The next financial crisis will be called…

The next financial crisis will be called…

In 2008, it became known as the sub-prime crisis. Today, we call it the GFC. Because the problem spread so rapidly. But the trigger is still burned into every investor’s memory as ‘subprime mortgages’.

To be honest, that’s a little misleading. It was widespread mortgage fraud that set up the crisis — on both prime and subprime lending. From there on in, everything relied on dodgy information.

The securitisation process and the creation of CDOs. The derivatives and the risk weightings. The credit ratings and the GSEs like Fannie Mae. You can blame who you like for the GFC. But the key to the crisis was the mortgage fraud right at the beginning of the process.

I mention that because Australia’s own mortgage lies are now mainstream news. I wonder what happens next…

Back to today’s topic. I’m offering you a chance to get ahead of the game. To name the next financial crisis, before it even begins.

I’ll even make it a multiple choice option for you. Unless you want to email us your own suggestion. Here’s what I came up with:

  1. The Basel Bubble
  2. The Zero Risk Ruination
  3. The Capital Crunch Crash
  4. The Bail-in Blow-up

 Before you make your choice, I better explain the different options.

Over the years, the world’s bank regulators have regularly met at Basel in Switzerland to rejig bank rules. Specifically, bank capital rules.

It’s a bit like Australia’s bank regulator, APRA, discussing how much of a deposit home buyers need while visiting Launceston.

When you buy a house, your deposit is your capital. It’s also the lender’s protection — a buffer. As long as house prices don’t fall beyond the amount of capital, the lender is safe. It can repossess the house and get back enough money to cover losses.

If you go into negative equity on your home, there’s trouble.

Banks themselves operate in much the same way as property buyers, when it comes to capital. They borrow money and lend it out, but maintain a capital buffer to absorb any losses.

At Basel, the regulators decide how much equity banks need to maintain. To protect people from the bank’s failure. Well, to reduce the probability of the bank’s failure.

The rules, known as Basel I, II, III and soon IV, are effectively global. But each jurisdiction implements them slightly differently.

Basel III went active two weeks ago, by the way.

The trouble with all this is that rules don’t work. The moment you create them, you just create a new set of incentives. People look for loopholes, ways to profit from the rules, or ways to misinterpret them.

The other problem is that the rules are made by politically influenced people. They tend to favour governments and government priorities. Such as lending to subprime borrowers for political reasons…

So it’ll come as no surprise that the Basel rules have created a bubble in demand for government bonds. Effectively, bank loans to governments.

But they did so in a peculiar way.

If you buy a government bond, your financial adviser should tell you something along the lines of ‘No investment is risk free’ and ‘Do not invest more than you can afford to lose’.

We have to say that stuff. It’s the rules.

But if a bank buys a government bond, it’s different. According to the Basel rules, that government bond is risk free. And so banks invest more than they can afford to lose.

Now, sovereign debt is obviously not risk free. But before we get to how this will go disastrously wrong, what were the Basel attendees even thinking?!

Their answer is that central banks can always print money and buy government bonds. So the chances of a default on government bonds are effectively zero.

The trouble is, that’s not necessarily true in Europe. The ECB is restricted in its ability to rescue individual governments in the eurozone.

And the Basel rules’ ‘zero risk’ justification doesn’t address the problem that default risk isn’t the only risk. You also face price risk on sovereign bonds. Their value can fall, just as your house price can fall, putting the bank into negative equity.

That’s when you get a banking crisis. And it’s how the next banking crisis will begin.

The Basel Bubble in sovereign bonds sets up the Zero Risk Ruination, creating a bank Capital Crunch Crisis. A banking crisis far more spectacular than subprime.

But what’s the bail-in blow-up?

That’s something new. Something I’ve only just untangled over the last few weeks of research.

I’ve warned you about bank bail-ins before. The idea is to use depositors’ money to rescue a failed bank instead of taxpayers’ money.

It’s the law in Australia, just FYI…

But it’s not just depositors who can get shafted. Anyone who lends the bank money, or owns bank shares, can wake up in the morning to discover they have nothing. Or that their loan to the bank was converted into bank shares at worthless prices.

One Italian committed suicide as a result of this. It’s very real. But it’s not what I want to focus on today.

The purpose of a bail-in is to rescue a bank in a way that prevents contagion. Contagion is what usually makes a banking crisis so dangerous. Banks lend to each other a lot, so when one goes broke, the next one follows, then the next one…

The traditional solution to this is a bailout. But politicians don’t want to pay for bailouts anymore. Some can’t afford it — their debt to GDP is at crisis levels. So they turn to depositors, lenders to the bank and investors instead.

People who invest in and lend to a bad bank should weather the losses, after all. It’s called capitalism.

The trouble is, the biggest lenders to banks are, you guessed it, other banks. So the bail-in solution doesn’t change the equation much. There will still be contagion as each bank is bailed in to rescue another.

It’s a Bail-in Blow-up.

Until next time,

Nick Hubble Signature

Nick Hubble,
For The Daily Reckoning Australia