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*****SPECIAL EDITION*****
December 30, 2015

This past weekend I saw the film The Big Short, based on a book by Michael Lewis about how a few hedge fund managers read the tea leaves correctly and shorted the housing market before the 2008 financial collapse. Setting aside the merits of the film, which could prove to be Oscar-worthy, the purpose of writing this is to look at today’s conditions with some perspective on the events that led to the financial collapse of 2008. (And speaking of Oscar-worthy, the ensemble cast was led by Christian Bale, Steve Carell, Ryan Gosling, and Brad Pitt—who also produced it—along with a strong supporting cast. Steve Carell especially stood out. Highly recommended.)
I am going to start by comparing some numbers for the US dating back to the end of 2004 vs. today. Why 2004? Well, 2004 is the year before the peak in the US housing market. US housing started to peak in February 2006, although many acknowledge 2005 as the peak year. Today, housing starts are roughly 55% of what they were at the peak. Existing home sales peaked in 2005 and today sit at 65% of that peak. The home ownership rate peaked in Q2 2004 and today is 93% of that peak. 2004 marked the last time US GDP actually grew according Shadow Stats www.shadowstats.com.
The SGS-Alternate GDP reflects the inflation-adjusted, or real, year-to-year GDP change, adjusted for distortions in government inflation usage and methodological changes that have resulted in a built-in upside bias to official reporting. Without the built-in upward bias, the US has been in a series of rolling recessions since 2000. Below is a chart showing official vs. Shadow Stats GDP annual growth.

Other comparisons to consider are as follows:
Measure
2004
2015
Increase
US National Debt
$7.7 trillion
$18.8 trillion
144%
US Personal Debt
$12.8 trillion
$17.4 trillion
36%
US State & Municipal Debt
$2 trillion
$3.1 trillion
55%
US population
294.4 million
322.4 million
9.5%
US GDP (Official)
$11.7 trillion
$18.2 trillion
55.6%
US National Debt to GDP ratio
66.4%
103.2%
55.4%
US Labour Force
140.1 million
149.5 million
6.7%
US Not in Labour Force
76.4 million
94.6 million
23.8%
US Food Stamps Recipients
25.5 million
45.2 million
77.3%
US Monetary Base
$774 billion
$4.0 trillion
417%
US Total Debt
$37.8 trillion
$64.5 trillion
70.6%
US Personal Debt/Citizen
$43,598
$53,821
23.4%
US Personal Savings per Family
$8,886
$8,949
0.7%
US Total National Assets
$64.0 trillion
$116.2 trillion
81.5%
What stands out here? US debt has increased sharply primarily due to government. Personal debt levels have grown more slowly while corporate debt (not shown) is somewhere in between and is up about 46% since 2004. The US population has only grown 9.5% but the US labour force has grown more slowly, while the percentage for those not in the labour force has grown faster. The number of food stamp recipients has grown sharply as has the number living in poverty (not shown). Savings per family is flat but debt per family and per citizen is up. Assets have grown primarily due to monetary inflation, given the huge debt level increases.
It is against this background that one wonders how the US managed GDP growth over the past number of years. For the majority of the population things have actually deteriorated. The benefactors of the improving economy have been the 1% and possibly the top 20% of the population. For most people, things are either worse or about the same.
Globally, debt has increased $57 trillion since the financial crisis of 2008. These numbers were as of February 2015; the debt is probably higher now. Total global debt is estimated at $200 trillion. As a result, the global debt-to-GDP ratio has jumped 17 percentage points. This huge increase poses a risk to global financial stability and to global economic growth. Yet the US has just raised interest rates by 25 bp while most of the other developed countries were lowering interest rates (including parts of the Euro zone and Japan going to negative interest rates) and increasing quantitative easing (QE).
It is unknown at this time how the US rate increase might impact all the debt, but a quick calculation suggests that it could cost the US economy alone an additional $1.6 trillion annually in interest payments. But just how much debt is there out there that could cause a problem? Quite a bit it seems.
How much debt could be at risk? There are some estimates that $14 trillion of largely corporate debt issued in US$ in emerging markets could be at risk. Much of this debt is commodity related. This debt was issued on the assumption the global economy would stay strong and the US$ would stay low against foreign currencies. There is further $5 trillion of energy debt that could be at risk because of the collapse in oil prices from over $100 to below $40. Global growth is as low as it has been since the financial crisis of 2008 and the US$ is the strongest since 2003.
