Remember 1929 when looking for the cause of the coming financial crisis


It has not yet been recognised that Ruth Bader Ginsburg’s death significantly raises the likelihood of a US-centric financial crisis this fall. The continued forbearance by lenders and bond trustees, the rule-waiving, and the explicit belief in further fiscal stimulus have all depended on the assumption that Congress would be open to any negotiations between the parties. But the possibility of any agreement has been damaged by fury among Democrats at President Donald Trump’s insistence that RBG’s successor must be appointed before the election.

Fed chair Jay Powell’s pleas for more fiscal support in recent days do not seem to have done the trick of concentrating members of Congress on the urgency of a reaching an agreement on additional fiscal stimulus. All that matters in Washington now is the fight over who succeeds RBG.

But there are entire industries, specifically airlines, hotels, and “core retail”, ie shopping malls, whose revenues have suffered deeply from the tailing-off of the initial federal fiscal stimulus and consumers’ fear of Covid infection. Each of these industries has been supported by previously “investment grade” tranches of securitisations that are going into default on a large scale.

The only way to get Congress to act on major new stimulus before January or February will be to have a financial crisis. Usually these are triggered by the failure of a large financial institution or the sudden, deep repricing of a whole class of securities.

The major banks are far more risk averse and better capitalised than in the past crisis, and the housing industry is prospering from the refinancing boom made possible by Fed easing. Since the Lehman/2008 crisis, risk has been moved off bank balance sheets and into securitisation markets.

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That is why I think it is more likely that the coming financial crisis will be triggered by the market’s rejection of a few classes of securities. Something like this happened in 1929 with the collapse of pyramided securities holding companies.

So to find the point of vulnerability in the US financial markets, I believe we have to look for the least legally flexible credit securities that can move the fastest from low risk to visibly defaulted.

Those would be the commercial mortgage-backed securities (CMBS), particularly those floated in the market between 2012 and 2017. Because they are (mostly) not held on bank balance sheets, there is no bank that can decide, say, to amortise their principal and interest payments over a longer timescale. Unlike almost all collateralised loan obligations, CMBS cannot have any substitution of collateral. Meaning you cannot move a few bad assets to the sponsor’s own balance sheet and replace them with performing assets that can be added to the CMBS collateral pool.

A CMBS manager generally holds small amounts of cash that are intended for maintenance or replacing necessary equipment or fixtures and furniture in shared areas. These “FF & E” pools typically will amount to about three months of assumed rent receipts.

Since the Covid-related economic crisis in March, the trustees for many CMBS bonds backed by troubled properties have allowed FF & E accounts to be used to pay enough principal and interest to avoid having the CMBS collateral from going into default. But that three months of cash has run out in many cases, particularly for hotels and malls. In the first weeks of September, there has been a rapid increase in the number of CMBS going into “special servicing”, ie a sort of formal default.

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This process will now accelerate rapidly, conterminous with the Supreme Court nomination fight and the election. In the most troubled CMBS structures, triple-A tranches are now jumping down to BB. This is the sort of surprise we got in 2007-2008, just as the last financial crisis accelerated.

Now, even deregulating conservatives I know want to restrict the Wall Street securitisation machine. This is because it is based on an elision of the truth that amounts to deception. Among the easiest targets in the aftermath of this will be the major credit rating agencies.

The ratings the agencies bestowed on CMBS were just a marketing tool for selling securities. They should not have any of the colour of independent free speech. At the very least, the agencies should be treated the same as research departments of securities firms. In the US that would mean being regulated by Finra, the broker-dealers’ self-regulator. That would be much more expensive than their current friendly chats with the SEC. And the rating agencies should be forced to assume more direct civil liability for misrepresentations of possible risks.



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