Here’s Where the Next Crisis Starts

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This post Here’s Where the Next Crisis Starts appeared first on Daily Reckoning.

The case for a pending financial collapse is well grounded. Financial crises occur on a regular basis including 1987, 1994, 1998, 2000, 2007-08. That averages out to about once every five years for the past thirty years. There has not been a financial crisis for ten years so the world is overdue. It’s also the case that each crisis is bigger than the one before and requires more intervention by the central banks.

The reason has to do with the system scale. In complex dynamic systems such as capital markets, risk is an exponential function of system scale. Increasing market scale correlates with exponentially larger market collapses.

This means a market panic far larger than the Panic of 2008.

Today, systemic risk is more dangerous than ever because the entire system is larger than before. Due to central bank intervention, total global debt has increased by about $150 trillion over the past 15 years. Too-big-to-fail banks are bigger than ever, have a larger percentage of the total assets of the banking system and have much larger derivatives books.

Each credit and liquidity crisis starts out differently and ends up the same. Each crisis begins with distress in a particular overborrowed sector and then spreads from sector to sector until the whole world is screaming, “I want my money back!”

First, one asset class has a surprise drop. The leveraged investors sell the sinking asset, but soon the asset is unwanted by anyone. Margin calls roll in. Investors then sell good assets to raise cash to meet the margin calls. This spreads the panic to banks and dealers who were not originally involved with the weak asset.

Soon the contagion spreads to all banks and assets, as everyone wants their money back all at once. Banks begin to fail, panic spreads and finally central banks step in to separate winners and losers and re-liquefy the system for the benefit of the winners.

Typically, small investors (and some bankrupt banks) get hurt the worst while the big banks get bailed out and live to fight another day.

That much panics have in common. What varies in financial panics is not how they end but how they begin. The 1987 crash started with computerized trading. The 1994 panic began in Mexico. The 1997–98 panic started in Asian emerging markets but soon spread to Russia and the big banks. The 2000 crash began with dot-coms. The 2008 panic was triggered by defaults in subprime mortgages.

The problem is that regulators are like generals fighting the last war. In 2008, the global financial crisis started in the U.S. mortgage market and spread quickly to the overleveraged banking sector.

Since then, mortgage lending standards have been tightened considerably and bank capital requirements have been raised steeply. Banks and mortgage lenders may be safer today, but the system is not. Risk has simply shifted.

What will trigger the next panic?

Prominent economist Carmen Reinhart says the place to watch is U.S. high-yield debt, …read more

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