A new financial crisis has begun. Maga-nomics’ kaleidoscopic trade restrictions (it changes when you shake it), extortion of assets using military threats, ‘reform’ masking xenophobia, racism, vengeance and tyranny, and disregard of the law or agreements are likely to lead to a significant global slowdown. The financial system is fragile and weakened by serial crises. Scandals around technology investments, reminiscent of the end of the dot.com boom, are inevitable. Geo-strategic confusion is prevalent. Extreme weather events, pandemics and resource scarcity haven’t gone away.
The central element is cash flow. The conversion of trade and activity will reduce incomes for households and businesses, decreasing consumption, which makes up around 50 to 70 percent of economic activity. Slowing demand reduced the need for investment. Government spending is unlikely to make up the shortfall due to an obsession with spending cuts, the constraint of rising budget deficits and high debt levels. Fear of wars means many countries must trade-off ‘guns and butter’. Rentier income from investments will fall. Erratic decision-making and reciprocal economic stupidity will heighten uncertainty and sap consumer and business confidence.
Cash flows drive asset prices. The values of all financial assets ultimately depend on their future earnings. Actual or, in the case of nascent businesses, the likelihood of future earnings will decline, bringing down the prices of shares and real estate. Even with the recent buoyant economy, many businesses are not profitable or don’t have positive cash flows. Others with high leverage can barely cover interest payments. Enthusiasm for speculative investments, like AI projects, which have generated few compelling revenue-generating products, is waning. The ‘greater fool theory’ that you can always sell at a higher price to someone was always financial charlatanism.
The principal weakness is debt, which there is no shortage of. Without nose-bleed borrowing levels, cash flow decreases are tolerable. If equity is a soft bed, debt is one of the nails. Tariffs and sanctions will raise price pressures and make it difficult to return to the ultra-low rates that made excessive indebtedness sustainable.
As incomes fall, households and businesses will struggle to meet obligations. Fiat money allows governments to continue the game by debasing the currency and purchasing power. Incapable of repaying borrowings, they will continue to issue new debt or create money, effectively paying interest and principal with new obligations they cannot honour.
Despite the shocks not having flowed through as yet in their entirety, financial distress levels are rising. US business defaults hit a post-financial crisis high of 9.2 percent, with rates for highly leveraged private equity loans and junk bonds reaching the highest levels since the pandemic. The International Monetary Fund has warned of rising distress in commercial property. Delinquency rates on mortgage, auto, credit card and other consumer debt are rising. Where America leads, others will follow with lags and local differences.
A high proportion of borrowing is secured over financialised assets. Consumer borrowings are primarily mortgages collateralised by houses. With leverage mandatory to boost returns, significant amounts of debt are supported by real estate, shares, bonds, fund investments, and even artworks. Equity and commercial property prices are down. As values fall further, the loan-to-value ratios rise, triggering margin calls, making claims on available cash or requiring asset sales. This forces a reduction of debt. High leverage and multiple layers of debt increase sensitivity to asset prices. Investors, asset managers (who often invest in multiple vehicles themselves), and the underlying investment all have borrowings. Lack of income from many investments means asset-rich business owners and investors have borrowed against the value of holdings to fund consumption or other ventures. The amount of debt also increased financial ‘innovation’ such as pay-in-kind securities where the borrower can meet obligations by issuing new IOUs.
Increased price volatility flows into risk models, forcing further deleveraging by increasing the level of collateral needed or the frequency of margin reviews. This affects loans and derivative positions, which are largely collateralised. Higher margins and the falling value of lodged collateral can quickly become toxic.
A highly interconnected financial system is the main pathway through which contagion is transmitted. Potential losses are considerable. Global exposure to commercial real estate is around $21 trillion, primarily bank loans. Non-investment loans and bond outstandings are around $5-6 trillion. Equity margin loans in the US are around $1 trillion globally, probably 3 or 4 times that. Many now have diminishing margins of safety. Some have negative equity—the asset value is less than the loan. Global bank equity is around $6-7 trillion. Banks are leveraged 8 to 10 times higher if ‘funky’ hybrid capital and bail-in securities do not work as intended. Large losses would be systematically relevant, placing some at risk of insolvency and threatening financial stability.
Intermediation has moved into the shadow banking system (non-banks, including institutional investors, public and private funds, securitisation vehicles, family offices and HNWIs), which accounts for around 50 percent of global financial services assets. It has boosted the supply of capital, but the real equity supporting these investments remains opaque. It also creates complex chains of risk with legal and financial rights or obligations, enforceability, and claim priorities uncertain.
Actual losses or markdowns on assets because of lower prices will result in a contraction of credit. Given the reliance on debt-funded consumption and investment, this will exacerbate any economic slowdown in activity. The diminished supply of capital will affect the value of existing ventures, many of which do not have sufficient liquidity to reach the operational stage.
The process is one of downward spiralling feedback loops. Losses lead to lower leverage and credit contraction, which lead to economic retrenchment and credit contraction, which sets off a new round. Illiquid markets, due to falls in market makers, struggle to handle demand, worsening conditions.
The severity of the new crisis remains unknown. A real economic slowdown comparable to the 1930s is not inconceivable. Large financial excesses, particularly the disjunction between cash flow and prices, make severe adjustments likely. A complicating factor is institutional memory from the 2008 crisis is now scarce. It would not help in any case because, as Harry Potter’s Lord Voldemort observed, “[Humans] never learn. Such a pity.”
Satyajit Das | Former banker and the author of The Age of Stagnation
(Views are personal)