In this guest post, former banker and banking lawyer Martin Lowy casts some doubt on the warnings about the increase in sovereign and corporate debt outstanding. He explores what the next recession might look like, and how it might (and might not) turn into a systemic financial crisis:
I have been writing about the dangers of too much debt for a long time. In my first book, High Rollers: Inside the S&L Debacle, published in 1991, I wondered whether America’s apparent 1980s prosperity had only been borrowed and would implode as the S&Ls had done. (No, that did not happen.) I wrote about the subject again in the 1990s in several American Banker pieces where I praised the theory of Islamic finance and the benefits of equity versus debt finance. And in 2009, my book on the GFC was called Debt Spiral: How Credit Failed Capitalism, and the cover has a lurid tornado devouring everything in its path. Thus my anti-debt credentials are in order.
But lately there has been a spate of Chicken Little articles outlining the gross debt numbers worldwide: in corporates and in sovereigns, in Japan, in the U.S., in several European nations, and in the developing world. The articles then relate those numbers to corporate earnings and GDP. Then comes a description of the debt in dollars incurred by non-U.S. entities. Where will they get the dollars to repay those loans? On top of all of that comes a description of the unfunded future U.S. liabilities for Social Security, Medicare, and much else. (Examples of these stories can be seen here and here, but there have been dozens of them, it seems to me.)
The numbers are indeed staggering, and the growth of global debt continues unabated. Where will it all end? The implication of the articles almost always is that it must end in financial Armageddon.
I would take that prediction with a grain of salt. We have seen financial Armageddon in 2008—or at least what might have been financial Armageddon, if the Fed had not propped up so many types of credits.
So we know what at least one kind of financial Armageddon would look like: A cascade of bad debt brings down a series of institutions, because they cannot pay their own debts after recognizing the bad-debt-related losses. There may be other kinds of financial Armageddon, but for the moment, let’s all focus on this cascade phenomenon that almost brought the world to a standstill in 2008 and that has been typical of financial crises globally, as described by Reinhart and Rogoff in their seminal treatise This Time Is Different.
Who Owns the Debt Matters
For those concerned about systemic crisis, the focus should be on who owns the debt and how their holdings are financed, not who issues debt and how much is outstanding.
If the debt is held by individuals storing savings and by institutions that can withstand losses, then the inevitable defaults that come with the next recession will not cause a cascade of fire sales and institutional failures. The level of debt will be decreased as it is written off, but the holders will not also become insolvent.
However, if the loans are held by weakly capitalized institutions that have financed the loans by incurring debt themselves, then a cascade is likely to occur, and regulators might to step in to prevent financial disaster.
To recapitulate, I see four basic categories of debt owners:
Savers. Savers own debt securities outright. This is a constantly growing category, because savers all over the world keep earning interest and dividends, their equity securities generally go up in price, and they keep adding to savings from earned income. The growth of debt is not so surprising when one considers the rising demand for it as an investment.
Unleveraged institutions. Institutions such as foundations, endowments and sovereign wealth funds typically are not leveraged — at least in the traditional sense. While they often take leveraged risk in their portfolios, it is uncommon for them to issue debt to fund their investments.
Leveraged but well-capitalized institutions. Some financial institutions borrow to carry the debt they own, but have enough capital and reserves to remain solvent even after substantial losses. My guess is that these include American banks—and perhaps some European and other foreign banks, though I am less certain about non-American banks being sufficiently capitalized.
Leveraged and inadequately capitalized institutions. These institutions borrow to carry the debt they own, but don’t have enough capital and reserves to operate through the losses from weak credits that occur in a significant recession. It is only this fourth category of debt holders that I think is likely to cause cascade-type problems.
Losses Likely Will Be Substantial
There will be defaults on weakly underwritten loans in the next recession—and losses in large numbers. The large numbers will include car loans in the U.S., student loans (most of whose losses the government will absorb), high loan-to-value (LTV) mortgages in the U.S., commercial real estate loans on retail properties in the U.S., dollar-denominated corporate and sovereign loans in developing nations, and many smaller categories as well.
The losses from underlying defaults will likely be magnified by the market’s inability to evaluate credit risks embedded in the defaulting paper and paper that looks similar. Thus, market values will overshoot to the downside.
