Why the Next Financial Crisis Will be in our lifetime

The previous week was heavily filled by the appearance of high profile personalities. From one side we had the ECB forum, where we heard the developed central banks’ chairmen. But nothing was more ironical than the speech of Janet Yellen in the British academy, UK. Yellen sent a reassurance message to the masses that we are not going to see another financial crisis in the close future. Analysts criticized her speech with bitter words; nevertheless they are divided into two groups.

First team is much more sentimental, their critics are built upon the geopolitical situation. They see that the conflict between the white house and the Federal Reserve and the Russian interference in the US election probe will heavily impact the economy and might cause the US economy big cracks.

The other side have much wider dark outlook to global issues like global growth, BREXIT shadows and the comments of central banks leaders that contradict Janet Yellen optimistic outlook.

Janet Yellen’s conclusion was built on the stress test report which was issued on June 22^nd, but let us first know what the stress test is, and the report outcomes. After the financial crisis the Federal Reserve established programs and frameworks to impose some regulations to assess the financial institutions’ activities to avoid another default as the 2008 one. The Federal Reserve is conducting annual assessment for the Bank Holding Companies (BHC). This assessment is divided into two steps: first one is the DODD Frank which was enacted in 2009, which oblige the 34 Banks to present an annual sheet for its financial situation. The second step is the Comprehensive Analysis & Review, which uses the DODD Frank to assess whether financial firms with $50 billion or more in total assets are sufficiently capitalized to absorb losses during the stressful conditions, while meeting the obligations of both creditors and households’ loans.

The Federal Reserve projections are based on three macroeconomic scenarios: 1. Baseline – not issued yet 2. Adverse 3. Severely adverse. In other words the Fed assumed some hypothetical economic conditions with adverse or severe adverse conditions and these conditions might face the economy at any time. The purpose is to recognize whether the BHCs and financial system will absorb these sever shocks. Upon that, the Fed will issue its final conclusion if banks are ready to absorb any coming shock for the economy as the 2008 one.

The second scenario, the adverse scenario will come in the form of global economic activity weakening in the period between 2017-2019 across USA, UK, EU, Japan and some developing Asian nations. Economic instability might occur in long term fixed income assets, and steepening in the yield curve of these countries. Also the adverse scenario predicts that US GDP will slide 2% more than the pre-recession period (1%) in the first quarter of 2018, the unemployment will increase to 7.25% in the Q3 of 2018, short term interest rates will fall near zero again, and the 10 year yields increase to 2.75% by the Q2 2017. The spreads between investment corporates bonds and long term treasury yields will widen to 3.75%. Equities will fall 40%, while houses prices fall 12% in 2018 Q1.

In this adverse scenario, the Fed suggests that losses may be $322 billion. The biggest sector may default is the credit card by $70 billion which represents 24.5%, while the commercial and industrial loans losses would be $67 billion. On the other hand losses caused by the financial markets might be only $3 billion, yet $46 billion will be caused by trading and foreign counter parties.

The severely adverse scenario assumes an entire global recession, accompanied with corporates loans and commercial real estate markets high stress. This scenario assumes the US to reach the trough in 2018 Q2, 6.5% below the pre-recession period peak. Inflation below 1.5% in Q2 2017 and 1.75% by mid-2018, unemployment will reach 10% by the of 2018 Q3. Equities will drop 50%. Treasury rates will fall and remain under zero through the end of the period. 10 year treasury yields drop to 0.75 running gradually to 1.5% by Q1 2019. Spreads between investment corporates bonds and yield of long term treasury securities widen to by 5.5% by the end of 2017.

The severe adverse will result $493 billion losses for banks. The two major losses will be in the credit card and commercial & industrial loans by $100 billion each. On the financial markets side the securities trading and counterparties losses will come on the second level by $86 billion, while the securities losses will represent only $5 billion.

Back to the second team, this team is attentive to the BREXIT shadows and its impact on global economy, which is expressed in the comments of central bankers in the ECB forum synced with Yellen’s speech, which came so pessimistic except for Mario Draghi’s speech. For instance, Mark Carny stated that the non-investment businesses weakest in half century, while the investment businesses are the weakest condition since the crisis. He added that UK companies are facing multiple uncertainties and hurdles appears in the form of high risk and BREXIT. The BOJ’s chairman added that despite the enhanced unemployment rate, wages are still soft. Also he added that business investment is still sluggish, despite the drop of unemployment.

Despite the IMF continuous and contiguous reports of the global sluggish economy, the main concerns is about repeating the 2008 scenario. When Bernanke (former Fed chair) was asked about the  financial markets current situation he stated that the economy was in its best cases; moreover, MOODDY’s continued to give the MBS AAA grade.

Yes, the Federal Reserve has succeed to built up a stable economic track. Yellen did not refer to a financial recession, she is a smart women and we all do not know the things that she has forgotten.

Yet, economy is economy. As long as we continue the financial system as it is, a financial crisis is highly expected. The only questions remain are how? why?and when?

Final words

• The main reason for the 2008 crisis was the lack of appropriate regulations under the 2005 prevention act, which came to obliged regular homeowners to convert their mortgages into uncollatrized asset and exposes thousands of home owners to credit default risk.
• It is true that geopolitics are important to be taken in our calculations, but when Yellen speaks she is only concerned by the Federal Reserve mandate.
• When Janet Yellen said that we won’t expect another crisis as far as our life time she meant that the amount of capital located in the US banks can prevent any foreseeable crisis in its bud, but she missed the true expression.
• Despite that big capital being pumped in the US economy so far, for some reason this may change in the future. In 2016 the Yuan was added to the SDRs by the IMF, and starting from 2018 the Shanghai stock market will be added to the MSCI and many investors have expressed their cheerfulness for this news by stating that they will pump a lot of money into Chinese markets. This will be a pivotal change on the capital flow map and it will have a negative impact on US markets, which remained on bullish base for more than century.