A decade on, Great Recession's ghost still haunting markets

Singapore

A DECADE after Lehman Brothers' 2008 bankruptcy, the fallout from the Great Recession continues to threaten today's financial markets.

Inflated asset prices, excessive borrowing and the threat of the unknown as central banks unwind their crisis-era policies are among the biggest concerns that analysts and fund managers shared with The Business Times.

Nikko Asset Management senior portfolio manager Robert Samson said: "Just as asset purchases over the last decade were unprecedented and largely experimental, so will be the experience of winding down these programmes."

The 2008 global financial crisis led major central banks around the world to adopt extremely accommodative stances, with almost-zero interest rate policies and massive asset purchases. Quantitative easing (QE) pumped a good US$12 trillion into the global economy.

The hunt for yield has created pockets of asset bubbles nearly everywhere, including in bonds, some equities and a great deal of real estate, said Mr Samson. "We expect the removal of easy money will ultimately deflate these bubbles, potentially in a disorderly fashion."

The "easy money" has also fuelled a sharp climb in corporate and government borrowing. Total global debt - including household, non-financial corporate, and government liabilities - grew from US$97 trillion in 2007 to a historical high of US$169 trillion in the first half of 2017, noted McKinsey Global Institute.

Mizuho Bank senior economist Vishnu Varathan said a decade of ultra-low interest rates has led to unintended shifts in investor behaviour, punishing savers and incentivising excessive borrowing.

Sharply higher indebtedness in Asia and the emerging markets, alongside materially inflated asset prices, could leave many households with greatly diminished assets but large and unwieldy debt burdens as central bank tightening begins.

Mr Varathan said: "This loss of net household wealth could trigger a vicious circle if banks clamp down ... This analogy may be extended to any other asset investment using borrowed funds."

As for corporate debt, sharply higher borrowing costs could strand corporates with sharply lower - even negative - returns on projects that used to be viable when it was cheaper to borrow.

A domino chain of defaults and cross-defaults as risk spreads widen could turn a liquidity crisis into a solvency crisis as corporates struggle to roll over loans.

Meanwhile, higher interest rates and wider risk spreads can also lead to a drop in the prices of bonds and the resulting re-allocation of funds could hurt emerging market (EM) currencies and equities, especially for countries with the "twin" current account and fiscal deficits.

The shift from easing to tightening in US and European central banks - and potentially Japan - has already wreaked havoc with emerging currencies in Argentina, Indonesia and Turkey. Funds that bet on low market volatility have imploded.

But could it get bad enough to cause a global crisis?

Mr Varathan thinks so.

"Usually, distortions like these will probably cause a little bit of disorderly repricing but not necessarily a crisis. But ... this has gone on for a decade, so it's a prolonged period of continued and accentuated distortion and very skewed imbalances in terms of the mismatch between savings and investments."

Nick Clay, lead manager at BNY Mellon Global Income, said it takes fortitude and a willingness to suffer to break an addiction, neither of which have been evident in the financial sector over the past 10 years.

"Instead, the opposite is true; we have learnt nothing and the addiction has simply intensified," he said.

For him, it is especially troubling that support for debt remains largely based on asset values rather than an ability to pay, which is reminiscent of the housing bubble that precipitated the global financial crisis, he said.

Non-bank mortgage lending, which has risen to more than 80 per cent of the US market, and global trade fears are worrisome as well.

If it is any consolation, regulators have patched up many of the fault lines exposed by the previous crisis.

Regulatory frameworks like Dodd Frank and Comprehensive Capital Analysis and Review have imposed much tighter controls over financial institutions.

But such regulations tend to focus on preventing a crisis that occurred in the past, said Andrew Gray, managing director and group chief risk officer at the Depository Trust & Clearing Corporation.

"It's likely that the next crisis will be entirely different, which is why it's so important that we ... have a forward-looking lens when preparing for future risks."

Meanwhile, capital and leverage ratios for banks have become "significantly stronger" both in quality and quantity, J.P. Morgan said in a report.

The firm argued that US large banks are less complex and far better capitalised today, and are subject to harsh stress tests. Tangible common equity ratios for US banks have almost doubled to 8.1 per cent from 4.1 per cent in mid-2008, while liquid assets plus Treasuries have risen to about 12 per cent of total assets from between 6.6 and 6.8 per cent in 2007.

"Global banks have never been better positioned from a solvency and liquidity perspective going into the next potential recession, and the probability of a systemically important bank failing has declined, while resolvability has improved substantially," said J.P. Morgan's head of European banks research Kian Abouhossein.

Manu Bhaskaran, chief executive of Centennial Asia Advisors, said policymakers are also more alert, less likely to be surprised and better prepared with counter-measures.

Investors, too, are "more careful to distinguish among assets, and more likely to differentiate between, say, one emerging market and another," he added.

Risk management has also evolved and become more sophisticated.

Singapore sovereign wealth fund GIC said a key post-Lehman takeaway is that risks can defy traditional definitions and boundaries.

"During the global financial crisis, many asset classes saw simultaneous losses and behaved in unexpected ways," a GIC spokesman said. "Linkages through the credit markets were much broader and deeper than expected. At GIC, we have taken such potential stresses into account in our portfolio design, rather than just relying on average historical correlations or their labels."

Janus Henderson Investors keeps a close eye on its counterparties, said Andrew Gillan, its head of Asia ex-Japan Equities.

"The main repercussion following the crisis is increasing diversification and increasing the monitoring of counter-party risks," he said.

Still, Mr Varathan of Mizuho said that financial institutions' balance sheets now carry a lot more credit exposure, while protection has lagged.

"I don't want to be condescending about this; there have been good improvements, but I think the financial market is ignoring other risks that have come about because the profitability and incentives to push products are still very high ... We are a long way off from having adequate checks. Risks still persist and appear in different forms."

A DBS Bank spokesman noted an increasing exposure to cyber security, as banks move more services online. That brings new and emerging sources of risks like high-speed algorithm trading - which can cause "flash crashes" - and cyber attacks and data breaches into the territory.

Another crisis is inevitable. The question is when, and in what form.

William Black, visiting scholar in financial regulation at the South-east Asian Central Banks Research and Training Centre in Kuala Lumpur, does not expect a bubble that will spread as wide a circle of devastation as the 2008 crisis anytime soon.

For one, that takes time. He said the 2008 crisis took 14 years to develop and professional watchdogs like auditors, credit-rating agencies and valuers were enablers of problematic practices.

What could the next crisis look like?

Mr Varathan said: "Almost by definition, the next crisis will probably come about from a risk that was not spotted - thus not mitigated against - or from a risk that is outside the locus of control of investors such as a trade war or policy mis-steps.

"In any case, preparing for an unknown and hard-to-time crisis probably entails investors sticking to the principles to being hedged, not overly leveraged and with some spare capacity in terms of cash cushion.

"Nothing spectacularly novel perhaps, but rather a sensible approach that fully expects collateral damage as part of the deal."