Are We Headed for Another Global Financial Crisis?
It’s been seven years since the global financial crisis of 2008. Although market volatility has picked up somewhat recently, markets have stayed relatively stable. Major world economies, such as the United States, Japan, China, and the Europe Union, remain sluggish, but are mostly reporting positive growth rates.
Are we embarking on a new era of prosperity? Or has the crisis morphed somehow into something altogether different? In short, is the crisis fully behind us? Or should we expect another one to erupt sometime soon? We asked CFA Institute Financial NewsBrief readers what they think the probability is that the world will experience another financial crisis in the next five years.
Poll: What are the chances of another global financial crisis occurring in the next five years?
Only 13% believe we won’t experience another major crisis. At the other extreme, 7% believe that an economic cataclysm is imminent. A plurality (44%) of respondents estimate a one-in-four chance that another crisis is on the horizon. About 23% of respondents handicap the odds at 50–50, while 13% put it at three in four.
These responses clearly indicate that the Great Recession has left an indelible mark on the minds of many poll participants and, quite likely, on the market as a whole. So let’s look at some of the key factors in the last crisis and compare them then and now. (This analysis will focus on the United States, the epicenter of the last crisis. I acknowledge, however, that other countries could find themselves at the center of the next crisis.)
With the passage of the Gramm-Leach-Bliley Act in 1999, the US Congress effectively repealed the Glass-Steagall Act. This removed the separation of investment and commercial banking and enabled banks to hold more securities, such as subprime mortgage-backed securities. In 2004 the Securities and Exchange Commission (SEC) rule change regarding capital adequacy required the major investment banks to adopt a version of the Basel II risk-weighting approach to capital adequacy. In practice it created mal-incentives for banks to own government bonds, which were given a zero-risk weighting, and triple-A mortgage-backed securities, which had capital requirements commensurate with their ratings. Mortgage-back securities rated AA or AAA only had a capital requirement of 2 cents on the dollar (i.e., leverage of 50-to-1).
In 2010 the Dodd-Frank Act was passed by the US Congress. Accordingly, banks must now meet their capital requirements at the holding company level and not just separately by operating divisions. During the crisis, many banks were able to securitize virtually all exposure to underlying loans. Under Dodd-Frank, 5% of securitized credit must be retained by the securitizer. So the incentives of the originator are now more in line with the security holder.
Between 2000 and 2005, the US Federal Reserve kept interest rates artificially low. These low rates encouraged borrowers to borrow more and banks to make more loans than they otherwise would. The long end of the curve was brought down by a rapidly growing current account deficit in the United States in which foreign trading partners used their US dollars to buy US Treasuries of all maturities. In fact, foreign ownership of US Treasuries skyrocketed from about $1 trillion in 2002 to about $2.1 trillion in 2006. Since the crisis, the central banks have been keeping rates even lower (near zero).
A major factor in the last crisis was, of course, the rapid growth of low-quality mortgages. Between 2000 and 2006, the combination of subprime and Alt-A loans rapidly grew their share of mortgage originations. Since the crisis, subprime alone has fallen from a peak of more than 20% of originations in 2006 to roughly 0.3% as of 2014. However, the spigot has opened elsewhere. Auto loans have grown rapidly to $970 billion. Through the middle of 2014, about 29% of all the securities based on auto loans to individuals were classified subprime, and defaults are now rising. Student loans are not broken out by quality (i.e., subprime), but there are two issues with them that are important to note. First, they have grown rapidly to $1.36 trillion. Moreover, as graduates and younger people are having a difficult time entering the work force, delinquencies on student loans in repayment are an estimated 27.3%. As it happens, the Federal government owns $883 billion (65%) of the student loans, so defaults will lead to more government bond issuances and, ultimately, more inflation. More recently, the Federal Housing Administration (FHA) has become much more aggressive with its capital requirements by reducing down payments and credit scores. In fact, many in the mortgage industry are preparing for a subprime resurgence in 2015.
In the wake of the crisis, the United States engaged in a wide range of massive bailouts. These bailouts took the form of both direct purchases of assets and guarantees. Consequently, the bailouts effectively transferred much of the bad debts to the balance sheets of governments worldwide. In response, a wave of money printing through various quantitative easing (QE) measures surged across the world. Whether this tide of new money will advance slowly over time or come crashing down quickly is far from certain. But it will eventually have an impact. Perhaps this is what our astute readers have sniffed out.
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All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.
Ron you did it again with another excellent article that makes you think. You also called attention to the repeal of Glass Steagall, which opened up the “bubbly machine.” I commend you for mentioning the Gramm-Leach-Bliley Act in 1999, which I rarely if ever see mentioned. With global money printing now universal, I expect a meltdown or “crisis” of one sort or another at the convenience of governments: no time table in my mind. Again, I appreciate your article on this subject. When a crisis comes it will be an opportunity for astute financial analyst advisors to protect their clients. Many employers will still be playing musical chairs.