The question is, will the losses be absorbed by the holders of the paper in a fairly orderly manner? Or will they cause a cascade of losses to other parties, as happened in 2008?
Who Holds the Paper Now and Who Held It in 2008?
My guess is that the financial market cascade will not occur, because the institutions that hold the paper are less dependent on short-term financing, more diversified, and better capitalized than they were in 2008. That is because (1) managements have learned from recent mistakes, (2) the large risk-taking securities firms have been absorbed into bank holding companies, and (3) Dodd-Frank and Basel III capital rules have made banks and their holding companies stronger.
If we look at the vulnerable financial companies that played major roles in the 2008 meltdown, we can see that most of them do not still exist, nor does any company that looks like them, with the possible exception of still-undercapitalized European banks. The major undercapitalized investment banks that relied on short-term funding all are gone. Bear Stearns effectively failed and has been fully absorbed into JP Morgan. Lehman failed, setting off some fireworks. Merrill is a subsidiary of BofA, and Goldman and Morgan Stanley are now bank holding companies. Thus the three surviving troublesome major investment banks are subject to the new capitalization and liquidity rules.
Other major participants in the 2008 cascade have either disappeared or are under new regulatory regimes that require them to be better capitalized and more liquid. For example, the undercapitalized and short-term funding-reliant SIVs that were set up by German and American banks have been wound up, and nothing similar seems to have taken their place. And after U.S. money-market fund reform, so-called prime funds manage just a fraction of the assets they did before the crisis.
Repos, which also prominently imploded in the 2008 cascade, do not appear to be a major source of financing for low-rated debt, which removes one of the primary sources of possible cascading. Indeed, the repo market is substantially reformed and smaller than it was in 2008. The marketplace now understands that adequate collateral is not enough to induce lenders to roll over outstanding repos in the face of possible counterparty failure. Morgan Ricks has the best discussion of this phenomenon in The Money Problem.
Some Areas of Risk
I have greater doubts about insurance companies that have gone up the risk scale in search of yield, which could be vulnerable. Some might fail, which would cause great pain for their customers. I also have doubts about Fannie, Freddie and other federal housing programs that have maintained a system of high-LTV lending despite the strong evidence that such lending is risky.
Fannie and Freddie might require government support once again. But they are now basically the government itself, so institutional hubris aside, such support need not be disruptive and could lead to beneficial changes. (Congress does have the power to cause an international crisis by refusing to fund Fannie and Freddie. It refused to fund the FSLIC back in 1982 and thereby caused the S&L problems to fester and to grow to at least three times what they had to be. See High Rollers for the details.)
Mutual funds again will be part of the story, as was Reserve Primary Fund in 2008. That is because, despite the fate of Third Avenue Focused Credit Fund (see my discussion here), many debt funds still maintain illiquid positions that they claim are liquid. And in 2017, the SEC botched the job of making a rule to force more realistic compliance with liquidity requirements. (See my discussion of the SEC’s botched job in Part III of my recent book InStAbILItY: Booms, Busts, the Fragility of Banks, and What To Do about It.)
Open-end bond mutual funds are likely to have to sell large percentages of low-quality bonds into a weak market, further driving down prices and causing losses to their stockholders and to others. But because their stockholders are mainly individuals who have invested their savings, the systemic consequence should be only the diminution of people’s savings.
An Economic Cascade
Rather than a financial cascade, we should expect an economic one, since consumers who suffer investment losses will spend less freely with the money they have left. That cascade effect — probably a global one — will deepen and extend the next recession, the same way Americans’ inability to tap home equity deepened and extended the Great Recession.
So while the lack of a financial crisis may be good news, the losses that investors will suffer in the next recession could have a real negative impact on global standards of living. Over-borrowing always has negative long-term consequences.
While I don’t expect these consequences will include a financial crisis any time soon, that will provide little solace to the people who lose their jobs, their cars and homes.
What’s more, my observations do not mean that a financial crisis cannot occur. It simply seems less likely that it will look like 2008. I do not think it will be caused by over-indebtedness, though I agree that over-indebtedness is widespread.
What Could Cause the Next Financial Crisis?
The most likely source of a financial crisis would be a global event, or a terrible miscalculation by the U.S. government, like if Congress effectively defaulted on U.S. financial obligations.
That would be a terrible and stupid thing to do. But almost anything is possible.