When the tide goes out you find out who was swimming naked, Warren Buffett memorably said. The tide’s definitely gone out in markets this year, but finance has come through with few problems. Is it possible that this time not many were skinny-dipping?
The optimistic view is that the typical culprits—speculators using borrowed money—had been caught out already in the past two years and so weren’t up to their usual tricks. The pessimistic view is that the blowups are still to come.
Start with the positive: the list of recent crises that made investors reassess the dangers. The shock of the pandemic in early 2020 revealed serious problems with leveraged trading and overnight borrowing in Treasurys. The Federal Reserve stepped in and backstopped the market, but fixed-income hedge funds that lost big as Treasurys moved in the wrong direction cut back.
In January 2021, short sellers were hit as Redditors piled into meme stocks such as GameStop, driving up their prices and causing multibillion-dollar losses for those betting against them. Melvin Capital, which was heavily short GameStop, finally shut down this year. Other hedge funds took note, and concentrated short positions were rethought.
Then in March last year—when the market was still super-bullish—hedge fund Archegos blew up, causing $10 billion or so of losses to investment banks that had unwisely lent it money. Soul-searching at the investment banks means they have re-examined their hedge-fund lending, while Credit Suisse decided to pull out of the business altogether. Again, greater powers given to risk managers mean there is less risk of a repeat.
Roll forward to the autumn and currency and bond traders began preparing for rate rises, led by surprisingly hawkish talk from the Bank of England. But prices snapped back abruptly in November when the Bank didn’t follow through with the expected tightening, again giving funds that trade on macroeconomic news a dry run for the volatility that has dominated markets globally since.
All of these big but not huge shocks helped ensure that risk-taking was cut back, meaning there were fewer highly leveraged players who might be taken out by the extreme moves of 2022 in stocks, bonds, commodities and currencies.
So far there has been only one true catastrophe in traditional finance, the freezing of the nickel market when the London Metal Exchange foolishly decided to save a Chinese firm caught out by massive wrong-way bets. But bad as that was, it was never going to be enough to take down important parts of the financial system.
There have been some total disasters in crypto, notably the collapse of the Terra “stablecoin,” but the links to traditional finance remain small enough that this matters little to the mainstream.
The other important pillar of support is that banks are significantly stronger than in the past couple of decades, thanks to post-2008 reforms. They can weather bad times more easily as a result.
So much for the good news. The prevailing mood of finance executives I’ve asked about the lack of trouble is summed up by a repeated response: “So far.”
Long before Mr. Buffett discussed naked swimmers, economist John Kenneth Galbraith invented the “bezzle”—fraudulent losses accumulated in the good times that are only discovered when the economy weakens. After a decadelong bull market with only the briefest of interruptions in 2020, there could be plenty of bezzles yet to emerge.
The biggest bezzles in recent history took painfully long to emerge. After the bursting of the dot-com bubble in March 2000, it was 18 months before accounting fraud took down power company and leveraged energy trader Enron in what was then the biggest-ever bankruptcy. After the 2008 financial crisis, scandals continued for years across both finance and real-economy businesses.
The feedback loop from finance to the real economy and back to finance takes time to create serious problems, too. Already the weakest and most indebted developing countries are in trouble, with Sri Lanka in crisis and Ghana imposing fierce austerity to keep finances in order. The rising dollar and higher U.S. bond yields hurt governments and countries that chose to borrow in dollars and have a mismatch of dollar costs and local-currency income.
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In 1994 and 1997-1998, it took more than a year for emerging-market crises—in 1994 Mexico’s “Tequila crisis,” in 1997 the Asian devaluations followed by Russia’s domestic-debt default—to feed back to Wall Street. When they did, Wall Street’s financial stability wobbled. More worryingly, the loss for investors in benchmark 10-year Treasurys from their peak is already much bigger than the shock of 1994.
There are two new risks that history doesn’t help with. The first is the unprecedented amount of liquidity that has been pumped into finance by central banks buying bonds. A lack of liquidity is what usually creates financial problems, as it prevents debts being rolled over. As the Fed and other central banks drain liquidity, problems might reveal themselves.
The second is that there’s a massive, and unknown, amount of private debt issued by lightly regulated shadow banks. My worry isn’t mainly that the lending turns sour (although it might). Rather, the danger is that the private-debt boom turns out to be a function of easy money. If investors prove less willing to lock up their money in private-debt funds as interest rates make mainstream investments more attractive, there will be a steady withdrawal of lending capacity. That could hold back the economy and make it harder for companies to refinance loans. These sorts of knock-on effects could take years to feed through into financial trouble.
I suspect there are plenty of underdressed bathers still to be exposed. I hope the crisis practice runs of the past two years mean there is less risk of Wall Street coming to a sudden stop.
Write to James Mackintosh at firstname.lastname@example.org
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