Thursday, June 23, 2016

Predicting a Crash: Part Three

The next step in predicting a crisis is identifying the causes behind the growth of the global debt problem. The proliferation of credit, loans, and any other form of borrowing does not occur randomly. Individuals, businesses, and governments are all affected by the state of risk in the economy, the availability of capital in the current setting, and how costly this capital will be. The growth of mortgage-backed securities (MBS) during the prelude to the financial crisis was caused by the perception that these assets were low risk increasing the demand for their creation. As a result, the amount of residential mortgage debt skyrocketed. After the unraveling of the housing market in 2009 and 2010, a similar trajectory has developed leading up to today. In this episode of Predicting a Crash, we're going to look at how central banks in developed nations have encouraged the formation of a debt crisis with cheap capital and a bloated money supply.



Before visiting the current debt crisis that has encroached upon the economic safety of the next three years, it's important to review the effects that the 2008 crisis had on shaping the market conditions in the next eight years. The failure of the housing market caused panic and uncertainty to freeze the credit mechanism in the residential, corporate, and public sectors of the economy. Banks which had been more than willing to initiate home mortgages just a couple years ago were reluctant to lend to anyone. The commercial paper market, an outlet of credit used daily by financial institutions, became a quiet doldrum. Even governments found it difficult to convince lenders to loan at a reasonable rate. After the capital mechanisms at the base levels of the economy broke down, a recession hit, and the Federal Reserve was forced to move into action. Ben Bernanke and now Janet Yellen sought to counter the debilitating effects of the crash by lowering every kind of interest rate their Board of Governors could think of, starting with the Fed Funds rate. Through conventional and unconventional open market operations they found ways to cut the discount rate, rates for mortgages, rates for interbank lending, and many more lending rates that were responding to panic and fear. The lower interest rates and a Federal Reserve willing to pump money into the economy caused money supply growth to accelerate in the years after the recession. Companies and households that were affected by the economic downturn that followed were not wary of the building debt crisis that they were creating; instead, they focused on recovering.


For corporations, recovering meant taking advantage of newly available capital with interest rates that were at record low levels. The Federal Reserve, exemplifying the "lender of last resort" role discussed by Walter Bagehot in 1871, encouraged the flourishing trend of lending capital in the face of uncertainty with their own loans to AIG, GMC, Chrysler, and most of the leaders of the financial services sector. When the recession hit commercial and industrial loans peaked during the recession as the Fed's easy money encouraged emergency lending. Financials eventually improved and loans dipped. Around the beginning of 2011, we see a different trend set in. Interest rates were still at all time lows and the Federal Reserve was still trying to prop up the floundering economy. The commercial and industrial businesses saw an opportunity; they could take the cheap money and invest it into their operations which were producing returns that were worth well above the cost of the loan. The result, the past five years of low-interest rates have pushed commercial and industrial loans 29.4 percent above its peak in 2009. Meanwhile, corporate profits after tax have only increased 5.7 percent since 2010. This disparity between earnings and debt load has come to define this period of low-interest rates and signals a potential breakdown in the balance sheets of companies in every sector of the economy. The built up pressure might finally crash the system if circumstances were to change (like a sudden drop in profits or consumption, or an increase in interest rates).


The same situation arose in the major consumer credit markets. Low-interest rates among institutions allowed them to charge less for mortgages, car loans, personal loans, and credit card rates. This is a healthy scenario when a recession is threatened. The low cost of loans allows consumers to get back on their feet and enter the market with a smaller chance of default. Lower repayment fees also leave a more income available for consumption. This makes sense. The healthy response soon denigrated into a dangerous environment where debt was encouraged even after the recovery had taken place. In between 2011 and 2015, interest rates on new car loans, personal loans, and credit cards fell significantly even though the recession had been over for almost two years. Delinquencies successfully fell, but in its place, a growing debt burden subtly inched its Monthly growth rates suggest that consumer credit growth had reached levels comparable to the years leading up to the financial crisis, debt growth rates that had ultimately brought down an economy. The same could be said about the housing market and mortgages. The Mortgage Bankers Association revealed a trend in mortgage purchases that reflects the trend in the early 2000's. Estimates for 2016, 2017, and 2018 continue to follow that pattern.


The charts and data above reveal the Federal Reserve's era of loose money which encouraged consumers and businesses to add on to debt loads that were already high. The picture painted in the United States is mirrored by monetary policy in countries across the globe. Japan, a developed nation with one of the highest debt-to-GDP ratios, saw credit explode as its central bank dropped interest rates to zero. The mature Asian nation also flirted with the idea of negative interest rates, an unconventional method that would lead to the addition of even more corporate and consumer debt. The European Central Bank continues to keep their interest rates low as the economic leaders there try to coax growth despite an aging population. Along with cheap capital, the ECB head Mario Draghi have employed aggressive quantitative easing measures hoping to encourage investments by supporting asset prices. Both policies have allowed the development of a credit trend similar to the one in the U.S. and Japan. Because of the interconnectedness of the institutions to which the largest central banks lend, the debt crisis spread to small, emerging economies in tandem. New firms in countries like Brazil, Russia, and China could access these funds through the hands of foreign investors able to lend at lower interest rates because of the atmosphere created by the Federal Reserve, the Bank of Japan, the ECB, and the many other institutions implementing loose monetary policy in the past few years.

So we're starting to approach a verdict. As we have looked further into the weakness of the global economy and the pressure of debt, fingers start to point at monetary leaders for their irresponsible handling of interest rate trends. In hindsight, almost everyone will assert that rate hikes came too late, a statement that is quickly followed by the question, "When will they raise rates?" During economic expansion that typically follows a recession, monetary institutions are generally supposed to increase interest rates to cool down the recovery. That path was not taken. Now, debt loads and weak market fundamentals are waited to unravel when necessary rate hikes finally occur. The unfortunate scenario has monetary leaders choosing between higher interest rates and another recession or more low-interest rates and more debt. The former will be chosen; thus, a crash should be expected. If you're worried about credit markets now, be prepared for even more anxiety when "helium" stocks are discussed in the next installment of Predicting a Crash.     

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