What will the next crisis look like?

Posted on 29. Mar, 2010 by Jean Jacques Ohana in Weekly Focus | Comments Off

The « Black Swan » theory, introduced by Nassim Taleb, contends that market disruptions arise in a totally unpredictable manner, independently of the players’ behaviour. Yet, most market disruptions are endogenous to the financial system, the final dislocation representing a phase transition of an unstable system from a state of expansion to a state of implosion.

The financial crisis of 2008 did not arrive like a streak of lightening in a blue sky. It is the story of how an initially anecdotal seed of instability turns into a giant rogue wave rippling through the whole financial system by amplification and spillover effects.

As a matter of fact, the subprime crisis started with the junior tranches of the worst quality of Mortgage-Backed-Securities (MBS) called subprimes. The first issues relating to defaults of poor-quality borrowers was reported in February 2007. The issues then spread to Alt ABS (Asset-Backed-Securities), which are  securitized instruments composed of badly documented loans. In August 2007, it infected all ABS, including senior tranches. Then, cash funds invested in ABS had to abruptly close in face of early redemptions. Every bank involved in the securitization industry was hit, including Bear Stearns, UBS, Lehman Brothers… After the bail out of Bear Stearns in February 2008 and the massive commodity and carry trade deleveraging of August 2008, the final round of instability was triggered in September 2008 by the default of Lehman. Every asset class from commodities to credit, equities and emerging debt was hit. Confidence progressively vanished, interbank market froze and only governments’ bailouts and central banks’ quantitative easing were successful at preventing a global financial meltdown.

The accumulation of stress within the financial system that paves the way to major financial disruptions is monitored through Riskelia’s cumulated Risk Aversion signal. This indicator integrates over time the manifestations of anxiety within the financial system: an upward trend is associated to recurrent stress episodes while a downward trend is the sign of a durable relief. The following graph shows that the 1998 LTCM default, the 2002 corporate debt crisis as well as the market turmoil of August 2007 and the financial crisis of the fall 2008 have all occurred in ascending phases of the risk accumulator. By contrast, the descending phases have been remarkably immune to large financial crises.

It looks like financial markets absolutely did not draw any lesson from the recent crisis. Financial regulation has been hesitant to say the least; speculation is at a climax as reflected by the network of asset class relationships (Commodities network and investors behavior); banks invest the abundant liquidity poured into the economy by the Central Banks in trading activities rather than in financing new projects. And as a result of this, financial bubbles are in construction everywhere. China’s lax monetary policy fostered a real estate mania  (Washington Post – In China, fear of a real estate bubble) while the financialization of commodities markets provokes a simultaneous rise of metal prices and inventories (Why commodity prices rise together with inventories?). The longer these instabilities develop, the larger the impact when these bubbles eventually implode.

At the same time, the G10 sovereign debt tornado gains momentum.

Since 2001, none of the G5 countries managed to generate a public surplus, only Germany succeeded in running two balanced years. And mathematically, they need to maintain their deficit under the nominal GDP growth to revert to a sustainable path. As inflation is anemic and potential real growth has been reduced to around 2%, they have to maintain their future deficit at around 4% of GDP (2% of real growth + 2% of inflation). None of these countries have undertaken the necessary steps to go back to fiscal sustainability. It comes as no surprise then that, after several decades of blindness and complacency, the acuteness of the G10 solvency problem is more and more acknowledged by investors…Greece, and very soon Portugal and Spain will experience insolvency situations as the austerity plans imposed to them fail or produce unprecedented depressions. This situation is very similar to the subprime crisis. The crisis first infects elements of minor importance: Dubai, Greece, Portugal. Then, the problem spills over to links of increasing systemic relevance: Spain, UK, France, US…

Riskelia has designed a cost of risk network in various asset classes (equities, coporate credit, cash liquidity, emerging credit, carry trades, banks, insurers G10). When a correlation in a pair of variables stands between 0.25 and 0.5, the two variables are linked by a thin line, when the correlation stands between 0.5 and 0.75, a bold line connects the points, and when correlation exceeds 0.75 a bold red line connects the two costs of risk across two different asset classes.

The network is presented below:

From here, we can elaborate a possible scenario for the next financial crisis:

  1. The weak link of the financial system is G10 solvency.
  2. The latter is closely connected to banks and financing liquidity. If it finds no solution, local banks of insolvent countries will inevitably be hit as emphasized in our previous post (Deciphering the G10 sovereign debt crisis: a macroeconomic perspective).
  3. Then the whole network will be infected as banks are the cornerstone of the whole financial system.

It is too early to predict the degeneration of the system. The seeds of financial instability grow in a climate of complacency and loose monetary policy: commodities and equities will continue their frivolous rise until upcoming G10 countries austerity plans and Chinese necessary policy shifts whistle the end of the game.

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