By Doug Noland
Credit Bubble Bulletin
“Those who do not learn history are doomed to repeat it.” I’ll add that those that learn the wrong lessons from Bubbles are doomed to face greater future peril. The ten-year anniversary of the financial crisis has generated interesting discussion, interviews and scores of articles. I can’t help but to see much of the analysis as completely missing the critical lessons that should have been garnered from such a harrowing experience. For many, a quite complex financial breakdown essentially boils down to a single flawed policy decision: a Lehman Brothers bailout would have averted – or at least significantly mitigated – crisis dynamics.
I was interested to listen Friday (Bloomberg TV interview) to former Treasury Secretary Hank Paulson’s thoughts after a decade of contemplation.
Bloomberg’s David Westin: “It’s been ten years, as you know, since the great financial crisis that you stepped into. Tell us the main way in which the financial system is different today than what you faced when you came into the Treasury?”
Former Treasury Secretary Hank Paulson: “Well, it’s very, very different today. So, let’s talk about what I faced. What I faced was a situation where going back decades the government had really failed the American people, because the financial system had not kept pace with the modern financial markets. The protections that were put in place after the Great Depression to deal with panics were focused on banks – protecting depositors with deposit insurance. Meanwhile, the financial markets changed. And when I arrived (2006), half or more of the Credit was flowing outside of the banking system. And we didn’t have the oversight we needed. We didn’t have the regulatory authorities to deal with a run, and this was a situation where there was a great deal of leverage. There was a great deal of risk. Today, when you look at it, we see a situation where the banks are better capitalized. We have much better regulatory oversight. I think there are fewer gaps. I think we have a better set of authorities. There is less of what I would call ‘dry tinder’ – there’s less excesses. So, I think there is less risk, although these things are unpredictable of having any kind of a major financial crisis, on the one hand. And there are some important new authorities. But some of the things we relied very heavily on have been taken away. So, I wish we had a few more protections.”
“…The thing I would be most concerned about are some of the authorities we used to stop the panic. The Exchange Stabilization Fund at Treasury we used to guarantee the money markets. Remember there was a run on the three and one-half trillion money markets, and the money markets were funding short-term borrowings for many of the biggest companies in the world. So when the money markets began to implode, the commercial paper market dried up. If these big companies started cutting back on their funding, this would have moved very quickly to their suppliers, to smaller industrial companies. It could have been disastrous. We stepped in and we used the Exchange Stabilization Fund to guarantee the money markets. We no longer have that authority.”
Mr. Paulson is surely accurate in stating the government “really failed the American people,” though I doubt future historians will see this failure having concluded with the 2008 crisis. Finance had fundamentally changed, and the regulatory framework failed to adapt. As Paulson said, Credit expansion (and finance more generally) had moved outside of traditional bank lending, but Washington had not constructed adequate safeguards and resolution mechanisms in the event of a panic.
While not inaccurate, this line of analysis misses the greater point – the critical lesson that went unheeded: It was “activist” government policy-making over an extended period that played a decisive role in the rapid expansion of non-traditional finance. Federal Reserve policymaking evolved to aggressively incentivize risk-taking and leveraged speculation. The government-sponsored enterprises (GSE) evolved from guarantors of mortgages to massive quasi-central banks, with unlimited access to cheap money market finance supporting enormous balance sheets and market backstop operations. Between the Fed and GSEs, unprecedented Washington “activism” created a backdrop conducive to a “wild west” derivatives marketplace ballooning to the hundreds of Trillions.
It is true that “we didn’t have the oversight we needed.” But the much greater issue was that Washington had become actively involved in promoting cheap Credit, abundant liquidity, and inflated securities and asset markets. Washington partnered with Wall Street to fundamentally and momentously change system-wide risk intermediation and resource allocation.
