Earlier this month marked the tenth anniversary of what economists generally agree was the beginning of the Global Financial Crisis. It was the worst economic downturn since the Great Depression during the 1930s, but what makes this even more notable is the fact that this year bears some startling resemblances to 2007.
So does this mean another deep recession is on tap? The world’s leading economists disagree about that.
Remember the Global Financial Crisis?
Most adults still remember the 2007-2008 Global Financial Crisis quite well, especially since it’s the worst time of economic distress the vast majority of us have lived through. The hallmark of the Great Recession was the housing crisis, which was marked by the subprime mortgage scandal.
The reason Aug. 9 is considered to be the anniversary of the beginning of the Global Financial Crisis is because it’s the date BNP Paribas Investment Partners announced that it was temporarily suspending redemptions from three funds. The firm cited “the complete evaporation of liquidity in certain market segments of the U.S. securitisation market” as the reason for the suspension.
Similarities with the Global Financial Crisis
Economists who argue that the world is about to be plunged into another deep economic downturn point to conditions in the U.S. that are similar to those in the mid-2000s. For example, Capital Economics Chief Markets Economist John Higgins said the unemployment rate in the U.S. has tumbled close to 4%, which he says is “probably close to its natural level.”
The Fed has also been acting similarly to how it acted in the lead-up to the Global Financial Crisis, he adds, as policymakers have been tightening policies to keep the economy from overheating. He also noted that equity valuations and corporate bonds are also high after a sudden sharp increase.
But let’s not forget that some analysts and economists have been crying gloom and doom and calling for a recession for the last year or two, so it doesn't come as a surprise that they're still expecting a recession, especially based on these similarities. However, there is another camp that doesn't think we're on the verge of another global financial crisis or that valuations are concerning, and Higgins in a recent note titled "Do valuations point to a re-run of 2007?" is part of this camp.
A repeat of the Global Financial Crisis?
He notes that there are some key differences in the housing market, the source of many of the problems in 2007 leading up to the Global Financial Crisis. For example, he doesn't think housing prices are as stretched now as they were a decade ago. He admitted that the Case-Shiller National Home Price Index has ticked slightly higher than where it stood in the lead-up to the crisis ten years ago.
He also notes that on the other hand, ratios of home prices compared to disposable income are roughly in line with the average looking back to 1975. In the mid-2000s though, this ratio was greatly elevated, he explained. He also pointed out that mortgage debt as a share of income is also smaller, and it's much less expensive to finance mortgages now than it was then. He notes that as the Fed raises interest rates, financing will get more expensive, but he doesn't expect it to even approach where it was leading up to the housing crisis.
Additionally, the criteria for lending have greatly been tightened, so it's more difficult for borrowers to get a loan. This happened after the government cracked down on subprime mortgage companies, which were lending much more money to borrowers than what they could really afford to pay. And finally, he said housing inventory is much lower now than it was leading up to the housing crisis.
A new culprit in the next financial crisis?
The Financial Times' Frank Partnoy is one of those arguing in favor of another Global Financial Crisis being just around the corner. At the end of last month, he noted the role of collateralized debt, packages created by "rocket-scientist financiers" who "buy up billions of dollars of risky loans and repackage them into complex investments with multiple layers of debt." Although he doesn't mention mortgage-backed securities, they were a big part of collateralized debt and played a key role in the collapse of the housing bubble. Following the housing crisis, U.S. regulators enacted Dodd-Frank in an attempt to keep that kind of risky debt from being bundled.
However, now he warns that high credit ratings are hiding structural instability, adding that the problem now is collateralized loan obligations. He said these CLOs bundle "risky low-grade loans into attractive packages and high credit ratings" and pointed to two deals greater than $1 billion apiece. He added that experts expect another $75 billion worth of such deals are expected before the end of the year.
Further, he explained that most of the loans in these deals are of junk status, although over half of the new debt has a triple-A rating, which is similar to the collateralized debt obligations that were widely sold during the early 2000s.
Is another Global Financial Crisis really on tap?
He argues that the problem here is packages of debt that are much riskier than it seems because credit ratings hide the reality, adding that regulators ignored what was happening and are doing so now by allowing credit rating agencies to dodge the Dodd-Frank Act. He goes on to point the finger at Moody's Investors Service and S&P Global Ratings as the main actors this time, just as he accuses them of being in the last Global Financial Crisis. And it doesn't help that President Trump may take aim at dismantling Dodd-Frank sometime soon.
It will take quite a while before we know whether Partnoy or Higgins will be correct. Both are approaching the question from different angles, so it's easy to see why each believes what they believe. If Higgins is right about another housing crisis not being around the corner, then it seems that a repeat can't happen, but the debt packages Partnoy writes about are concerning and, as it's sometimes said, "Fool me once, shame on you; fool me twice, shame on me."