing market concentration and creating barriers to entry in banking, clearing, and ratings.
- Securitization – Whether risk retention/other regulations designed primarily to respond to the subprime mortgage crisis are optimized to reduce systemic risk without suppressing systemic benefits in other asset classes.
- Hyper-risk – The impact of quantitative easing and ultra-low interest rates on risk-pricing mechanisms, and whether these policies have encouraged excessive risk-taking by investors seeking to harvest capital gains in a low yield environment, and by banks seeking to bolster profits by lending to riskier borrowers.
- Mercantilism – Whether aggressive monetary stimulus, which tends to devalue a country’s currency and make its exports more competitive, will trigger competitive currency devaluation and other trade barriers by other countries seeking to manage their trade deficits.
- Central bank divergence – Whether divergent policies (loosening in Europe/Asia versus tightening in the U.S.) will encourage speculation in the bond and currency markets.
- Dollar-denominated credit – Whether emerging market companies who have borrowed heavily in U.S. dollars can manage any credit squeeze wrought by local currency depreciation.
- “Drug-resistant” recessions – Whether central bankers have innovations, besides slashing interest rates below the “zero lower bound” and printing money, that will stimulate the economy without destroying government balance sheets.
- Zero lower bound – The consequences of negative nominal interest rates (where depositors pay rather than receive interest to maintain accounts, but borrowers pay less the longer they take to repay their loans) on perceptions of lending risk, incentives to make loans to riskier borrowers (rather than pay to hold excess cash at the central bank), and on the stability of insurance companies, pension funds and other organizations with long- term liabilities and demographic risk.
- China – Whether the government can command a soft landing of its economy, including managing its debt crisis and dwindling reserves.
- Sovereign wealth – Whether funds run by natural resource revenue-dependent countries can manage the rapid liquidation of assets to cut budget deficits resulting from falling commodity (especially oil) prices.
- Populism – Whether populist sentiment (left or right) will trigger decisions (such as Britain’s potential Brexit from the EU) that might hinder free trade.
- Non-correlated risk? – Whether insurance-linked securities, which purport to offer diversification based on low correlation to other markets, pose a contagion risk in the event of a large-scale natural catastrophe and sentiment-based volatility.
- Bailouts – Whether contingent convertible debt securities that automatically convert to equity (or are written down) when a bank crashes will obviate the need for taxpayer bailouts without inducing a panic that contaminates the entire financial system.
The 2008 financial crisis was sui generis, caused by the collapse of an unprecedented bubble in the value of one major financial asset—residential mortgages. Accounting rules accelerated these losses into the balance sheets and income statements of a relatively small number of large financial institutions, which were carrying these assets with debt. The fall in mortgage values seriously weakened the capital positions of these firms and threatened their stability. These factors are not present in today’s troubled economic conditions.
The fault of one government policy
The 2008 financial crisis was the result of four converging elements, all linked to a single U.S. government policy: an attempt to increase mortgage credit for low-income borrowers by forcing Fannie Mae and Freddie Mac—the two government sponsored enterprises (GSEs) that were the principal buyers of residential mortgages—to reduce their underwriting standards. The policy, known as the affordable housing goals, was adopted in 1992 and was pursued through two administrations until 2008.
First, over this 16 year period, affordable housing goals produced a deterioration in the quality of the mortgages outstanding in the U.S. Before 1992, Fannie and Freddie would accept only prime mortgages—loans with downpayments of at least 10-20%, solid credit scores and debt-to-income (DTI) ratios that did not exceed 38% after the mortgage closed. By 2008, however, the GSEs were accepting loans with no downpayments, low credit scores and DTIs as high as 50%. As a result, just before the crisis, more than a majority of all U.S. mortgages were subprime or otherwise low quality, and 76% of these mortgages were on the balance sheets of government agencies, primarily Fannie and Freddie. This shows, without question, that the government created the demand for these loans.
An unprecedented housing bubble
Second, new reduced underwriting standards created an unprecedented housing bubble. This is clear when we consider the effect of reducing downpayments. If a potential buyer has $10,000 to buy a home, and underwriting standards require a 10% downpayment, the buyer can purchase a $100,000 home. But if the downpayment requirement is reduced to 5%, the same buyer can purchase a $200,000 home. More money chasing any asset will inevitably cause inflation in its value, and once started a bubble feeds on itself. By 2008, it was nine times larger than any previous housing price bubble.
Third, before 2008, most U.S. mortgages were held by three different kinds of financial institutions—government agencies like Fannie and Freddie, leveraged funds of all kinds and banks in the U.S. and abroad. Because mortgages were generally considered good collateral they were carried with debt. Thus, not only were homebuyers becoming more leveraged, with 30 year fixed rate mortgages and low downpayments, but financial institutions were then further leveraged by borrowing to carry these deficient assets.
Fourth, many mortgages were held by financial firms in the form of mortgage-backed securities (MBS). These instruments were backed by pools of mortgages, with MBS holders receiving payments of principal and interest that were paid into the pool by homeowners and passed through to investors. Banks in particular were encouraged to hold MBS by the internationally-agreed Basel standards, which reduced the capital charge for holding a mortgage from 4% to 1.6% if the mortgage was held in the form of a highly-rated MBS.
Virtually every aspect of the meltdown can be traced to federal policies, many of which were designed to boost home mortgages. It’s all laid out in Hidden In Plain Sight: What Really Caused the Worlds’ Worst Financial Crisis and Why it Could Happen Again, a new book by AEI’s Peter Wallison. It’s a must read for anyone who wants the straight dope on what caused the 2008 crisis. (Here’s an excellent review by Alex Pollock. Also,Wallison will discuss the book, this Wednesday at The Heritage Foundation).
Wallison’s book is a valuable corrective, because too many policymakers have been getting away with a false narrative. These officials want us to believe the crisis had nothing to do with the government’s affordable housing goals, and that deregulation and private-sector greed caused the meltdown.
Yet the financial crisis was, in truth, firmly rooted in a set of ill-conceived government policies that allowed too many people to take out home mortgages.
How much did the financial crisis of eight years ago cost the world, cost all of us? There are several ways to tackle that question.
One could examine the public bill for bailing out the giant banks that fell over like ninepins. One could look at the mountains of public debt piled up in the wake of the crisis (as governments, thank goodness, carried on spending while tax revenues collapsed in order to stop their economies slumping into new depressions).
One could contemplate the hellish spike in unemployment across the western world during the slump itself – all those people thrown out of jobs as business confidence evaporated, all those wasted resources, those lives damaged.
Former Treasury Secretary Henry Paulson told an audience of bankers and economists at a hotel on New York’s Fifth Avenue today that many of the factors that contributed to the financial crisis of 2008 are still in place. Asking rhetorically whether another crisis could occur, Paulson said: “The answer, I’m afraid, is yes.”