What’s missing in the 10-year crisis anniversary dialogue is a more comprehensive discussion of several decades of serial booms and busts, including the factors behind the 1987 stock market crash; the late-eighties boom and bust; the S&L crisis; the 1994 bond market rout; the 1995 Mexico collapse; the 1997 “Asian Tiger” collapse; the 1998 implosion of Russia and Long-Term Capital Management; the 2000 collapse of the “tech” Bubble; the 2001 crisis in Brazil; the 2002 U.S. corporate debt crisis; the 2002 collapse of the Argentine peso and so on.
I have for a long time now argued that “unfettered” contemporary finance is dangerously unstable. I believe it has become only more unsound – and perilous – over time. Here in the U.S., it was easy to disregard the spectacular boom and bust dynamics that were wreaking havoc throughout numerous overseas economies (heck, they worked to keep U.S. rates and market yields low!). “The Maestro” and his monetary magic had everything under control. Things, however, finally came home to roost in 2008. The mighty U.S. was not immune after all. Indeed, years of government interventions, manipulations and market backstops ensured the accumulation of excesses and structural maladjustment to the point of risking financial collapse.
To focus on Lehman as the critical factor in the crisis is to disregard the true culprit, the intoxicating amalgamation of contemporary finance and “activist” government monetary management. As always, Credit is self-reinforcing. I (among others) have argued that Credit is inherently unstable, with today’s unconstrained contemporary Credit remarkably unstable. Asset inflation is the most dangerous form of inflation, as “Wall Street” market-based finance and modern central banking doctrine specifically champion rising securities and asset prices. What is more, government and central bank promotion of asset inflation guaranteed that leveraged speculation evolved into a dominant force throughout global finance.
For more than nine years, I’ve argued that responses (U.S. and international) to the 2008 crisis unleashed the “global government finance Bubble.” I believe speculative leverage is a greater global issue today than even in 2008. This leveraging has become integral to global liquidity, liquidity that fueled precarious booms in China, throughout the emerging markets and even in Europe. Furthermore, this global liquidity has over the past decade been “recycled” into Bubble U.S. securities markets, illustrated by the massive (Fed’s Z.1) “Rest of World” flows into U.S. financial assets.
The “global savings glut” thesis was popular back during the mortgage finance Bubble period. We were to believe a persistent surplus of “savings” over “investment” explained low market yields and overly abundant marketplace liquidity. Yet “savings” is not going to suddenly disappear. Liquidity created in the process of expanding speculative leverage, on the other hand, can evaporate almost instantly in the event of an acute bout of de-risking/deleveraging. And if this liquidity had evolved into a prevailing source of finance for the asset markets and real economy, an abrupt change in market perceptions will have profound ramifications for both financial and economic stability. Most critically, the longer speculation-related liquidity has fueled the markets and economy, the deeper the structural impact and the greater the subsequent dislocation when this liquidity source is interrupted.
It was imperative for policymakers to make fundamental post-crisis changes to their approach with incentive structures, incentives that had fomented progressively more systemic financial and economic Bubbles. That was the key lesson from the crisis – one that went unheeded. Policymakers instead moved aggressively in the opposite direction: Their market interventions and manipulations became only more extreme. The upshot has been historic Bubbles around the globe, stocks and bonds and across asset markets more generally.
The issue in 2008 was not Lehman as much as it was tens of Trillions of leveraged securities holdings and derivatives whose value had been inflated by a confluence of speculation, leverage, liquidity overabundance and market misperceptions. This self-reinforcing liquidity backdrop had not only inflated the value of mortgage-related securities, it had inflated the value of the underlying collateral (home prices). This liquidity was also being recycled through the securities markets more generally, in particular inflating the prices of U.S. equities and corporate Credit.
This powerful dynamic of liquidity excess and rising asset prices propelled an unprecedented degree of sophisticated risk intermediation and derivatives trading that worked to distort, disguise and inflate various risks. Market risk perceptions became utterly distorted. These factors fundamentally loosened mortgage Credit and system Credit Availability more generally. The resulting massive expansion of mortgage Credit, ultra-easy financial conditions and resulting asset inflation (inflated perceived wealth) stoked both spending and investment.
