Where to Look for the Next Wall Street Blowup

Warren Buffett memorably said when the tide goes out, you’ll find out who’s swimming naked. The tide has certainly disappeared in the markets this year, but finances have weathered with some problems. Is it possible that this time there are not many people who are thin?

The optimistic view is that the typical culprits – speculators using borrowed money – have been discovered over the past two years and are therefore not their usual ploy. The pessimistic view is that explosions will still happen.

Let’s start with the positive: the list of recent crises prompted investors to reassess the risks. The shock of the pandemic at the beginning of 2020 revealed serious problems with leveraged trading and overnight borrowing in Treasury. The Federal Reserve stepped in and got the markets back on track, but fixed-income hedge funds that suffered big losses due to Treasuries moving in the wrong direction were cut.

In January 2021, short sellers were hit when Redditors flocked to meme stocks like GameStop, sending their prices up and causing billions of dollars in damage to those who bet against them. Melvin Capital, which was a short-term GameStop, finally closed this year. Other hedge funds have taken note and concentrated short positions have been reconsidered.

Then, last March – when the market was still super bullish – the Archegos hedge fund blew up, causing $10 billion or more in damage to investment banks that hadn’t intentionally loaned it money. Soul searching at the investment banks meant they re-examined their hedge fund lending business, while Credit Suisse decided to pull out of the business altogether. Again, the greater authority given to risk managers means less repeat risk.

Turn to autumn and currency and bond traders begin to prepare for rate hikes, led by surprising hawkish talk from the Bank of England. But prices turned sharply back in November when the Bank failed to live up to its expected tightening, once again leaving macro-news-based exchange-traded funds dry on the back of volatility. has dominated the markets globally since then.

All of these big but not overwhelming shocks have helped ensure that risk taking is reduced, meaning there will be fewer players with more leverage that could be put off by extreme moves. by 2022 for stocks, bonds, commodities and currencies.

So far, there has been only one real disaster in the traditional financial sector, the freezing of the nickel market when the London Metal Exchange decided foolishly to save a trapped Chinese company. stuck by big wrong bets. But the bad news is that it will never be enough to take down vital parts of the financial system.

There have been a number of overall disasters in crypto, notably the demise of “stablecoin” Terra, but the ties to traditional finance are still small enough that this doesn’t matter to the mainstream.

The other key pillar of support is that banks have been significantly stronger than they have been in the past few decades, thanks to post-2008 reforms, so they can weather the bad times more easily.

A lot for the good news. The prevailing mood among the financial executives I asked about not having trouble was summed up by a repeated response: “So far.”

Long before Mr. Buffett discussed nude swimmers, economist John Kenneth Galbraith invented “holes” – heavy losses that accumulate in good times that are only discovered when weakened economy. After a decadelong bull market with only the shortest disruptions in 2020, there could be a lot of upside yet to emerge.

The biggest disasters in recent history took a long time to appear. After the dot-com bubble burst in March 2000, it was 18 months before accounting fraud brought down the power company and leveraged energy trader Enron in the biggest bankruptcy since before to now. After the 2008 financial crisis, scandals continued for years in both the financial sector and the real economy.

The feedback loop from finance to the real economy and back to finance also takes time to create serious problems. The weakest and most indebted developing countries are struggling, with Sri Lanka in crisis and Ghana adopting drastic austerity policies to maintain financial order. The rising dollar and higher US bond yields have hurt governments and countries that have chosen to borrow in dollars and there is a disparity between dollar costs and local currency earnings.

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In 1994 and 1997-1998, it took more than a year for emerging market crises — in 1994 the “Tequila Crisis” in Mexico, in 1997, the devaluation of Asia, then Russia’s domestic default – just returned to Wall Street. When they did, Wall Street’s financial stability was shaken. More worryingly, the losses for investors on standard 10-year Treasuries since the peak have been much larger than the 1994 shock.

There are two new risks that history does not address. The first is the unprecedented amount of liquidity that has been injected into finance by central banks buying bonds. Lack of liquidity is what often creates financial problems, as it prevents debt from rolling over. As the Fed and other central banks run out of liquidity, problems can reveal themselves.

The second is that there is a huge and unknown amount of private debt issued by heavily regulated shadow banks. My main worry isn’t that lending goes sour (although it can). Instead, the danger is that the private debt boom turns out to be a function of easy money. If investors show little willingness to lock up their money in private debt funds because interest rates make mainstream investments more attractive, the likelihood of lending will diminish. That could slow down the economy and make it harder for companies to refinance loans. Impacts of this kind can take years leading to financial trouble.

I suspect a lot of unclothed bathers are still exposed. I expect the crisis practice of the past two years to mean less risk for Wall Street is stopping suddenly.

Write to James Mackintosh at james.mackintosh@wsj.com

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Edmund DeMarche

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