Sunday, February 6, 2011

Oliver Wyman: The Financial Crisis of 2015

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An interesting paper by international management consulting firm Oliver Wyman, on the potential for the next Financial Crisis to play out around 2015.  This is not necessarily a 'prediction' per se, but an outline of the next black swan.  At the heart of it is once more.... central bankers, especially those of an American kind.   I am 100% sure the central bankers will cause another crisis, but what year and via what instruments is a guess.  I proposed emerging markets and/or commodities in 2009 as the most likely outcome (the next crisis is never the same as the last crisis) and this is the same path Oliver Wyman also utilizes.   Frankly the global political upheaval of rising food prices (not to mention energy) has me finding it hard to believe the central bankers can just print to their heart contents for years more on end, so I am finding it difficult to figure how the end game looks.  Then again The Bernank says global food inflation is not due to his acts, only the ever rising stock market can he take credit for.  Either way, I continue to believe Bernanke today is Greenspan 1998 - a semi deity ("the Maestro") who can control the world and save us from everything; but Bernanke 2018 will be seen in the same light as Greenspan 2008.
  • The sub-prime crisis of 2007 will not be the last financial sector crisis.
    Even during the relative calm of the last 25 years, we witnessed the
    property crises of the early 90s, the Asia currency crisis, the LTCM/
    Russia crisis and a number of other smaller emerging markets-led
    financial crises
    . We are due another crisis soon.
  • Financial services executives and regulators have worked hard to
    design a safer and more stable financial system, but we will not know
    whether they have succeeded until it is tested by the next crisis. The
    first aim of our 2015 crisis scenario is to stress test the design of the
    new financial system, to consider how well it would stand up to this
    type of adverse scenario
    .
  • The broader aim of the report is to encourage readers to think about
    the future financial system using several scenarios rather than basing
    decisions on a single predicted course of events
    .  
  • Our scenario is not a prediction. Our aim in describing it is to show
    that current efforts underway to create a better system should not
    be taken as an assurance that the system is now safe from future
    crises. Other plausible scenarios may show the same thing, though
    potentially with different strategic implications. We encourage you to
    use several such adverse scenarios in your planning, tailoring them to
    the risks facing your institution.
  • The financial crisis of 2008 shook politicians, bankers, regulators,
    commentators and ordinary citizens out of the complacency created
    by the 25 year “great moderation”. Yet, for all the rhetoric around a
    new financial order, and all the improvements made, many of the
    old risks remain.
    The basic regulatory framework – of bank debtor
    guarantees and regulatory bank capital and liquidity minima (that is,
    of risk subsidies and compensatory risk taxes) – has been maintained
    with tweaked parameters. And, within this system, bank shareholders,
    bondholders and executives still have incentives that might herd them
    towards excessive risk taking.

The full pdf is here, but the The Atlantic does a nice job describing the stress case as outlined in the pdf.  Again, this is but one scenario... 
  •  The world is slowly inflating a commodities bubble that could burst just like the housing market in 2008, creating an even more devastating worldwide recession.
  • Let's start in 2011. The world is in a three-speed recovery, with Europe at the bottom, the U.S. in the middle, and Asia growing between 6 and 10 percent. If you're an investment bank looking for high returns, where do you look? The fastest gains are in the hottest markets, and the hottest markets are in the developing world. In particular, commodities investments (gold, silver, platinum, rare earth metals, oil) have soaked up lots of excess global money supply and central banks have dropped their interest rates.  
  • In the U.S. housing bubble, over-valued homes encouraged families to go on a debt-fueled spending spree In the commodities run-up, emerging economies are on their own spending sprees, building up their cities and digging out more valuable metals. But just as the housing bubble was powered by a false faith that home prices would rise forever, it's wrong to believe that commodity prices have no ceiling due to insatiable demand from China, India and other developing countries.
  • The year is 2013. Western banks are investing heavily in new growth markets. Emerging economies are raking in investments to finance huge development projects and live outside their means (Real stat: in Brazil, public debt rose 13 percent in 2010 and household debt-to-income doubled in five years). Both sides are betting on the continued rise of commodity prices.
  • Now look at China, the world's largest commodities buyer. Prices for Chinese goods continue to rise dramatically in 2013 and the country's cheap currency isn't appreciating fast enough to offset rising food and metal prices. To fight back rampant inflation, China hikes up its interest rates and accelerates its currency appreciation. This has two side-effects. First, exports fall hurting the economy. Second, home values stop rising, hurting middle class Chinese families.
  • The Chinese economy, once an unstoppable commodity consumer, slows down. Investors freak out. Commodity prices collapse and the countries that export them (Russia, Brazil, Latin America, Africa) find themselves in the same position as an over-leveraged home owner in 2008. They've made promises based on the rising price of an asset whose price is suddenly collapsing. Everybody pulls back at once. It's another global recession.
  • The first wave hits international banks with direct exposure to Latin American development projects. The second wave hits U.S. insurers with indirect exposures through investments in infrastructure funds and bank debt. 
  • The third wave hits Western governments. A price crash in commodities along with a banking crisis could move developed countries dangerously close to deflation. Governments would respond the same way they responded to the Great Recession: by spending lots of money. But do we have the capacity to absorb another round of deficit spending? It's not clear.

To review how Great-Great Recession 2015 would affect the world:
  1. The commodity producers --  Latin America, Africa, Russia, Canada and Australia -- will have seen the price of their chief asset plummet overnight.
  2. China, the world's largest commodity importer, will have unwittingly created its own painful squeeze by getting trapped between inflation and an undervalued currency. 
  3. The developed world economies will have seen another round of foolish betting require yet another round of government bailiouts.
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But in the meantime we party like it's 1999!

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