'..There is a critical lesson that went unlearned from the previous crisis episode: government and central bank-related risk distortions are fundamental to self-reinforcing Bubble inflation and resulting deep structural maladjustment.
One can age the mortgage finance Bubble period at about six years, commencing around governor Bernanke's 2002 "helicopter money" speeches and the Fed's focus on mortgage Credit as the expedient for (post-"tech" Bubble) systemic reflation. It would not, however, be unreasonable to date the Bubble genesis back to 1994/95, with the rapid expansion of GSE and Wall Street Credit.''Myriad changes to the financial structure have seemingly safeguarded the financial system from another 2008-style crisis. The big Wall Street financial institutions are these days better capitalized than a decade ago. There are "living wills," along with various regulatory constraints that have limited the most egregious lending and leveraging mistakes that brought down Bear Stearns, Lehman and others. There are central bank swap lines and such, the type of financial structures that breed optimism.
March 17, 2008 - Financial Times (Gillian Tett): "In recent years, bankers have succumbed to the idea that the credit world was all about numbers and complex computer models. These days, however, this assumption looks ever more of a falsehood. For as anyone with a classical education knows, credit takes its root from the Latin word credere ("to trust") And as the current credit turmoil now mutates into ever-more virulent forms, it is faith - or, rather, the lack of it - that has turned a subprime squall into a what is arguably the worst financial crisis in seven decades. Make no mistake: what we are witnessing right now is not just a collapse of faith in one single institution (namely Bear Stearns) or even an asset class (those dodgy subprime mortgage bonds). Instead, it stems from a loss of trust in the whole style of modern finance, with all its complex slicing and dicing of risk into ever-more opaque forms. And this trend is not just damaging the credibility of banks, but the aura of omnipotence that has enveloped institutions such as the US Federal Reserve in recent years."
Gillian Tett was the preeminent journalist during the waning mortgage finance Bubble period. She was seemingly alone in illuminating the degree of excess in subprime Credit default swaps and structured finance more generally. By March 2008, she had already recognized "the worst financial crisis in seven decades," while Wall Street was trapped in denial. Ms. Tett also appreciated the damage being done to Federal Reserve credibility. Yet no one could have anticipated the evolution of policy measures adopted by the Fed and global central bankers over the following decade. Credibility's New Lease on Life.
What I remember most vividly from the Bear Stearns episode was how well the markets took the spectacular collapse of a $400 billion Wall Street institution. After beginning 2008 at 1,468, the S&P500 closed at 1,277 on Monday, March 17. The index then rallied double-digits to 1,440 by May 19th. I recall about that time being informed that I needed to "get on with my life." Bear Stearns had been resolved. The Fed had it all under control. The crisis was over - before it even got started.
It was not over. I was convinced the overriding issue was Trillions of mispriced securities and derivatives throughout the markets - the enormous gap between perceptions and reality. Both the financial system and economy had grown dependent on rapid Credit growth. Moreover, mortgage lending had come to dominate overall system Credit, while debt growth was increasingly vulnerable to risk intermediation fragilities. Speculative leverage, also closely interlinked with risk intermediation, had evolved into a major source of marketplace liquidity.
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Importantly, however, 10-years of previously unimaginable stimulus measures - culminating in "whatever it takes" Trillions of (non-crisis) QE, negative rates and market manipulation - ensured that faith in central bank power reemerged stronger than ever. There is a critical lesson that went unlearned from the previous crisis episode: government and central bank-related risk distortions are fundamental to self-reinforcing Bubble inflation and resulting deep structural maladjustment.
One can age the mortgage finance Bubble period at about six years, commencing around governor Bernanke's 2002 "helicopter money" speeches and the Fed's focus on mortgage Credit as the expedient for (post-"tech" Bubble) systemic reflation. It would not, however, be unreasonable to date the Bubble genesis back to 1994/95, with the rapid expansion of GSE and Wall Street Credit.
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We're now well into the high-risk phase of the boom cycle. The February blow-up of the "short vol" funds marked an inflection point, one I have compared to the collapse of Bear Stearns structured Credit funds in the summer of 2007. Ten-year Treasury yields have jumped 44 bps so far this year, and the dollar has been under pressure. The VIX, Treasury market and greenback have calmed down of late, which has supported an equity market recovery. Corporate Credit, however, has been notably less resilient.
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The big unknown is the scope of financial leverage and embedded leverage in derivatives markets that have accumulated over this long boom cycle. The dynamics of this Bubble contrast meaningfully from those of the last. The big financial institutions are not sitting on huge holdings of potentially toxic securities and mortgage-related derivatives. Myriad risks these days are more complex and concealed - and, importantly, even more esoteric.
I would argue that the Bubble in government finance has distorted pricing and liquidity throughout the securities and derivatives markets. Securities markets have succumbed to systemic mispricing, a circumstance fostered by liquidity misperceptions and readily available market risk "insurance." The previous cycle's "Moneyness of Credit" evolved into central bank-induced "Moneyness of Risk Assets." And while virtually everyone takes comfort from the apparent soundness of financial institutions, crisis lurks in the tangled world of securities and derivatives markets liquidity.
About a decade ago, runs on Bear Stearns and then Lehman fomented the '08 market crisis. I suspect the next U.S. crisis will unfold with "runs" on stocks and corporate Credit. We've already witnessed how quickly the VIX and equities derivatives markets can dislocate. I'm curious to see how interest-rate and Credit derivatives perform in a backdrop of faltering equities, illiquidity and derivatives market stress. And considering the direction of policymaking in Washington, don't be all too surprised by an unexpected bout of market tumult in Treasuries and the dollar.'
- Doug Noland,
Nobody Thinks It Would Happen Again, March 17, 2018
ContextHave a laugh – Psycho'I define a Bubble as a self-reinforcing but inevitably unsustainable inflation. Household Net Worth at 500% of GDP is not sustainable..''Deflation may actually boost output. Lower prices increase real incomes and wealth. And they may also make export goods more competitive.' - BIS'You’ll often hear risk being equated with return on financial television..'The Dangerous Delusion of Price Stability - William White(Global - 2018) - '..manifestations of Monetary Disorder..'