A decade on…


This week’s blog comes from Chris Lowe, Transaction Advisory Services Partner &  joint head of our Capital & Debt Advisory team.

Is it really a decade since the start of the credit crunch? Apparently so, although picking one significant date could put us in danger of missing a vital point: crashes and crunches don’t tend to come without early warnings or in one big hit. So this week we look back to 2007, but also forward and think about where risks are building or even remain.

Picking a date…

Judging from the wealth of articles appearing in the last few weeks, there’s a strong consensus that 9 August 2007 – the day BNP Paribas froze its investment funds – was the start of the global financial crisis. It’s human nature to create significant dates, but I’m not convinced that it’s helpful to pick just one moment in of this complex crisis.

The BNP Paribas freeze didn’t come out of the blue. Ripples from US subprime reached Europe in early 2007. HSBC warned on 8 February 2007 that increased provisions in  its US mortgage business would result in much higher than expected loan impairment and risk costs in their 2006 results. The growing incidence of problems in US subprime lending led EY to comment in March 2007 that:

Problems in US sub-prime lending have demonstrated just how quickly liquidity can dry up, even in relatively benign economic conditions. The fear is that this tightening will spread to other credit markets.  Companies who obtained credit easily in recent years will find it much tougher going if economic growth slows and liquidity dries up.

“EY Analysis of Profit Warnings, Q1 2007”

Arguably we could then pick the day of the HSBC statement. Or perhaps we should choose 22 June 2007, when Bear Stearns bailed out two hedge funds. As Martin Sandbu of The Financial Times points out, this was “the first clear admission that the assets its funds had invested in were worth much less than almost everyone had thought.” That’s pretty much the crux of most crises. Although, as he argues, what the BNP Paribas’ statement in August signalled was that this solvency issue had become the liquidity crisis we’d foreshadowed earlier in the year.

So, 9 August 2007 isn’t an unreasonable date, but it feels a bit like we’re picking the day where the roof began to fall in.  Should we instead pick the point where when tiles first began to slip, or when inspectors gave the roof a clean bill of health, or when the architects first came up with the complex design? Or should we go right back to when the regulators loosened their rules on roof construction? Should the intervention to fix the roof have come sooner?

Although, going back to that complexity of design, collateralised debt obligations and credit default swaps were little understood by many – a factor that undoubtedly contributed to the unaddressed build-up of risks and the pain that followed. Markets reacted in 2007, but not in a way that suggests that investors saws these events as something monumental at the time.

All of which is relevant to today…

S&P 500 & FTSE 100 in 2007

What’s next?

The anniversary of the last crash has unsurprisingly drawn attention to what could cause the next one. Are there new issues hiding in plain sight and is the system stronger this time around?

To start with the latter question, the financial system is stronger in terms of regulation and bank capitalisation. Governments, central banks and the main actors in the last crisis also have vital experience gained from handling the last crunch. The next crisis – when it comes – won’t look exactly like the last for these very reasons.  Nevertheless, it will have echoes, primarily because we’re still living out its consequences. And here there are issues that aren’t so much hiding as blazing, many of which we’ve discussed before.

Something old…The hangover

QE eased the stresses in the system and reduced the necessity for painful restructuring, but the liquidity equivalent of the hair of the dog has created an extended hangover. Global debt as a percentage of GDP is higher than 2007.  Consumer credit is getting hot again – especially in car credit. Central banks hold a fifth of government debt.  ‘Zombie’ companies have been able to struggle on. There is consequent drag on productivity and lingering risks around how we normalise the capital environment. In the meantime, this abnormal environment has echoes of 2005-6.

Last month, the $26.9 billion of junk bonds sold had the highest proportion of deals on record with weak investor protections, Moody’s Investor Service reported this week.  About 60 percent of the risky U.S. corporate bonds sold had few protections written into their deal documents, Moody’s said.  In the leveraged-loan market, nearly three quarters of the debt is “covenant lite” after three years of record issuance.

“Junk bonds work without a net”, Bloomberg 13 July 2017 

And this clearly isn’t a world without risk. Beyond from the obvious geopolitical ones, there are some less discussed but also in plain sight. Like… what if the US Congress fails to raise the debt ceiling this autumn?

Something new…Changing market flows

The rapid rise of ETFs (exchange-traded funds) has slipped far more under the radar, although less so these days as it’s being picked out by several commentators as being symptomatic of massive liquidity and the unpredictable change in market flows. An ETF owns underlying assets (stock, bonds, currency etc) and divides ownership of those assets into shares. These ‘passive’ investments now account for than $4tn of global assets under management. Their popularity is such that JP Morgan estimates that ETFs account for about 60% of the US equity asset management industry, doubling their share in the last decade.

That’s a great deal of money and it’s going into new areas – does that sound familiar? An “Inverse Vix”  ETF that benefits from is the world’s 34th most actively traded equity security. Its popularity could be partly responsible for the low volatility, but no-one is sure – which is at least half the point. Perhaps these investments aren’t so ‘passive’?

Something digital…Structural stresses

It’s also worth remembering the interplay with political and structural risks – which for many companies remain the biggest concerns.

Take freight automation, one of the hottest topics in labour replacement. There are approximately 3.5m professional truck drivers in the United States, according to the American Trucking Association. And, unlike traditional industries, like steel and mining, jobs are spread across the country. Truck or delivery driver is the most common job in over half of US states. Automation is coming somewhere down the line and it will create new companies and jobs in data centres, but these aren’t like-for-like. Equally profound are the knock-on effects of driverless trucks – and cars – and of the shift to electric. We may have moved from peak oil supply to peak demand.

This is by no means an exhaustive list. I’m not expecting to wake up to a crash tomorrow– baring some catastrophic trigger – but we are watchful again.

If and how worry is starting to feed into markets and corporate behaviour is a subject we’ll return to next week.