The world's next credit crunch could make 2008 look like a hiccup
Is this why central bankers are so scared of raising interest rates?
A solar eclipse, a super moon, the FTSE 100 breaching 7,000 and the US Federal Reserve speaking in tongues - truly some kind of financial apocalypse must be nigh. Well, maybe.
We are certainly living in strange times. An unprecedented monetary experiment is coming to a staggered end and no one knows the potential repercussions - a plague of frogs cannot be entirely ruled out.
For the time being, the markets remain sanguine, expecting, for example, a gentle increase in the Bank of England’s main interest rate to just 1.5pc by the end of the decade. And, who knows, maybe the markets are right.
But maybe it’s too quiet. Last week, Ray Dalio, the founder of the $165bn (£110bn) hedge fund Bridgewater Associates, wrote a widely-circulated note warning his clients that the US Federal Reserve risked setting off a 1937-style crash when it starts raising interest rates again.
Then, as now, the central bank had spent years printing money in order to help the American economy recover from the 1929 crash. But the side effect was a stock market bubble, which promptly burst when the Fed prematurely increased rates. Mr Dalio is worried about a repeat performance: “We don’t know - nor does the Fed - exactly how much tightening will knock over the apple cart.”
It’s true that the policy and regulatory response to the last crisis often sows the seeds for the next. It is not hard to map out a sequence of events in which that proves to be the case again. If it were, a US stock market crash might be the least of our problems.
In 1937 the US was, economically speaking, an island, entire of itself; today, thanks to globalisation, the power of the dollar and a long period of ultra-loose monetary policy, it is a part of the main.
Christine Lagarde, the head of the International Monetary Fund, recently raised concerns in India about the ripple effect of Fed tightening on countries that have borrowed heavily in dollars and whose still-recovering economies remain vulnerable to a rate rise.
And in 1937 the equity markets were the financial be-all and end-all; today they are dwarfed by the debt markets, which are, in turn, dwarfed by the derivatives markets.
The total value of all global equities was around $70 trillion in June last year, according to the World Federation of Exchanges; meanwhile, the notional value of all outstanding derivatives contracts was more than $690 trillion. It is worth noting that the vast majority (around four-fifths) of all existing derivatives contracts are based on interest rates.
The derivatives market is the not the vast roulette table of popular perception. These financial instruments are essentially insurance policies - they are designed to protect the holder from adverse price movements.
If you are worried about (to pick some unlikely examples) a strong euro, or expensive oil, or rising interest rates, you can buy a contract that pays out if your fears are realised. Managed well, the gain from the derivative should offset the loss from the underlying price movement.
Nevertheless, the arguments employed by the derivatives industry sometimes sound similar to those employed by the pro-gun lobby: derivatives aren’t dangerous, it’s the people using them that you need to worry about.
That’s not hugely reassuring.
What could go wrong? Let’s say that US interest rates do rise sooner and faster than the market expects. That means bond prices, which always move in the opposite direction to yields, will plummet. US Treasury bonds are like a mountain guide to which most other global securities are roped - if they fall, they take everything else with them.
Who will get hurt? Everyone. But it’ll likely be the world’s banks, where even little mistakes can create big problems, that suffer the most pain. The European Banking Authority estimates that the average large European lender still has 27 times more assets than it does equity. This means that if the stuff on their balance sheets (including bonds and other securities priced off Treasury yields) turns out to be worth just 3.7pc less than was assumed, it will be time to order in the pizzas for late night discussions about bail-outs.
Barclays has predicted that if the yields on 10-year Treasury bonds reverted back to their historical average it would wipe nearly a fifth off the tangible book value of European banks.
Yes, a fifth. This is what is meant by interest rate risk. It’s big and it’s real and the banks know all about it. Their answer is to hedge the risk with interest rate derivatives. It’s one of the reasons why there are so many of these contracts in existence. So that’s all OK then.
Just one question though: who have they bought those derivatives from? Why, other banks of course. This creates what is known as counterparty risk. Bank A sells insurance to Bank B. But then Bank A gets into financial difficulties (a significant deterioration in their creditworthiness would be enough) and suddenly Bank B isn’t as well protected as it thought it was.
Indeed, Bank A might start struggling precisely because of the insurance it has sold to Bank B. What if it can’t honour the contract? This creates a potential Catch-22 situation: the derivatives work as long as they’re not needed; calling them into action renders them useless.
This is precisely the kind of thing that occurred during the credit crunch - banks stopped trusting each other. New rules introduced since then require banks to actively manage their counterparty risk. In other words, banks are being asked to hedge their hedges. Are you starting to feel uneasy yet?
It is far from clear whether any of this makes the system less risky or just further complicates the cat’s cradle of financial interconnectedness.