Importantly, the critical factors fomenting the mortgage finance Bubble were all made more powerful by post-crisis policy responses: The amount and impact of leveraged speculation and resulting liquidity excess; endemic asset inflation; derivatives-related masking and distorting of risk; deep-seated distortions to both the financial and economic structure. Similar dynamics to those that fueled previous U.S. market and economic Bubbles now encompass the world.
Bubble markets remained largely oblivious to risk heading right into the 2008 crisis. There was no appreciation for how vulnerable the liquidity backdrop had become to abrupt change. After all, the GSEs and Fed had for years cultivated the perception of impenetrable market liquidity backstops. And this misperception incentivized risk-taking – aggressive speculation, leveraging, risk intermediation and derivative strategies – that basically ensured acute vulnerability to a bout of de-risking/deleveraging. Sure, Lehman could have been bailed out. But that would have only ensured an even more extended period of (“terminal”) excess and a more perilous crisis.
I appreciate Hank Paulson’s focus on the critical role played by non-bank Credit in the crisis. But when discussing how the system has become sounder post-crisis, he falls back on the standard “the banks are better capitalized.” We are to have faith that system stability has benefitted from better oversight and regulation – that policymakers learned from history.
Market were blindsided in 2008. There was a complete lack of appreciation for how distortions at the “periphery” – in particular Trillions of risky mortgage loans, securities, derivatives and speculative leverage – had late in the cycle come to provide the marginal source of finance fueling increasingly maladjusted financial and economic structures. There was no understanding of how unstable finance had nurtured acute fragility – no appreciation for how the inevitable eruption of risk aversion at the “periphery” would over time imperil stability at the “core.”
There are today ominous parallels. In 2007 and well into 2008, it was “subprime doesn’t matter.” Today, “EM doesn’t matter. China doesn’t matter. Tariffs don’t matter. Debt doesn’t matter.” Corporate earnings, tax cuts, deregulation and technological prowess ensure the robust U.S. economy will remain immune to global financial and economic issues. The powerful “core” is invulnerable to a weak “periphery,” much as the highly liquid and resilient market in “AAA” was (right into the fall of 2008) perceived unaffected by faltering lower-tier securities. There is the current misperception that global “whatever it takes” ensures liquid and robust securities markets.
I have posited that the global Bubble has been pierced at the “periphery.” Global financial conditions have tightened, although there is the typical ebb and flow between risk aversion and risk embracement (fear and greed). It’s my view that unprecedented speculative leverage has accumulated throughout global markets and that the destabilizing process of “de-risking/deleveraging” has commenced in the emerging markets. The first phase of this process has seen faltering liquidity at the “periphery” spur additional speculative flows to the “core.” Increasingly, however, I would expect global de-leveraging to have negative ramifications for risk-taking and liquidity more generally.
It’s worth noting Friday’s 26 bps surge in Italian 10-year yields. Italy’s yields were up as much as 35 bps intraday (to a four-year high 3.26%) before settling somewhat lower. Italian bank stocks sank 3.7% in Friday trading, this after Italy’s populist government appeared to agree on a 2019 budget deficit of 2.4% (above the anticipated 2.0% ceiling). Why such a forceful reaction (considering U.S. deficits will likely soon approach 5% of GDP)?
I’m thinking back to when subprime issues began afflicting the “Alt A” (less than prime) mortgage market. Current market focus has turned to Italy – a heavily indebted sovereign borrower increasingly vulnerable to a tightening of global financial conditions; a prime beneficiary of loose finance on the upside, now at risk as a marginal borrower in a shifting liquidity backdrop. From my analytical perspective, Italy is a key player as we monitor for crisis dynamics gravitating from the “Periphery” to the “Periphery of the Core.”
