Avoiding a long-term financial crisis after covid-19
We've safely averted much of what would result in a long-term financial crisis during the covid-19 downturn, write Preston Caldwell and Eric Compton.
Research conducted by Morningstar’s team of analysts suggests that any economic downturn related to covid-19 will not play out similarly to the 2008 global financial crisis. We’ve found that the odds of a financial crisis shifted after 2008, and that they are still long enough today that we do not expect a US financial crisis to be the outcome of covid-19.
For the US, the question of whether a financial crisis will occur is largely the question of whether a banking crisis will occur. The US has experienced three banking crises in the past 100 years: the Great Depression, the savings and loan crisis, and the global financial crisis of 2008-2009. Research has shown that financial crises linked with banking crises are the situations that lead to the longest and largest impairments of long-run gross domestic product.
We group the general causes of banking crises into two main categories: liquidity crises and capital crises. Often these occur hand in hand, and each can cause the other.
What starts a liquidity crisis?
Funding liquidity tends to dry up within the banking sector; this tends to cause the banking system to become dysfunctional and can turn into mass insolvencies. When banks run out of liquidity, they can no longer lend effectively into the economy. This causes liquidity to dry up for the entire economy, and previously healthy nonbank companies can feel the liquidity crunch as well.
How a liquidity crisis has been averted for now
Our initial concern when the covid-19 shutdowns began was that a liquidity crisis could happen. There hadn’t been enough time for any losses when the shutdowns had just started, but willingly shutting off 30 per cent of the economy is unprecedented and sentiment was likely to swing wildly. When the markets lose confidence and everyone is trying to adjust at the same time, liquidity tends to dry up and the financial markets were ripe for potentially damaging disruption.
Our thesis during this time was that the Fed had an essentially unlimited ability to provide liquidity to the financial system, and it was willing to provide that liquidity to do whatever it takes. We also believed that the Fed had learned from the GFC and it would act more quickly and more decisively. We think the Fed better understands the potential contagion caused by a Lehman Brothers-like event.
These predictions have played out, and the Fed has successfully fulfilled its role as a lender of last resort. Key spread benchmarks have recovered, and other signs of financial stress have receded. In many cases, all it took was an announcement from the Fed, as spreads started to recover before any action was even taken in certain instances.
The Fed better understands the potential contagion caused by a Lehman Brothers-like event
As such, with the initial liquidity pressure now dealt with, and with the market generally having confidence in the Fed’s commitment to support the financial system, we think a liquidity crisis has been averted. We also don’t think a second wave of infections would cause the same stress in the financial system as the first wave did (a better-prepared healthcare system is a main reason for this), which we think removes the risk that we could get a repeat of what happened in late March.
What causes a capital crisis?
A capital crisis can be any situation where enough capital is destroyed so as to cause the system to become non-functional. In these situations, certain assets turn out to be worth materially less than they were thought to be, and the destruction to the banking industry’s balance sheet is large enough to cause a capital crisis. For example, in the lead-up to the GFC, many financial decisions were made on assumptions regarding the worth of mortgages, which turned out to be worth materially less than originally assumed. These miscalculations caused a destruction of capital in the system that was material enough to cause a capital crisis.
How a capital crisis has been averted for now
The Office of Financial Research’s methodology suggests that the risks within the US financial system, particularly as they relate to solvency, are lower than what we had heading into the 2008 downturn. In agreement with the OFR’s financial system monitor, our thesis is that the risk of insolvency and a capital crisis for the US financial system appears to be much lower this time around.
The Fed has called out different valuation levels as being potentially riskier, particularly the higher growth in equities in 2019, commercial real estate pricing compared with 10-year Treasury yields, and farmland prices. Residential real estate has generally been subdued, showing none of the signs that we saw last time around.
The housing cycle plays a key role in the overall market cycle and in financial crises. But we believe the residential housing market won’t be an issue this time around, given the lack of exuberance. It would take unprecedented strain on consumer finances and housing prices to see anything close to what we saw last time. To date, the housing market is holding up well, with pricing showing no serious deterioration and mortgage purchase activity also largely recovering, indicating surprisingly healthy demand.
When it comes to price appreciation and market valuations, we don’t see the obvious signs of excess that could have been seen in 2000 or 2007. Commercial real estate pricing has been fairly strong, and equities had posted a strong run heading into February 2020, but none of this appeared to necessitate a crisis for correction. The rapid expansion of credit often precedes an upcoming crisis. Eventually enough risk is taken on projects that don’t pan out, and impairments occur as estimates of future cash flows prove to be too optimistic.
In the private sector, it was households that leveraged up heading into 2008, materially above trend. This pickup in leverage presaged the subsequent impairment of consumer balance sheets, largely through declining housing prices. Since the 2008 downturn, households have gone through a period of deleveraging. Our impression is that the consumer is in a much better place than pre-2008.
Our analysis of the key risk factors contributing to the main types of financial crises indicates that our current situation looks much less vulnerable than in the runup to the 2008 global recession. Combined with the historically strong monetary and fiscal policy response we’ve seen, we think the risks of a US financial crisis are far lower than in 2008.
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