Three Conditions and Three Warning Signs

How to Tell if the Next Financial Crisis is Upon Us.

In the last post, it was suggested that the rapid collapse in oil prices might have set up a repeat of the 2008 financial crisis. Before we all run for the bunkers and the freeze-dried food, we should know the conditions needed for a crisis to happen, and the signposts we’ll see if the crisis gets going.

For a sector correction to become a meltdown, and for that to turn into a global crisis, several preconditions need to be in place.

The first condition is a serious market sector correction.

According to some participants in the market for energy company bonds and loans, such a correction is already underway and heading toward a meltdown (the second condition). Others are more sanguine, and expect a recovery soon.

That smaller energy companies have issued more junk-rated debt than their relative size in the economy isn’t under debate. Of a total junk bond market estimated around $1.2 trillion, about 18% ($216 billion, according to a Bloomberg estimate) has been issued by energy-related companies. Yet those companies represent a far smaller share of the economy or stock market capitalization among the universe of junk-rated companies.

If the beaten-down prices for junk energy bonds don’t stabilize or recover a bit, we might see the second condition: a spiral of distressed sales of bonds and loans. This could happen if junk bond mutual funds or other large holders sell into an unfriendly market at low prices, and then other holders of those bonds succumb to the pressure of fund redemptions or margin calls and sell at even lower prices.

The third condition, which we can’t determine directly, would be pressure on Credit Default Swap dealers or hedge funds to make deposits as the prices of the CDS move against them. AIG was taken down when collateral demands were made to support existing CDS agreements, and nobody knew it until they were going under. There simply isn’t a way to know whether banks or dealers are struggling until the effect is already metastasizing.

The unknown is how much of the $2.77 trillion of junk CDS on bank balance sheets on June 30 this year was energy-related. If history is any indicator, the CDS in the distressed energy sector already far outweighs its 18% share of the junk bond market.

But if we watch for the following three signposts, we’ll know that the crisis play is happening again:

  • One sign would be for non-energy junk bonds to begin dropping in price. That would mean large holders are exiting from all junk bonds, not just those companies affected by low oil prices.
  • Another sign would be sudden drops in share prices for banks or insurance companies that hold small amounts of energy-related bonds or bank loans, a clue that some market participants think they have derivative exposure.
  • A third sign to look for would be the rumors or news that the big, investment-grade energy companies are having trouble renewing their Commercial Paper, bank loans or maturing bonds (the Exxon-Mobils and Shells of the world).

If we see all these signs in a matter of days or weeks, then our global financial system is being tested once again by the small community of speculators that profit from betting against industries, countries, or markets. They made a fortune betting against mortgages. Most of them didn’t retire to enjoy that wealth. They moved on to the next trade, and every day they try to repeat their investing success.

The next time their presence was really visible was the European Debt Crisis of 2011/2012. That didn’t take down the global financial system, but it was close. If Spain, Portugal, Italy and Ireland had followed Greece into debt restructuring, we would have had another global crisis, most likely even larger than the 2008/2009 episode. Only a major commitment from Germany kept the rest of Europe’s weaker countries from failing on their debt, too.

In March of 2012, the Greek “credit event” that triggered payment on CDS was estimated to apply to CDS that equaled 30% of the 300 billion Euro Greek sovereign debt market, or roughly 90 billion, (about $118 billion in US dollars at the time). The “settlement price” for that CDS event was 21.5%. So the winners in the CDS bet took home 78.5% times $118 billion, or approximately $93 billion. That was nearly twice the size of the CDS payoff when Fannie Mae and Freddie Mac went into receivership. Nice trade for those who made it.

Do we need to remind ourselves that Fannie and Freddie were the Exxon-Mobil and Shell of the mortgage business? Or that no target is too big if trillions of dollars can be used to make the bets?

So where will the “next trade” be?

Anywhere there might be weakness.

This month, it’s in energy companies that borrowed more than $200 billion while planning on oil prices staying over $100 a barrel, and gasoline staying over $3 a gallon.

Only time will tell whether there have been enough bets against those optimistic energy companies to make it a problem for everyone, and not just them.


5 Responses to Three Conditions and Three Warning Signs

  1. irongate says:

    outstanding as usual howard. I hope you are getting a lot of eyeballs here

  2. mrhonkytonk1948 says:

    Thanks, Howard. This is a real concern. I get the feeling that 2008 changed very little in regard to transparency or oversight of CDS and related derivatives.

    • hhill51 says:

      I’m working on a piece to lay out the framework to turn the derivatives market into an actual free market. Many people don’t realize that “free markets” as envisioned by economists they admire are NOT unregulated markets, but actually need regulation and disclosure to function as those theorists imagine they do. Markets with asymmetric information for different classes of participants always trend toward manipulation.

  3. Kyle says:

    When a hedge fund manager says that banning naked CDS would “significantly reduce liquidity in credit markets”, what all does that statement mean? Even if 80% of these derivatives are naked, how does the average person benefit from this market being in existence?

    • hhill51 says:

      I’m sure the people who made fortunes trading commodities before the Grain Futures Act said the same thing. I suppose at some level having a multiple of any given credit trading in the market makes that credit “more liquid.” Ordinary people? It’s probably better to look at it like High Frequency Trading – a tax on the rest of us.

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