Ten years after Lehman collapse, these risks could cause the next crisis

Sep 16, 2018, 12:12 PM


On Sept. 15, 2008, a credit crunch turned into a full-blown crisis when New York-based investment bank Lehman Brothers collapsed. The global recession that followed is still too fresh in many people’s memories to be considered history. But 10 years on, the state of the financial system suggests that the crisis has been relegated to the history books for many in the industry.

In 2018, Wall Street is enjoying another heyday. Bonuses for bankers have returned to pre-crisis levels, profits for commercial banks are at a record high, the stock market is in its longest bull run in history, the US economy is humming, and deregulation and tax cuts rule the day in Donald Trump’s administration

Around the world, regulators and policymakers say that measures taken in recent years have made banks safer than ever, with more capital and targeted oversight informed by mistakes made before Lehman went bust. That said, there are still plenty of potentially dangerous risks brewing in the financial system. Aggressive financial engineering in the pursuit of profit is alive and well. Complacency could lead to trouble, as it always does.

The UK’s Financial Conduct Authority just gave a timely reminder that the onset of a crisis can be sudden. “Most if not all of the firms which failed had been reporting relatively robust financial positions right up to the point when they did fail, with financial statements signed off by their boards and large audit firms,” Charles Randall, chair of the British regulator, said earlier this month.

On the 10th anniversary of Lehman’s bankruptcy, these are the things that market watchers believe could cause the next crisis.

Foreign corporate debt Global non-financial corporate debt more than doubled in the past decade, to $66 trillion in the middle of last year, according to McKinsey. Two-thirds of this debt has been raised in emerging markets, with the added risk that many of these companies have taken advantage of low interest rates to borrow in US dollars.

As corporate debt has increased, the quality of the credit has declined. Analysts at McKinsey say a quarter of corporate issues in emerging markets are at risk of default today, a figure that could quickly increase with a sharp rise in interest rates. US interest rates and the dollar are rising as record amounts of the debts come due.

The current turmoil in Turkey is an example of what can go wrong. The Turkish lira is in freefall against the dollar, and investors are increasingly unsure as to whether Turkish companies will be able to pay their dollar-denominated debt with the rapidly depreciating liras they generate in revenue. Some European banks have loaned heavily to Turkish companies, putting them on the hook in the event of cascading defaults.

There are also worries about China’s debt binge, which has left the world’s second-largest economy with a corporate debt pile worth about 160% of GDP, the highest in the world. The ability of the Chinese government to prop up growth, stabilize its over-leveraged economy, and fight a trade war with the US will be tested, and any slip will reverberate across the global economy.

Collateralized loan obligations These sound eerily similar to the collateralized debt obligations (CDOs) that caused so much chaos during the 2008 crisis. These assets are another example of securitization in which leveraged business loans (meaning debt from companies with sub-investment grade ratings) are pooled together and then divided into tranches. There are other similarities to pre-crisis securitization practices: CLO documentation is long and complex and each CLO usually has more than 100 issuers bundled into one product, according to Bloomberg.

For the most part, people think that CLOs are pretty safe. Even during the worst of the last crisis, the top tranches never defaulted. The argument is that this time is different because the company loans aren’t as vulnerable to changes in interest rates as the subprime mortgag...