The Financial Crisis of 2016
by George Hatjoullis
There is much talk of a coming financial crisis. I have some experience of financial crises, having been working ( as either strategist, proprietary trader or fund manager) in financial markets continuously since 1984, and sporadically since 1974. I retired two years ago so this will be the first one I shall observe from the outside as it were. Attempts to articulate my experience can be found throughout my blogging, notably in discussions of market failure.
A necessary condition for a financial crisis is a market failure, in my experience. In a market failure transactions drop to a minimal level and prices become quite arbitrary and meaningless. A closing price may be posted but little is, or could ever have been, traded at the posted price. Unfortunately, some idiot that had never traded introduced the idea of mark-to-market as a risk management tool. Assets are valued at arbitrary and quite meaningless prices necessitating real economic actions such as selling in a failed market. Institutions end up forcing sales in non-failed markets because it is the only place they can reduce risk. The failure in one market is thus spread to others by the mark-to-market rule and need to reduce risk. The contagion is introduced by the risk management structure.
The extent of the contagion depends, in part, upon the extent to which the asset traded in the failed market is distributed within the system and how transparent this distribution. This may sound odd as logically if a problem is widely distributed it is a diversified problem and less important to any individual entity. True enough if the distribution is known. However, it may not be known. This allows counter party risk to enter the equation. If I do not know who has the toxic product it is prudent to become suspicious of every counter party. So once again trading is generally reduced or prices adjusted to reflect possible risks. A lack of transparency is also implicated in contagion.
Finally, there is the question of leverage. Extensive leverage means that large price moves will wipe out the capital of some players. If the location of the leverage and the wipe out is known it helps. However, it can still cause institutional failure and a cascade of failures. If it is not known it can cause panic and the counter party risk problem is also leveraged. Contagion is thus also linked to leverage.
So a financial crisis (as I have experienced) requires a market failure, a lack of transparency and lots of leverage in the system. Is this the situation that we face going into 2016? It is certainly the case in China and the Chinese financial markets have been in meltdown. Chinese financial markets exhibit all the characteristics of ‘failure’. Do they portend contagion in other regional markets? I would suggest not for the simple reason that the Chinese authorities kept ‘western’ financial institutions at arms length. Indeed all the discussion is about real economy consequences of China’s problems. These are material but offer only an indirect link to ‘western’ financial markets. It is not obvious that this indirect link can create a financial crisis in the ‘west’. Let us explore.
The Chinese growth story led to excessive and ill considered investment in the extractive industries. The result has been a collapse in the prices of the products extracted. Those that have invested in these industries will be experiencing losses. That is how a market system works. Equity and bond holders will incur losses in aggregate. There is complete transparency (I cannot rule out fraud of course) on which entities and financial products are involved and the extent to which they are leveraged. A large part of the equity and bond holding is in the hands of leveraged (hedge) funds and non leveraged funds. These funds will incur losses. The hedge funds are set up as risk capital funds (you can lose the lot) so no one investing should be too put out by the losses. The non leveraged funds are normally diversified except for the specialist funds. Once again it is hard to see where the crisis comes from.
Financial crises normally involve banks. Collectively banking systems have never been better capitalised. Leverage has been contained by regulators. Some banks will have exposure and will incur losses but unless the frenetic regulatory activity since 2008 has been futile (always possible) no system should be threatened by a serious recession in one commercial sector. What was all the stress testing about? Liquidity is still available to banks at very low cost. Hard to see a systemic crisis originating here.
The reason that people are concerned is because equity and bond values have had an extended bull run and no one believes it can go on for ever. In my view that is why there cannot be a crisis! In all previous crises someone has said to me, “it’s different this time”. No one has said this to me and when they do I shall buy tinned food and defendable land. Indeed, my ex colleagues constantly tell me that sentiment is very bearish. Not really typical of a crisis in the making.
This does not mean equity and bond prices cannot correct lower. Indeed I expect them to do so. After such a run valuations tend to get ahead of reality and they need to drop a bit or stand still to let reality catch up. If reality is also having some problems then a correction is inevitable. However, let us not make a crisis out of drama.