The ECB’s “whatever it takes” policy approach has incentivized leveraged speculation, especially at the Eurozone’s relatively higher-yielding periphery. A Friday Bloomberg headline: “Sovereign-Bank ‘Doom Loop’ Haunts Rattled Italian Markets.” Italy’s banks are not alone in holding leveraged bets on Italian debt. It’s been too easy for the leveraged speculating community to borrow at negative rates (i.e. short German two-year debt at negative 54 bps) and profit from the spread. Italian debt has surely been one of the most popular “carry trade” speculations in the world, perhaps also financed with interest-free borrowings from Japan. Meanwhile, funds have likely flowed into Italian debt from Japan, with savers and institutions alike reaching for yields. And, now remembering back 20 years, leveraged derivatives bets on Italian debt played a role in the 1998 (Russia/LTCM) crisis.
If, as I suspect, the global risk-taking and liquidity backdrop is changing, “marginal” borrowers such as Italy will be viewed in different light. Yields are rising, which means the value of EM and Italian debt is declining. When these securities offered rising prices and stable spreads, risk embracement saw self-reinforcing speculative leveraging and attendant liquidity abundance. And as wonderful and enduring as this dynamic appears on the upside, speculative leverage is inevitably problematic on the downside. Lower bond prices (higher yields) force a reduction in leverage, which can lead to a self-reinforcing “Risk Off” contraction of marketplace liquidity.
Interestingly, the euro declined 1.2% this week, with the Swiss franc down a notable 2.3%. Key Eastern European currencies (Czech koruna, Bulgarian lev, Romanian leu and Hungarian forint) fell between 1% and 2%. The week provided a reminder of how Italian debt worries can spark worry for Italian banks, European banking, the euro and Eastern European economies.
Worries about Europe spur the U.S. dollar, with a stronger American currency reminding the world of festering EM issues. The Argentine peso sank 9.9% this week. For the most part, however, global markets ended the third quarter with a semblance of stability.
A bloody Friday in Italian debt certainly wasn’t going to tarnish a big quarter for U.S. equities. The S&P500 returned 7.7% for the quarter, lagging the Nasdaq100’s 8.6%. The Nasdaq Telecom index jumped 11.7%, and the Biotechs (BTK) surged 13.2%. The NYSE Healthcare Index gained 12.7%. The Dow Transports rose 10.0%, with the DJIA up 9.0%.
It may have been subtle, but there was some quarter-end market action that might just portend an interesting Q4. There was the 32 bps one-week surge in Italian yields, along with the 8.3% drop in Italian bank stocks. The European (STOXX600) Bank index was down 3.0% in the final week of the quarter, with Japan’s TOPIX Bank Index dropping 2.0%. Curiously, especially with Treasury yields trading at highs for the quarter, U.S. Bank stocks (BKX) sank 4.7% this week. The Broker/Dealers were down 3.1%. There was, as well, the return of concern for tightening global dollar funding markets. The fourth quarter starts Monday, with various indicators pointing toward an important tightening of financial conditions.
As I chronicle history’s greatest financial Bubble, I’ll take note of this week’s developments in the Judge Kavanaugh Supreme Court confirmation hearings. Thursday’s hearings were nothing short of incredible – incredibly dramatic, emotional, tragic and disturbing. Our country is being torn apart – and the tearing has turned more unambiguous and heinous. Ramifications for what is unfolding in society, politics and geopolitics are as profound as they are far-reaching. But with stocks right at all-time highs, what’s to fret about…
It was a week that pitted Democrats and Republicans in Washington, with vitriol and differences that appear more irreconcilable than ever before. There was also President Trump speaking at the United Nations, with world representatives either laughing “with” or “at” the leader of the free world. And it’s this confluence of division, contempt and hostility in the face of an increasingly fragile global Bubble that has me deeply concerned. A global crisis in the current backdrop would make 2008 seem like a walk in the park.
I’ll conclude with an astute observation from Bloomberg’s David Westin:
Westin: “You lost some of the legal provisions that you described. What about political? Because one of the things you had going for you – and I know it was difficult and was not all in a straight line – but through that crisis you got Congress, you had a President, even with low approval ratings, to really back you. Do we still have that same political capital – or political competence – given what happened last time?”
Paulson: “That’s really a key question…”
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