The Next Crisis: Some thoughts on shapes, paths and catalysts

“History doesn’t repeat itself but it often rhymes” – Twain (though disputed)

The 2007-08 “Great Recession” (or Global Financial Crisis as Australians prefer to call it) was a financial crisis that saw some of the largest losses and contagion effects across asset classes in at least 30 years and was coupled with one of the deepest recessions experienced in the USA in terms of job losses, since 1930. Arguably the only reason we are sitting here typing (or reading) this, is thanks to the deep and unprecedented government interventions in both fiscal and monetary policy.

Like all crisis, the recriminations began relatively swiftly after it was apparent the world was returning to some form of normal. The dominant financial narrative that has emerged is that the banks needed to be bought to heel and more highly regulated to control their reckless actions. From the investor’s perspective, money has flowed towards more “tail hedge” products that attempt to protect the downside risks of a 2008 style event and the associated catastrophic loss of capital. Further, money has flowed to those funds that performed best in 2008 and to increase due diligence of the funds used, particularly in the Hedge Fund space.

Now this neither is an exhaustive list nor is the purpose of this article to pass judgment on the narrative. Rather, it is to examine the unexpected side effects of the responses to 2008. We will focus on a few of the points raised above, then look at how these may be interacting in ways that were unanticipated.

Government Reaction: Banking Regulation

“The law of unintended consequences, often cited but rarely defined, is that actions of people—and especially of government—always have effects that are unanticipated or unintended. Economists and other social scientists have heeded its power for centuries; for just as long, politicians and popular opinion have largely ignored it.” – Norton

There have been a number of pieces of legislation introduced across the globe, with two of the most important being:

1)     The Dodd-Frank Act: Introduced in the USA, this sweeping piece of legislation created a host of new governing bodies and legislation in relation to banking;

2)     Basel III:  Regulations on capital requirements, introduced by the Bank of International Settlements.

The sections of these pieces of regulation that are most relevant to this piece relate to the obscure area of “Repos” or Repurchase Agreements. This is where banks use collateral (in the same way when someone takes a mortgage out against their house, their house is collateral) and often that collateral is US Treasury Bills which are short term loans issued by the US Government to fund themselves.

One side effect of the changes in regulation is that Banks find it much harder to issue loans or credit originating from these. There are also less of them available due to the Quantitative Easing programmes undertaken which has seen the US Federal Reserve purchase substantial amounts of these Government Bills. There has also been heightened demand from other market participants who want to use them.

Intertwined with this development in the Repo market, is that the Dodd-Frank Act has made it much more difficult for banks to use their own balance sheet to trade or hold securities, with the rationale it was the holding of Mortgage Backed Securities that got them into trouble in 2008. We will return to this point further on.

For a fuller description of this incredibly obscure and difficult to understand part of the banking system, please follow this link to an IMF paper.We won’t go much more into detail here; needless to say it is a relatively obscure and hard to understand part of the banking system but one that is what we would call “important plumbing”!

Investors Reaction: Changing the funds they use

“Worldly wisdom teaches that it is better for reputation to fail conventionally than to succeed unconventionally.” – Keynes.

The reaction to 2008 and the QE that followed has seen all asset prices rise, but some have received more flows than other. Namely the flow into Bonds, both Government and High Yield (the so called reach for yield that has taken place) is larger than the flow into Equities.

Read more here