On August 9 2007, BNP Paribas Investment Partners decided to suspend three of its hedge funds, citing “the complete evaporation of liquidity in certain market segments of the US securitisation market”, which made it no longer possible to value fairly the underlying US asset-backed securities in those funds.
This announcement made it clear to the market that there were trillions of dollars of essentially worthless derivatives circulating within the global financial system. The GFC had begun.
It is instructive to look back now at the key signs preceding the crisis and ask, a decade on, whether we are now clear from those problems?
While there are many studies into the causes and consequences of the GFC, one of the most compelling, and widely referenced, was by Warwick McKibbin and Andrew Stoeckel of the Australian National University, who formalised three ‘shocks’ which they proposed created the onset of the GFC.
- The bursting of the housing bubble causing a reallocation of capital and a loss of household wealth and a drop in consumption.
- A sharp rise in the equity risk premium (the return equity investors require over and above the return on risk-free bonds) causing the cost of capital to rise, private investment to fall and demand for durable goods to collapse.
- A reappraisal of risk by households causing them to discount their future labour income, increase savings and decrease consumption.
In our new report The Global Financial Crisis: 10 years on KPMG Economics has repeated the analysis undertaken within the McKibbin and Stoeckel study to see whether any of the identified shocks are at, or near, levels that indicate another crisis is imminent within the US and Australia.
Our findings suggest that while there is not likely to be a ‘GFC2’ emanating from the US any time soon, there are some indicators that policymakers need to be mindful of.
On housing, while the US market has never recovered from the sub-prime crisis, the Australian market has boomed over recent years. As we explained in our recent report What’s driving house prices in Sydney and Melbourne?, prices in those cities are 14 percent and 8 percent respectively overvalued and there will be a decline, but not a ‘bubble bursting’ as those prices are still within historically reasonable parameters.
However, mortgage delinquency rates (of more than 30 days or more) in Australia are now 1.5 percent – lower than the July 2011 peak of 1.87 percent but higher than the pre-GFC rate of 1.03. While this pales compared to the US peak of 11.5 percent in January 2010, (now down to 3.9) regulators will still want to keep an eye on this.
On risk premia, Australia has actually been more volatile than the US since the GFC – on average since March 2010, Australia’s being 2.8 percent to the US 2.5 percent. For the US, it appears current levels are within the range pre-GFC, while it seems equity investors in Australia are applying a higher risk premium than they were prior to the crisis.
And on household risk, while there has been no significant slump in consumption since the GFC (or the end of the resources boom), low wage growth and a sticky unemployment level of around 6 percent and considerable ‘under-employment’ has caused a cautious approach to household spending.
But the major difference to the global economic situation of a decade ago is the pre-eminence – but also risk – of China.
Its staggering growth of the last ten years to become the world’s largest economy on a GDP basis has coincided with a large rise in debt – and with rapid increases in property prices, outstanding mortgages are now almost equal to GDP.
Rising defaults, allied to the fact that Chinese mortgage lending (like US) is on a non-recourse basis indicates the risk associated with the Chinese housing market is not immaterial.
There has been no slowdown in Chinese consumer spending in anticipation of an impending domestic economic meltdown. Risk premia has also risen slightly since mid-2016, indicating the cost of capital in China is increasing.
Investment activity from lower-medium (BBB) grade corporate bonds may fall, which would pull down overall levels of economic activity.
Issues such as extreme debt-to-GDP levels, accelerating house prices (despite the introduction of various regulatory controls), consumer biased recourse residential mortgage financing, and rising cost of capital suggest the risk profile of China is increasing.
While Dickens told us nearly 200 years ago to ‘never say never’, an assessment of the tell-tale signs suggests that two out of three shocks are showing signs of emerging, but they are not at a point where it would seem an economic catastrophe is imminent.
Today, the possibility of a black, grey or white swan event originating from within financial system causing global chaos is modest. The biggest risks to the world today seem to be centred on geo-political games of brinkmanship. Losses associated with those games won’t be measured in dollars and cents, but rather in the much more valuable terms of human life.
This was first published in the Australian Financial review