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The next crash risk is hiding in plain sight

The Financial Times logo The Financial Times 10/08/2017 Gillian Tett
web_financial trash bins © Ingram Pinn web_financial trash bins

Editor’s note: The opinions in this article are the author’s, as published by our content partner, and do not represent the views of MSN or Microsoft.

A decade ago, I spent a sleepless night worrying about a Spanish trash bin. The reason? On Thursday August 9 2007, financial markets suddenly seized up.

Since I was running the Financial Times markets team, I spent two days frantically trying to identify the reason for the panic. Nobody knew. But that weekend I suddenly woke in the middle of the night with an image of a Spanish bin in my head.

A month earlier I had attended a credit conference in Barcelona, where I read brochures about a little-known, and supposedly safe, entity known as a “structured investment vehicle”. The material had seemed achingly dull. So on the way home I tossed the papers into an airport bin — and forgot it. But, somehow, my subconscious knew that had been a mistake. So I awoke and went online to uncover what I had left in that bin.

By dawn I had realised that those widely ignored investment products were a key culprit in the market mystery: the details were complex, but essentially these SIVs held toxic mortgages and were plagued with dangerous asset-liability mismatches that had caused investors to panic.

There is a lesson in this tiny piece of personal history, as we look back from the 10th anniversary of the drama to assess what happened — and not just to observe that our brains can work in mysterious ways.

Sometimes, market shocks occur because investors have taken obviously risky bets — just look at the tech bubble in 2001. But other crises do not involve risk-seeking hedge funds, or products that are evidently dangerous. Instead, there is a ticking time bomb that is hidden in plain sight, in corners of the financial system that seem so dull, safe or technically complex that we tend not to focus attention on them.

In the 1987 stock market crash, for example, the time bomb was the proliferation of so-called portfolio insurance strategies — a product that was supposed to be boring because it appeared to protect investors against losses. In the 1994 bond market shock, the shocks were caused by interest rate swaps, which had previously been ignored because they were (then) considered geeky.

And in 2007 it was not just those SIVs and conduits that were a trigger. Products such as collateralised debt obligations or credit default swaps, which had also been ignored, were another ­problem.

The good news today is that it does not seem as if the financial system faces an imminent threat of another “boring” time bomb causing havoc. Western banks are well capitalised, regulators are alert, the global economy is growing and central banks are providing monetary support.

In 2007 it was not just those SIVs and conduits that were a trigger. Products such as collateralised debt obligations or credit default swaps, which had also been ignored, were another ­problem

But the bad news is that precisely because the system has become so flush with cash — and seemingly calm — there is complacency; and not just about the dangers of clearly risky bets (say, Argentine bonds), but about the perils of “safe” assets too.

Consider the world of exchange traded funds. This sector has recently exploded in size: with more than $4tn in assets under management globally and about $3tn in the US, it eclipses hedge funds. ETFs do not usually attract much attention, since the sector — yet again — seems geeky and dull.

But they have profound consequences: Marko Kolanovic, a senior JPMorgan strategist, estimates that passive and quantitative investors now account for about 60 per cent of the US equity asset management industry, up from under 30 per cent a decade ago.

This is changing market flows in potentially unpredictable ways that investors and regulators do not entirely understand, and spawning some esoteric products. This year, for example, investors have rushed into an obscure “Inverse Vix” ETF that benefits from low volatility. This ETF is now the world’s 34th most actively traded equity security, exchanging hands more often than the stock of Chevron or Pfizer, and has returned almost 100 per cent this year. It appears to have distorted measures of volatility this year, creating an impression of calm. But, as my colleague Robin Wigglesworth notes, those Vix trades could spark a whiplash effect if sentiment shifts.

Or consider Treasury bonds. Most investors assume that Treasuries are the risk-free pillar of modern finance, and that government bond yields will stay low for a long time. But only a few days ago Alan Greenspan, former Federal Reserve chair, warned that the bond prices “are in a bubble” and “when they [real long-term interest rates] move higher they are likely to move reasonably fast”.

If so, this could create some unexpected chain reactions in the bond and derivative portfolios of investors, banks and insurance companies. And if the US Congress fails to raise the debt ceiling this autumn, sparking a technical default on some Treasuries, more feedback loops could emerge too.

Don’t get me wrong. I am not arguing that such shocks are imminent or likely. But the key point is this: if we want to avoid a replay of 2007, we must keep questioning our assumptions — and peering at the parts of the system that seem “boring”, “geeky” and “dull”.

Our mental bins can sometimes hold time-bombs; particularly when investors are intoxicated by an asset-price boom.

gillian.tett@ft.com

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