Regulators are clearly worried. They have brought greater transparency to the derivatives market, demanding better reporting and that a higher proportion of contracts be routed through central counterparties or clearing houses, which sit between the two sides of a trade and sort out the mess if anyone goes bust.
But, again, the risks haven’t been magicked away. Clearing houses are designed to deal with one or two counterparties going down. But what happens if more go kaput? The clearing house itself would face collapse, be judged too big to fail and, well, you already know how this story ends.
It doesn’t take a soothsayer to foretell that taxpayers would, yet again, have to clean up the mess.
ben.wright@telegraph.co.uk
AJ adds: So, the international financial system is like a house of cards. Knock one out and the rest may come down.
In 1937 the US was, economically speaking, an island, entire of itself; today, thanks to globalisation, the power of the dollar and a long period of ultra-loose monetary policy, it is a part of the main.
Christine Lagarde, the head of the International Monetary Fund, recently raised concerns in India about the ripple effect of Fed tightening on countries that have borrowed heavily in dollars and whose still-recovering economies remain vulnerable to a rate rise.
And in 1937 the equity markets were the financial be-all and end-all; today they are dwarfed by the debt markets, which are, in turn, dwarfed by the derivatives markets.
The total value of all global equities was around $70 trillion in June last year, according to the World Federation of Exchanges; meanwhile, the notional value of all outstanding derivatives contracts was more than $690 trillion. It is worth noting that the vast majority (around four-fifths) of all existing derivatives contracts are based on interest rates.
The derivatives market is the not the vast roulette table of popular perception. These financial instruments are essentially insurance policies - they are designed to protect the holder from adverse price movements.
If you are worried about (to pick some unlikely examples) a strong euro, or expensive oil, or rising interest rates, you can buy a contract that pays out if your fears are realised. Managed well, the gain from the derivative should offset the loss from the underlying price movement.
Nevertheless, the arguments employed by the derivatives industry sometimes sound similar to those employed by the pro-gun lobby: derivatives aren’t dangerous, it’s the people using them that you need to worry about.
That’s not hugely reassuring.
What could go wrong? Let’s say that US interest rates do rise sooner and faster than the market expects. That means bond prices, which always move in the opposite direction to yields, will plummet. US Treasury bonds are like a mountain guide to which most other global securities are roped - if they fall, they take everything else with them.
Who will get hurt? Everyone. But it’ll likely be the world’s banks, where even little mistakes can create big problems, that suffer the most pain. The European Banking Authority estimates that the average large European lender still has 27 times more assets than it does equity. This means that if the stuff on their balance sheets (including bonds and other securities priced off Treasury yields) turns out to be worth just 3.7pc less than was assumed, it will be time to order in the pizzas for late night discussions about bail-outs.
Barclays has predicted that if the yields on 10-year Treasury bonds reverted back to their historical average it would wipe nearly a fifth off the tangible book value of European banks.
Yes, a fifth. This is what is meant by interest rate risk. It’s big and it’s real and the banks know all about it. Their answer is to hedge the risk with interest rate derivatives. It’s one of the reasons why there are so many of these contracts in existence. So that’s all OK then.
Just one question though: who have they bought those derivatives from? Why, other banks of course. This creates what is known as counterparty risk. Bank A sells insurance to Bank B. But then Bank A gets into financial difficulties (a significant deterioration in their creditworthiness would be enough) and suddenly Bank B isn’t as well protected as it thought it was.
Indeed, Bank A might start struggling precisely because of the insurance it has sold to Bank B. What if it can’t honour the contract? This creates a potential Catch-22 situation: the derivatives work as long as they’re not needed; calling them into action renders them useless.
This is precisely the kind of thing that occurred during the credit crunch - banks stopped trusting each other. New rules introduced since then require banks to actively manage their counterparty risk. In other words, banks are being asked to hedge their hedges. Are you starting to feel uneasy yet?
It is far from clear whether any of this makes the system less risky or just further complicates the cat’s cradle of financial interconnectedness.
Regulators are clearly worried. They have brought greater transparency to the derivatives market, demanding better reporting and that a higher proportion of contracts be routed through central counterparties or clearing houses, which sit between the two sides of a trade and sort out the mess if anyone goes bust.
But, again, the risks haven’t been magicked away. Clearing houses are designed to deal with one or two counterparties going down. But what happens if more go kaput? The clearing house itself would face collapse, be judged too big to fail and, well, you already know how this story ends.
It doesn’t take a soothsayer to foretell that taxpayers would, yet again, have to clean up the mess.
ben.wright@telegraph.co.uk
AJ adds: So, the international financial system is like a house of cards. Knock one out and the rest may come down.
