Modern finance (1982-) is the story of testing the limits of leverage (global debt capacity). The consolidated ratio of domestic credit to GDP for the developed world has been steadily rising for thirty years. Levels of indebtedness have reached unprecedented levels not seen since WW2. And these levels of indebtedness have been achieved in a world without financial repression: there are no war-bond drives, no interest ceilings, no Treasury-Fed treaty. This has all been accomplished in the free market.
And it is an impressive achievement: to be able to accumulate trillions upon trillions in debt in a free market without government compulsion. Although the phenomenon of the “debt supercycle” is not new, what we see today is the mother of all supercycles. Somehow, the developed nations have managed to build sufficient confidence in the stability of the financial system and the financial markets that investors willingly hold the debt of highly-leveraged borrowers whose only source of liquidity is more debt.
The principal drivers of this growth, both in the US and abroad, have been disintermediation and securitization. Prior to the modern era, the total amount of debt was limited by (1) the capital levels of financial institutions and (2) growth in pension assets.
Disintermediation has freed debt growth from these limiting factors, and securitization has made possible endless permutations of asset repackaging. In housing finance, we have seen mortgages packaged as RMBS, repackaged as CDOs and then repackaged again into CDOs of CDOs which are in turn purchased by financial institutions which fund themselves in the debt markets. Whatever equity there ever was in housing finance resided pretty much with the original borrower, who frequently had no equity to start with. That, gentlemen, is truly a triumph of leverage (a $10 trillion triumph).
In the US, nonfinancial debt has grown by 8 times since 1982, while financial debt has grown by 18 times, clear evidence of using debt to buy debt to buy debt.
And how has this mountain of free-market debt been built? Confidence, unprecedented confidence (plus recklessness compounded by indexation). When an investors buys a Treasury bond, does he ever ask “How is the US going to pay me back”? Never. He purchases on the basis of the presumption of liquidity: that no matter what, there will be a liquid market in the long-term debt of the US government. And he will probably be right. The last time the Treasury bond market dried up was in the spring of 1933, when the banking system was being liquidated, the Fed was defending the gold standard, and the government ran out of money.
Today, the global debt mountain rests on the confidence that the authorities will never allow another massive debt liquidation to occur. Such a liquidation was threatened in 1982, 1992, 1998, 2002 and 2007, and each time the authorities stepped up and provided the “bidder of last resort”. Other than the much analyzed Lehman failure, the authorities have not allowed panic to bring down the pillars of financial stability, and in the Lehman case they immediately drew a line between Lehman as the rest of the financial system. The question to be asked about 2008 is not who was allowed to fail, but rather who, besides Lehman, wasn't.
It is interesting to note that in the US, private market debt peaked in 2007 and has been slowly declining ever since (fully compensated for by the growth in federal debt). In other words, it can be argued that 2008 was the “Minsky moment” for dollar-based finance. Too soon to say; right now it could go either way.
The threat to global financial stability today is not the collapse in the market for American mortgage securities and their derivatives; that has occurred and been fully digested.
Today’s threat to global stability is the accelerating decline in the market for the debt of the peripheral eurozone governments and their banks. It is fair to say that not one of the PIIGS can readily refinance its government or bank debt in the private bond market today. Each of them is facing its own private financial catastrophe (delayed but not solved by EU bailout money).
Confidence has evaporated, liquidity has been withdrawn, and leverage has been deemed excessive for each of them: Portugal. Ireland, Italy, Greece, Spain and now Cyprus. The bond market is awarding no points for effort; they are all contaminated despite occasional virtue.)
Confidence is fragile: built up over decades, it can disappear overnight (e.g., September 15, 2008). Any shock can trigger the panic. What was an acceptable credit yesterday can become radioactive today. Confidence is precious; it makes the world go round. Once lost, only overwhelming firepower can bring it back. Firepower such a $1 trillion bank capital injection coupled with an overnight doubling of the Fed’s balance sheet. Under such circumstances, it was futile to “fight the Fed”.
The market expectation for a similar European demonstration of shock and awe is slowly fading (but not yet shattered). It seems that every day, Merkel has to reiterate that Germany will not participate in a massive government/bank bailout with no strings attached, and that Jens Weidmann has to reiterate that the Bundesbank/ECB will not provide the bidder of last resort for junk-rated PIIGS securities (although ECB collateral standards keep declining).
This week’s EU summit will demonstrate to the world, once again, that there will be no German capitulation. Will that be the trigger for Europe’s Minsky moment, or will it be delayed? I don’t know. But what I expect is a continuing loss of confidence in the eurozone, a further decline in market liquidity, and the ultimate end of the European debt supercycle.