Domestically in the US some $1.3 trillion of student debt is at risk because millennials can’t find good jobs and, in many cases, no jobs. The banks convinced the government to pass a law that students cannot declare bankruptcy because of student debt. How much of this $1.3 trillion is uncollectable is unknown. The other sector that has seen debt explode in the past few years is car loans. Car loan debt is estimated to be well over $1 trillion in the US and has grown over 50% in the past five years. Recent Q2 figures showed that four banks alone had just over $1 trillion in car loans. These four banks are Ally Financial (ALLY-NASDAQ), Wells Fargo (WFC-NYSE), JP Morgan Chase (JPM-NYSE), and Capital One (COF-NYSE).
The global economy has become dominated by the finance sector. At one time, the financial sector wasn’t even 20% of the economy. Today, it is well over 30% and before the 2008 financial crisis the finance sector had reached over 40% of the economy. It is interesting to note that back as early as 1999 finance stocks made up only 13% of the S&P 500’s market cap. Today, they are around 17% and before the 2008 financial meltdown they had reached over 22%. Finance has become quite dominant when compared to the other sectors of the economy.
Financial derivatives have increased at a mind-boggling rate since 2000. The global market for financial derivatives is estimated at over $700 trillion (that’s face value). (Note: some studies suggest this may be over $1 quadrillion). The amount held by US financial institutions is estimated at $483.5 trillion, so the US banking institutions dominate the sector along with Deutsche Bank of Germany. In 2000, the amount of derivatives held by US financial institutions was only $94 trillion for a 420% increase.
So, what is a derivative? Derivatives are a security with a price that is dependent upon or derived from one or more underlying assets. The assets may be bonds, stocks or commodities. Derivatives are contracts between two or more parties. A participant in the derivatives market doesn’t even have to own the underlying bond, stock or commodity. The most common examples of a derivative are futures and options. As well, forward agreements or future rate agreements and interest rate, currency and equity swaps are also quite common. Not so common and the ones that came into being in the past 20 years or so were what one calls synthetic derivatives such as credit default swaps (CDS) and collateralized debt obligations (CDO). There are also mortgage-backed securities (MBS) which are asset-backed securities secured by mortgages. MBSs can also be turned into collateralized mortgage obligations (CMO) and the previous mentioned CDO. Debt, such as student and car loans, have been turned into CDOs. While futures and options are traded on an exchange, most other derivatives are traded only on the over-the-counter (OTC) market.
While it would be nice to believe that derivatives are used only for hedging, their biggest function is speculation (leverage) and arbitrage. In other words, one doesn’t have to be a market participant to actually engage in the trading of derivatives. The amount of derivatives outstanding can far exceed the supply of the actual underlying bond, stock or commodity. Why? Because one has to put up less margin or collateral for a derivative than one would have to put for the actual bond, stock or commodity. Hence, the leverage inherent in derivatives. As a result, the actual risk is considerably lower as well, but could be as high as $3.3 trillion in the US banking system alone according to numbers from the Office of the Comptroller of the Currency (OCC). A shift in interest rates or a large default could trigger a financial meltdown not unlike 2008.
At the heart of the financial crisis of 2008 were the banks who, because of slack lending practices were able to create money, primarily because banks were not shackled by reserve requirements. With the repeal of Glass-Steagall in 1999, banks were able to start acting like investment dealers. The original Glass-Steagall of 1933 prohibited banks from engaging in the investment business. With the end of Glass-Steagall, banks were now able to operate like an investment bank, but with much higher capitalization that allowed them to leverage their balance sheets to levels never seen before. It wasn’t unusual for banks to have leveraged their balance sheet 30 or 40 times (and some higher) before the 2008 financial meltdown. Even today, banks remain highly leveraged compared to previous times. Investment banks were constrained because of low capital compared to commercial banks and therefore had to act more prudently. This is no longer the case as the investment banks have converted to banking conglomerates so that they are all treated the same.
US M2 money supply that was $4.9 trillion in 2000 exploded to $12.4 trillion today—a gain of 153%. In 2008, M2 stood at $8.3 trillion so it has increased 49% since then. A big chunk of the increase in money supply went into housing. The banks further exacerbated the situation through sub-prime loans. That allowed people to buy a house with little or no money down and even no income at a low interest rate that would not rise for a fixed number of years. In many cases loans were being made at upwards of 125% of the value of the house. When the interest rate on the mortgage loans rose, many couldn’t pay it and defaulted.
Further mortgage loans were bundled up in MBSs and sold in tranches. Buyers and lenders alike also engaged in CDSs and CDOs. The rating agencies aided the situation by according these MBSs, etc. with high credit ratings, including AAA when the MBS might be 20% junk sub-prime mortgages. The rating agencies led by S&P and Moody’s were, of course, paid huge fees to give favourable credit ratings.