Larry, much appreciated! And you are right, it is the job of the analyst/advisor to be prepared when a day like that arrives…
All of these disadvantages invited some economists to call for a reduction in interest to zero .
Hello Ron
I enjoyed your blog post, which, I think, was intended to make your readers sit up and think.
I voted on your poll as well – what I voted on (50%) was probabilities as opposed to possibilities, and the specific question of whether the US stock market would realize the sharp decline it did in 2008.
I think that given the amount of money tied up in boomer real estate that is coming online as they scale down, the likelihood (=possibility, as opposed to probability) that the stock market (and by that I mean the US public markets) will take a dive like that experienced in 2008, is closer to 15%, as opposed to my 50% vote.
Unforeseen political upheavals and geographic events – more likely the latter than the former – as we, and I include our oilsands in this (I am a Canadian), recklessly ruin the heritage given to us by our forefathers, will no doubt move the dial towards 50% but these would, in my opinion, be black swan events.
I remain an eternal optimistic of our fellow humankind.
Kind regards and a pleasant weekend
Savio
Savio, Not sure I follow your percentages, but thank you for your comments. Have a great weekend as well!
Who knew, such an insightful analysis from a gentleman who grew up on the mean streets of Chicago.
Bob, Thank you!!!
Hi Ron,
That was a good article… Look forward for such more from your side.
Thanks,
Cheers!
Sanjeet, thank you so much…!!!
That’s a great article! But only one query!
How would inflation be higher if government issues bonds? Ideally, issuance of government bonds will reduce the liquidity in the market (if people buy these bonds).
Thanks.
Hi Harshil, insightful question! I was perhaps a little too loose with my language. I did not mean to imply that government bond issuance is linked causally to inflation. (In fact, it is precisely the opposite.) What I meant is that such government bond issuance is correlated to inflation insofar as large amounts of defaulting student loans (and existing massive government debt) would mean the government would need to pay for these bad debts via inflation over time. Sorry for any confusion!!!
Further on your expectation of inflation: depends on what you mean by “inflation.” An increase in money supply (already massive) or an increase in general price level? Deflation of general price level is a likely outcome when those not able to repay default on loans made possible by central bank interventions. Destruction of liabilities through defaults eliminates assets held by makers of loans, thus impairing demands leading to generally decreasing prices. Lurking deflation leads to continued central bank interventions and competitions among them to inflate their currencies. This is a race to the bottom. Current outlook is worsening.
The article gave an interesting reading and data on auto n education loans defaults is an eye opener to believe history repeats itself.
Hi I D Singh, thanks for the comments. Much obliged!
Very interesting article. I was wondering whether a Grexit could provoke such major global financial crisis?
Hi Ron,
Very insightful article.
Thanks,
Vivek
I think, the crises will be more offen. The reason is simple, the magnitude of the private financial wealth (Bain report) is USD 600 trillion, while world GDP is only around USD 70 trillion. The amount of global currency exchanges is more than USD 1000 trillion (equivalent), while world trade is only USD 18 trillion per year. This is a kind of short-termism, lead to instability. Inter-government finacial flow is supervised by the IMF, but the private global financial flow is without supervision. In reality, the private global financial flow is much bigger the sovereign financial flow.
Yes your article is hitting at the heart of the problem in the short term, and also in the long term.
Cheers
I think, the question is not whether we can expect another financial crisis, but rather whether we ever got out of the crisis at all. Unequal distribution of wealth, problems with reproduction of jobs, wealth virtualization. That are just some problems front of us.
5% of 65 Trillion, just does not sound like enough skin in the game to make them honest. Why isnt there a petition to bring back glass-steigal?
Having crisis again is scary .Each crisis affects the life of many and particularly vulnerable groups r not in a position to safeguard themselves. Is it not the time to recast the policies of past as repeated use of same set of policies have rendered them weak if not useless.
Brilliant piece Ron.
Last 6-7 years of crisis have probably taken the world towards beggar-thy-neighbor type policy thinking.These policies r counterproductive for world as a whole and led to great depression in 1930s.Therefore a dialogue is required to avert a new crisis,cooperation&coexistence.
A well written article indeed. Questions spill when we see and analyze performance of Banks post crisis. We are chased like before by financial and subsequent economic disaster, we fail to counter crisis for reasons; we are not planned and prepared, we only counter crisis not rectify our carelessness and errors, we do what we wish to quadruple profits at the cost of ordinary citizens, we care for bank’s profit discarding CSR.
We need to take steps that are beneficial for both society and bank, and the economy at large. Weshould be proactive and prepare in advance so to cope with this meance (crisis) successfully. We need to stop applying and employing obsolete laws and regulations.
Hi Ron, Very interesting & knowledgeable reading as in my view USA is a biggest borrower Country which has arms and ammunition industry,& to get going it Impose War like Situation on other countries. Now this situation of Car & educational loan will create a situation much Worse then what we have seen in 2008
There is certainly a great deal to find out about this subject.
I really like all of the points you’ve made.