Are We Headed For Another Subprime Lending Crisis?
Credit markets, though harder to follow than equity markets, provide clearer signs of looming economic decline.
October 2015 | by Robert Harris
What executive isn’t challenged by the daily barrage of conflicting economic reports attempting to clarify the question of the hour: will the global recovery build or lapse into another recession? Indeed, executives around the world are evenly split on the topic. And while the savviest executives and investors know better than to get caught up in the short-term fluctuations of the economy, many others, looking for evidence of longer-term trends, still fixate on movements in the equity markets.
They shouldn’t. The fact is that those markets, well analyzed as they are, don’t predict downturns effectively. Credit markets are a better place to look for signs of impending trouble, in no small part because they have been at the core of most financial crises and recessions for hundreds of years. Parsing the credit markets isn’t easy—there’s no single number remotely like a share price to monitor, and there are many moving parts. But for executives willing to take the time to understand the relationship between the financial and economies, the markets can provide clearer indicators that a recession is on the horizon.
Incubators of Crisis
Unlike equity markets, credit markets don’t always function smoothly during difficult times. That, in part, is why they are a better source of clues about where the economy is heading. The credit markets are where crises develop—and then filter through to the real economy and drive downturns in the equity markets. Indeed, some sort of credit crisis has driven most major downturns over the past 30 to 40 years (Exhibit 3). Such crises include not only the recent property debacle in the United States and the 1990 one in Japan but also the crises generated by excessive government borrowing in Latin America in 1980 and by excessive corporate borrowing in Southeast Asia in 1997. So executives who find reasons for optimism in today’s equity market levels might be less sanguine looking at today’s credit markets. It’s still not clear whether prices have stabilized in once overheated real-estate markets. Banks are still somewhat vulnerable. And the level of government debt in the United States and elsewhere is still an issue.
Moreover, the pattern of crisis development shows clearly enough that the one thing we can know for certain is that economic crises will erupt in the future—in part because the credit markets work almost as if designed to cause them. That may be a provocative point, but consider this:
- The credit markets are extremely illiquid. The trading volume of most equities is many orders of magnitude greater than that of typical debt instruments. In fact, you could argue that debt is sold rather than bought. Plenty of investors analyze stocks on their own and call their brokers now and then to buy one. But they buy debt, for the most part, only when a broker calls with inventory to sell. This illiquidity sometimes makes it difficult for banks or other investors to sell credit assets at a reasonable price. In addition, providers of short-term credit—to banks, hedge funds, and other financial institutions—may be simply unwilling to extend new credit when old debt comes due, forcing debtors to sell assets to pay down debt just as they are least sellable.
- The banking system and many investors, particularly hedge funds, earn a significant portion of their profits on the mismatch between their assets and liabilities: they invest in longer-term loans and other investments and borrow with short-term deposits and debt. Banks make attractive returns when (as is normally the case) long-term interest rates are higher than short-term ones. Normally, this formula works well. But two things can happen to disrupt it. Sometimes the yield curve inverts, with short-term interest rates higher than long-term rates; then, normal banking profits disappear. More important, short-term credit markets sometimes freeze up, so banks, hedge funds, or financial institutions can’t get short-term debt at a reasonable price, or any price. As a result, they sell assets at distressed prices—if they can find buyers.
- The system suffers from chronic group-think. Participants in the credit markets tend to pursue the same strategies because it’s so easy for banks to monitor what other banks are doing. Banks and investors observe which banks or other investors seem to be making the highest profits and then implement similar strategies. If contrarians in the market were to counterbalance credit excesses, the system should stay in equilibrium. But the system makes it very difficult for investors with contrarian views to apply them. For example, during the recent real-estate bubble, plenty of people were trying to figure out how to bet against the housing market but couldn’t, because they didn’t have the massive amounts of collateral required.
- Expectations of government bailouts create tremendous moral hazard—certainly in the bailout of US banks after the subprime-mortgage fiasco and most likely in Greece when it was at risk of defaulting on its sovereign debt. If the European Union hadn’t been expected to step in and rescue the country, the spreads on its debt would have been much higher, years before the crisis hit, relative to, say, German bonds or other euro bonds, given the enormous levels of government debt and its large social obligations. Instead, investors assumed that the EU or one of its members would bail out Greece and continued to lend to it at rates far below levels that would have reflected the true risk of the debt.
Unfortunately, it takes several years for crises to develop, and once the conditions are in place, they are nearly inevitable. The only way to stop one is to anticipate it years in advance; for example, preventing the US subprime crisis would have required clamping down on borrowing in 2005. Avoiding the crisis in Greece would have required something similar in 2005, 2006, or even earlier.