The world appears to have forgotten a key lesson of the global financial crisis: some problems were spotted earlier but sidelined
JPMorgan CEO Jamie Dimon’s remark that “when you see one cockroach, there are probably more” is a blunt reminder of the global financial crisis in 2008. At the time, a flood of bad mortgages had revealed a tenuous labyrinth of complex, highly vulnerable financial products that saw some US investment banks collapse and equity markets struggle for six years to recover losses.
Evidence is mounting that we are approaching danger again, with revelations of bad debt exposure for regional and investment banks as a consequence of two bankruptcies. Auto parts maker First Brand Group filed for bankruptcy protection last month with US$11.6 billion in liabilities, while car dealership Tricolor did likewise with more than US$1 billion in liabilities.
It is true that US markets bounced back a day after some banks’ stocks suffered their steepest single-day losses in more than six months on October 16. Wall Street’s fear index, the CBOE Volatility Index, shook off the anxiety after sharply jumping the day before.
However, many questions remain about the magnitude of exposure to holdings of other bad debt and the potential global fallout. Accompanying those is the backdrop of record sovereign debt worldwide, erratic trade policy confrontations and geopolitical tensions.
For the moment, CEOs are still leaning in, with more than half in an EY-Parthenon survey in September saying they are “investing to accelerate portfolio transformation”. But as the 2008 global financial crisis showed, situations change swiftly, especially in a highly interdependent global economy.
Meanwhile, CEOs are saying privately they have growing concerns about state capitalism and the erosion of independence at the US Federal Reserve, among other issues. These uncertainties could stop the music again, as former Citigroup chairman and CEO Charles Prince put it when the global financial crisis was beginning to unfold.
Dimon’s warning reflects his role in helping Washington navigate emergency relief to contain the financial wildfires and stabilise capital markets, including JPMorgan’s rescue of failing rivals Bear Stearns and Washington Mutual in 2008. His outlook reflects finance’s innate vulnerability: the history of Wall Street traces the mercurial rise and fall of institutions when value is destroyed after public trust implodes.
What Dimon saw during the global financial crisis is how events snowballed when increasing numbers of risky subprime mortgages defaulted as the US housing bubble burst. Years of low interest rates and easy credit created an unsustainable cycle. Housing values rose so fast that banks initially figured they would still have sufficient equity after foreclosure sales.
The music stopped. Housing sales collapsed in the face of rising interest rates. Marginal borrowers, holding adjustable-rate mortgages, saw payments soar. Home values plummeted, leaving them owing more than their houses were worth.
That set off a chain reaction. Mortgage-backed securities (MBS) packaged bundles of individual mortgages to pass off risks to investors, who borrowed heavily to own these securities. MBS products magnified and accelerated the collapse. That, in turn, brought the demise of credit-default swaps (CDS), instruments designed as insurance policies against MBS defaults. These derivatives were poorly understood and there wasn’t enough capital set aside to pay out MBS losses.
Today’s macroeconomic backdrop is dramatically different, but in some ways even more problematic. “Financial stability risks remain elevated amid risks presented by stretched asset valuations, growing pressure in sovereign bond markets and the increasing role of nonbank financial institutions,” the International Monetary Fund’s Global Financial Stability Report observed earlier this month.
Interdependence among financial markets has intensified, heightening contagion risks, which facilitated a global recession during the global financial crisis. These markets “have become more connected, which has made it easier for financial conditions to spread across borders, including to major advanced economies”, the Bank for International Settlements concluded in a June report.
Global banks, asset managers, insurers and pension funds often hold overlapping exposures. This is more worrisome because the multilateral frameworks used to coordinate policies among the world’s largest economies, especially during a crisis, have been swept aside by bilateral and regional diplomacy.
Interdependencies accelerate ripple effects, which range from a liquidity squeeze in credit markets to capital flight, when investors demand higher returns for increased risks. The collapse of Silicon Valley Bank in 2023 shows the velocity at which stress spreads.
Another structural change has enormous consequences, but the global financial crisis sheds little light on it. This is the transition of financial intermediation to non-bank institutions, such as hedge funds, private equity firms, leasing enterprises, digital concerns and pension funds.
This rise is demonstrated by the emergence of the private credit market, which reached US$3 trillion in January, compared to US$2 trillion in 2020. Morgan Stanley estimates growth to about US$5 trillion by 2029. Private credit risks include opacity, leverage, illiquidity and misaligned incentives between fund managers and investors – vulnerabilities akin to the global financial crisis.
Confidence in regional banks’ underwriting discipline has been shaken. Full, transparent disclosure must become standard practice. Investors need to see valuations of financial institutions’ assets and liabilities, risk concentrations and default rates. This would help them recalibrate counterparty risks and demand higher compensation for exposure.
Central banks and regulators should broaden oversight while strengthening early warning systems. They should also review liquidity backstops to be preemptively prepared. Stress tests must evolve to include the failures that unfolded over the past few weeks. One overriding lesson of the global financial crisis is that some problems were spotted earlier but sidelined. That is too costly a lesson to ignore.
