Will this spark the next financial crisis?

The higher that global equity and bond prices climb, the more vulnerable they are to a major fall. But what’s likely to prompt such a setback?

The higher that global equity and bond prices climb, the more vulnerable they are to a major fall. But what’s likely to prompt such a setback?

Markets are gloriously unpredictable. So it could be – literally – anything. The only likely element is that the exact catalyst won’t be forecast by anyone.

Or it could be a good old-fashioned financial crisis, a replay of a past disaster about which we’ve all forgotten. And one of those is now rearing its ugly head again…

Why do banking crises happen?

Most financial crises originate from within the banking system. Yet they start from such promising beginnings. A lender launches a new product, leverages up an old one or provides more and more credit for what develops into a speculative buying frenzy. Prices surge as investors enjoy the party. It seems a great idea at the time.

Until it all goes wrong, that is. Then lots of players lose a stack of money, lenders become ‘risk-averse’ – i.e. they stop lending – and prices crater. As the old saying goes, people “invest in haste and repent at leisure”.

I used to believe that banking-inspired crises coincided with the pension cycle. After a panic, lenders would become more sensible again. For a couple of decades, at least. But after the retirement of the last manager to survive the previous crisis, a fresh set of ‘experts’ would be unleashed on the markets with new wonder products. In the absence of experienced warnings, the boom and bust thing would begin once again.

Just like technology, it seems that banking life cycles are getting shorter too.

You won’t need reminding that the last great financial panic was getting underway only a decade ago. You could make a case – and I wouldn’t argue with it – that the planet hasn’t yet fully emerged from this particular crisis. That’s why interest rates are still at 5,000-year lows. And despite some hawk talk from the US Federal Reserve, there aren’t too many signs of them rising by much.

I digress. Back to the potential woes of the banking system.

CDOs are back…

One of the major causes behind the 2008 Great Financial Crisis was the role of synthetic CDOs (collateralised debt obligations).

Here’s the story so far. Synthetic CDOs are complicated derivatives. To cut a long story short, they allow buyers to make large leveraged bets on companies’ wellbeing.

CDOs package up a range of credit default swaps (CDS – in effect, corporate insurance policies) into bundles that are split into different risk levels (tranches). Sellers of CDS receive income that’s paid by ‘short’ players who want insurance against a possible default. Within a CDO, the equity tranche pays the highest returns. But it’s also the most likely to be obliterated if default losses top 5%-7%.

10 years ago, lots of CDO bets went wrong, nearly destroying the financial system.

The estimable Zero Hedge site sums up the current situation:

“Less than a decade after being forced to take a taxpayer-funded bailout to avoid an embarrassing bankruptcy filing, Citibank, proving they learned precisely nothing from the so-called ‘great recession,’ has put a 35-year old in charge of once again making the bank a powerhouse in the Synthetic CDO market. But please don’t worry about the risk because this time Citi says they’re building the business in a ‘way that insulates them from any losses’.”

Ha, love the sarcasm about risk! Bloomberg continues the tale:

“It’s an astonishing comeback for the roughly $70bn market for synthetic CDOs. But perhaps the most surprising twist is…many in the industry say [Citigroup is] responsible for over half the deals that come to market. [While] few see corporate defaults surging any time soon, as years of rock-bottom interest rates have pushed investors toward riskier products, the revival of synthetic CDOs may be one of the clearest signs yet of froth in the credit markets.”

…and Wall Street wants ‘in’

Bloomberg suggests that BNP Paribas appears to be active in synthetic CDOs while other Wall Street banks that have kept away from the market since the crisis are also looking for a bigger slice of the action.

And who’s buying these CDOs? “If you guessed 20-something year old pension and insurance fund investors who were in middle school during the last financial crisis then you’re absolutely right…congratulations”, says Zero Hedge.

“There’s a whole generation of people in finance who never knew or forgot the problems with synthetic CDOs,” says financial market consultant and author Janet Tavakoli. “Just as derivatives can lever up the upside, they can lever up the downside.”

Quite. In other words, CDOs may have been repackaged. They may even have been de-risked to some extent. But the principles of leverage remain just the same as they’ve always been. You don’t get extra reward without taking extra risk.

I admit that I don’t know precisely what will cause the next financial panic. Synthetic CDOs may not, by themselves, be responsible. But I’m very clear about one thing. They’re very likely to make such a crisis a whole lot worse.


PS: while we’re on the subject of corporate payments…you may have seen my colleagues talking about ‘Brexit severance cheques’.

Well, the last round has just finished. So it’s too late to claim your share of it.

But while you’ve missed out this time, plenty more cheques will be handed out in the future. The next giveaway date that our team is targeting is October 4th.

Click here for full details.

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