What the hedge fund managers in the The Big Short did was to bet against this house of cards by purchasing CDSs. The CDS was effectively an insurance policy against a default by a lender. The hedge fund managers started a little early, including some in 2004 as they saw what was going on as a disaster in the making. For the next few years they looked to be wrong as the housing market stayed strong and the stock market kept moving higher.
The hedge funds faced threats of withdrawals and lawsuits because of their position. The financial institutions selling the CDSs to the hedge fund manager treated them like a joke. After all, housing prices only go up; right? The hedge fund managers’ patience paid off and they made billions when the market collapsed in 2008.
The result was that an estimated 5 million lost their homes and another 11 million discovered that their homes were worth less than their mortgage. The numbers were actually worse than the Great Depression. Americans lost the equivalent of $12.8 trillion in the great housing collapse of 2008–2010. The banks who were at the heart of the financial crisis were bailed out by the taxpayer at a minimum cost of $700 billion (TARP) and, in reality, it was most likely in excess of $1 trillion. Upwards of 500 banks failed. Numerous funds were closed. Lehman Brothers was the sacrificial lamb of the big institutions that failed. Only one banker went to jail because of the crisis. The bankers paid themselves huge bonuses following the release of the TARP money to bail them out. Depositors were protected through the Federal Deposit Insurance Corp. (FDIC), but the FDIC became bankrupt and it too had to be bailed out by the US taxpayer. The US government’s two biggest agencies involved in the mortgage market known as Fannie Mae (Federal National Mortgage Association) and Freddie Mac (Federal Home Loan Mortgage Corp) were bankrupt.
Today, there is the emerging market debt, energy debt, student loan debt and car loan debt. There remains even sub-prime mortgages but they are just not as prevalent. Much of that debt has been securitized into CDO’s then resold as high yielding investments. Car loans have also been securitized and much of it is not unlike the sub-prime mortgages that were seen prior to the financial crisis. If only 10% of this debt were to default (an estimate of at least $2.1 trillion) it would be bigger than the sub-prime loan collapse of 2008. But this time, because of the financial crisis of 2008 plus the debt crisis of 2011–2013 in the Euro zone, the central banks do not have the wherewithal to bail out the financial system as they did in 2008. No wonder they have changed the rules so that it will be the depositors that pay rather than the taxpayer. This is known as a bail-in as opposed to the bail-out that took place in 2008.
If the global banking system were to face another financial crisis it would be the fourth one in the past 17 years. The first one was the Russian default of 1998 that led to the collapse of Long Term Capital Management (LTCM) a hedge fund so large it almost brought down the banking system. The second was the High Tech/Internet collapse of 2000-2002. The third one was the financial meltdown of 2007-2009. Each crisis required a larger commitment and bail out from the central banks coupled with a sharp drop in interest rates. The 2008 meltdown took interest rates in the US and elsewhere to historical lows that had never been seen before.
The taxpayer is tapped out and the central banks themselves would be in a bind. The US Federal Reserve has some $1.8 trillion of MBS on its balance sheet alone. Much of it is of questionable value. The FDIC is tapped out as well, as once again the US taxpayer would have to come to the rescue. But that scenario is unlikely. It is the depositors in the financial institutions that will pay when the next crisis happens.
As was the case leading up to the financial crisis of 2008, evidence was gathering that there was a problem as far back as 2004. Yet it took another 3–4 years to materialize. The current crisis is also percolating in the background. It was most likely being noticed back in 2013/2014 when the Greece mess was dominating the headlines in the Euro zone. The next crisis could be upon us by 2017. Already, a number of high-yield funds have closed their doors or are restricting withdrawals. Fed Chair Janet Yellen dismissed them as a one-off. Leading up to the financial crisis of 2008 Fed Chair Ben Bernanke was also dismissive of a brewing financial crisis. After all, the Fed works for the banks, not for the people, because the banks own the Fed and the banks own the US government and practically all the candidates for President. But they won’t tell you that.
As was the case leading up to the financial crisis of 2008, another crisis is percolating. When it will hit remains an educated guess. The signs are there. The recent closing or restrictions on withdrawals for some high-yield hedge funds is, as they say the canary, in the coal mine. When some funds closed in 2006 and 2007, no one paid any attention until it was too late. Well almost no one paid attention except for some like the hedge fund managers of The Big Short.
David Chapman
Disclaimer: David Chapman is an independent investment advisor with IA Securities. The financial markets are risky. Investing is risky. Past performance does not guarantee future performance. The foregoing report has been prepared solely for informational purposes and is not a solicitation, or an offer to buy or sell any security. Opinions are based on historical research and data believed reliable, but there is no guarantee that future results will be profitable.

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