In the last global financial crisis, sub-prime mortgages were identified as the root of all evil.
Collateralised debt obligations (CDOs), securities backed by bad mortgages and sold by wicked bankers to unsuspecting investors, unleashed a world of misery and financial pain.
The 2015 film The Big Short, which tells the story of the last crisis, sent cinemagoers home depressed.
Several large banks had already begun selling billions in so-called “bespoke tranche opportunities” (BTOs), which was essentially another name for CDOs, the end credits informed.
Here we go again, I read in my friends’ eyes, and they in mine.
“History doesn’t repeat itself,” Mark Twain once assured us.
The next crisis can’t stem from the same source. That would be too obvious, repetitive, mundane even.
“But,” said Twain, “[history] often rhymes.”
If he was right, and we have little reason to doubt his wisdom, then the next crisis does need to sound like the previous one. It needs to be similar if history is to rhyme.
Something similar to a CDO that isn’t a CDO would then have to trigger the next financial crisis…
Ring-a-ding-ding: We have a winner!
Old habits die hard
The Bank of England issued an ominous warning yesterday.
It’s getting rather good at that of late, chiefly thanks to Brexit, but this is one we’ll want to heed.
High-risk lending is back.
Regulators responded to the last crisis with stricter rules for banks and other financial institutions that were thought responsible for the mess.
Governments had to be seen to act, hold the perpetrators to account and make sure it wouldn’t happen again through the introduction of new legislation.
But old habits die hard – especially if you’re not really forced to change your ways.
As soon as banks were out of the spotlight they relapsed. The rebranding of the tainted CDOs as BTOs is but one example.
Governments slacken the reins the minute they think the danger has passed. The shackles that are meant to save banks from themselves and others are loosened again.
Earlier this year, US President Donald Trump rolled back some regulations of the Dodd-Frank Act. His predecessor Barack Obama had put Dodd-Frank in place to restrain the financial service industry.
Two decades earlier, the Bill Clinton administration had repealed the Glass-Steagall Act which had forced banks to separate their commercial banking from their investment banking.
The reckoning followed later with “too big to fail” banks that had to be bailed out with taxpayer money.
“From 1945 to 1975, when the global financial system was tightly controlled, most years were entirely free of banking crises,” the Economist instructs us this week.
“Since the 1970s, the deregulation of national banking systems and the lifting of constraints on the global flow of capital ushered in a new era of financial boom and bust.
“Re-regulation since 2009 has not fundamentally changed this picture.”
The memory of global regulators evidently doesn’t go back far enough, otherwise their instincts would surely be to tighten rather than relax their grip on the financial industry.
Now we’re a decade on from the start of the last crisis and the Bank of England is sounding the alarm again.
The market that’s driving the Bank on edge this time around is another form of high-risk lending: leveraged loans.
Leveraged loans are credit lines extended to companies that already have debts worth more than four times their earnings.
The US market for these loans has more than doubled since 2010. The capital invested in this market currently exceeds $1 trillion.
That’s worrying, says the Old Lady of Threadneedle Street:
“The global leveraged loan market was larger than – and was growing as quickly as – the US sub-prime mortgage market had been in 2006.”
It’s clear why the Bank of England would experience a déjà vu while observing the growing market for leveraged loans.
Leveraged loans and sub-prime mortgages are as different as night and later that night.
This time it’s not households defaulting on their mortgage but companies unable to pay back owed money.
In both cases financial institutions borrowed money to parties of which it was quite evident from the start that they would have trouble repaying.
The Bank warns that the UK isn’t immune from these practices, which is a bit of an understatement.
Given the size of the UK’s financial services sector, I’d say the country is extremely vulnerable to a global boom in risky lending.
After the crisis, the central bank set up the Financial Policy Committee (FPC) which is to keep an eye on potential risks to UK financial stability.
It notes that lending standards are falling in the UK. The issuance of leveraged loans by UK companies hit a record £38 billion last year.
This year it’s at £30 billion and counting…
Debt held by those riskier firms amounts to a fifth of all lending to UK companies.
Wait a minute… I’ve seen this movie before. Literally.
What happens when those leveraged loans can’t be repaid? Companies default and too big to fail banks get in trouble.
And, since we’re working under the assumption that history rhymes, governments stand at the ready to rescue those financial institutions once more.
Next time it may not be taxpayer money that’s at risk – that would be too much like the last time. Depositors on the other hand could well find their assets used to bail banks out of trouble.
“Bail-outs” will become “bail-ins”. Not exactly the same, but not fundamentally different either.
History would not be repeated, but it would sure rhyme.