Market Omens

The Return of Meltdown Risk?

Lehman Brothers
Not again? Scenes of dismay at the Frankfurt stock exchange back in 2008. Source: DPA

They are complicated and extremely dangerous. And almost ten years after the financial crisis of 2008, some of its riskiest assets are making a comeback. The structured products with which investors blindly bet on real estate prices and company values are back. These “synthetic CDOs,” or collateralized debt obligations, gained notoriety when they were described as financial market “nuclear bombs” in the Hollywood film “The Big Short.”

Time for some déjà-vu. A decade after the financial crisis, terms like “as in 2007” or “since 2007” keep turning up in the headlines. Among other indications, we are seeing the fastest CDO growth, the biggest investment funds and the highest volume of new corporate bond issues since 2007. Propelled by the flood of money coming from central banks, investor thirst for higher yields seems to have reached a level similar to that of a decade ago. Are we in the same dodgy situation as we were back then, when massive losses in the US real estate market were passed on to the rest of the Western world through arcane financial products?

There doesn’t seem to be any acute risk of another crisis today. As eye-catching as the headlines that draw simple comparisons with 2007 are, the reality is much more complicated.

Today's biggest risks are not hidden behind inscrutable financial alchemy, but are there for all to see.

However, there is one parallel. As in 2007, valuations and the resulting risk-taking seen in financial markets have climbed to extreme levels; this observation is supported by a variety of numbers. For instance, the average yield on corporate bonds with very poor credit ratings has dropped to a record low of 2.3 percent in the euro area.

In other words, investors are willing to accept these very low returns to finance companies threatened by bankruptcy. Market conditions are similarly extreme for government bonds, some equities and certain types of real estate.

At the same time, all this cheap money coming from central banks has contributed to the reemergence of the opaque products that have been frowned upon ever since the financial crisis. In addition to CDOs, for example, there is a booming market for collateralized loan obligations, which play a key role in the current rash of corporate takeovers.

But this is where the similarities end. The market for structured products is growing, that is true – but it’s still miniscule compared to the market in 2007. Moreover, these products are not being financed with nearly as much debt, they do not invest in subprime loans, and there are no longer any banks that use off-balance sheet entities to invest in this market.

So while investors are increasingly being lured into non-transparent credit risks, the new ways with which this is happening do not present a serious danger. For instance, Internet-based peer-to-peer lending is too small to have a systemic impact. In general, banks are in better shape than they were in 2007 too. They have significantly more capital and liquidity, are much more strictly regulated, and have modified their bonus systems so they do not reward short-term performance in the same way.

On the other hand, one should remember that every financial crash is different, and that each successive crash rarely happens for the same reason as the one before it. About 400 years ago, it was tulip bulbs in the Netherlands, 17 years ago it was technology shares, and in 2007, it was due to real estate securities.

This is why a simple comparison with the current situation to 10 years ago is not very instructive. A level-headed assessment of the status quo, however, reveals that risks are building up in financial markets once again. As is so often the case, an excessively relaxed monetary policy is the main driver. Thanks to Western central banks’ low interest rates and balance sheet inflation, virtually all securities are at record levels. All the cheap money flooding the market has investors so befuddled that they have lost sight of the risks. In their desperate search for at least a little yield, they reach for anything that promises to generate a profit.

Today’s biggest risks are not hidden behind inscrutable financial alchemy, but instead are there for all to see in products as simple as they are supposedly safe: in the bonds of heavily indebted countries, in junk bonds, in stocks and exchange-traded funds.

The jury is still out on whether the last of these, so-called ETF’s, will accelerate a crisis if prices decline rapidly, as CDOs did 10 years ago. Instead of banks, this time around, it could be pension funds and insurance companies, with their large investments in the bond market, that could be hard hit.

We know that history doesn’t ever repeat itself in exactly the same way. And prophets of doom are often neither popular nor right. But it would be negligent to simply ignore, or even deny, the tremendous rise in risk in financial markets in an already heavily indebted Western world.

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