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It’s a ‘Swimming Naked’ Moment: The Financial System Has a Real Test


The investor Warren Buffett once gave a famous warning: “It’s only when the tide goes out that you learn who’s been swimming naked.”

The tide has just gone out again, and clues to who’s been swimming naked have begun to emerge.

Mr. Buffett first made that comment in 1992, after Hurricane Andrew exposed the inadequacies of the insurance industry, to describe the rosy appearances that can mask financial recklessness until the good times end.

With a contagious virus seemingly out of control; supply chains disrupted and travel and tourism collapsing; an oil price war that has sent crude prices plunging to their biggest one-day drop since 1991; and stocks that may have just careened into a bear market for the first time in 11 years, the financial system is about to undergo its first real-life stress test since the financial crisis and recession more than a decade ago.

“I’m worried,” the Harvard economics professor Jeremy Stein told me on Monday, as the Dow Jones average was dropping a record-setting 2,000 points. “I don’t usually think of the stock market as having that large a quantitative impact on the real economy. But with credit markets also beginning to show real signs of strain, the potential for damage is elevated.”

On some level, we all knew that the unprecedented bull market that began exactly 11 years ago wouldn’t last forever. But as the years went by with only short-lived corrections, the horizon for the next bear market seemed to be receding ever further into the future. How bad could it get, with U.S. unemployment at an all-time low and short-term interest rates barely above zero?

And if things got bad, the Federal Reserve was there to take care of us — especially with a president browbeating the Fed chair to keep stock prices rising. “Investors’ misplaced confidence in the Fed’s ability to control the stock market, and even the economy, is being heavily tested by this steep correction,” said Jim Stack, a market historian and founder of InvesTech research. “I’m concerned that a lot of risk-averse capital has gone into the stock market over the past few years without appreciation for the inherent risk in a mature economy and late-stage bull market.”

That kind of complacency is exactly what breeds overconfidence, unsustainable valuations, and, finally, bear markets. They tend to begin when investors least expect them, with causes that at the time are unforeseeable — like the emergence of the coronavirus.

While the full extent of the damage remains to be seen, there’s no doubt that the spreading virus will take a serious toll on global economic activity. Tourism alone accounts for 13 percent of Italy’s gross domestic product. Even if that is cut in half, it would have a devastating impact on Europe’s fourth-largest economy and its still-fragile banking system.

And that’s just one country. Travel and tourism are slumping worldwide. Meetings and conferences are being canceled. Schools and universities are suspending in-person classes. The prospect of sharply diminished economic prospects is a major reason that oil, banking and airline stocks are dropping even more than the market as a whole. That’s not an irrational investor panic.

But a falling stock market, in and of itself, isn’t likely to trigger a recession. It didn’t cause the financial crisis, but it did help expose the excesses of the mortgage-backed securities market and inflated real estate prices, which in turn led to the collapse of Lehman Brothers and a worldwide recession.

There’s no reason to believe that anything of that magnitude is lurking within the financial system today. But no one can be sure until the financial plumbing comes under pressure.

Already, some stresses are emerging, especially in credit markets. With risk-free U.S. Treasury yields at historic lows after the financial crisis, investors poured into riskier, high-yielding debt, especially junk bonds. Since the emergence of the virus, that flow has reversed abruptly. Last week investors pulled out $12.2 billion from mutual funds and exchange-traded funds that buy corporate bonds and loans, the largest amount since the financial crisis. Investors withdrew $5.1 billion from junk bond funds, after pulling $4.2 billion the week before.

Junk bond worries were already acute in the oil sector even before the Russia-Saudi Arabia price war. Energy companies account for 13 percent of triple-C-rated bonds, the bottom tier of the high-yield market. Those bond yields surged to nearly 13 percent last week as prices dropped. (Yields move inversely to prices.)

The risk is that a wave of defaults and bankruptcies in the oil sector could start a chain reaction. Some issuers were already rushing to reassure investors that they had adequate liquidity to meet debt payments. But shares in Chesapeake Energy, a big junk bond issuer, dropped to 15 cents on Monday, a 30 percent one-day decline.

Leveraged loans, which are private loans to already heavily indebted borrowers, could now emerge as the mortgage-backed securities and collateralized debt obligations of the financial crisis. Just as mortgage and debt securities were packaged, carved up and sold to often unwitting investors before the financial crisis, risky high-interest loans have been similarly packaged over the past decade, mostly by nonbank issuers. Given their high yields, collateralized loan obligations, or C.L.O.s, as they’re known, surged in popularity, and the market for them had grown to an estimated $1.2 trillion by the end of last year.

Professor Stein is concerned that no one knows how the leveraged loans will perform in a downturn. “I’m worried about all the nonbank corporate lending,” he said. “So much of the credit formation has been in the leveraged lending market and the ultimate suppliers are nonbanks. They’ve done well. But when they hit their first round of defaults, this will be new. There may turn out to be something of a bubble.”

European banks are another potential weak link. The London-based HSBC Holdings and Standard Chartered have already issued profit warnings because of the coronavirus, but if the crisis deepens, others could be at risk. “Italy has always been just one shock away from crisis,” Professor Stein said. “The European Central Bank will have to act very aggressively if the Italian banks run into solvency problems.”

All of this is unfolding after years of low interest rates, which have left the Federal Reserve with only so much room to maneuver. Professor Stein was a Fed governor from 2012 to 2014, and “I’d have to vote for a rate cut if I were still there,” he said. “But how much effect can that have? The interest rate on 10-year is already below 0.5 percent.”

One answer may by aggressive fiscal stimulus rather than monetary policy. “The first line of defense has to be: Stop the virus,” Professor Stein said. “The second should be fiscal policy. I’d give everyone a fast tax cut so that people who miss a couple of paychecks aren’t immediately left in distress.”

Fiscal policy, of course, depends on the White House and Congress enacting legislation. As the market was plunging Monday, President Trump blamed the “fake news media” for inflaming the sense of crisis and added, incorrectly, that “nothing is shut down, life and the economy go on.”

A few hours later, in a White House press briefing, he said he would push for a payroll tax cut and financial help for hourly workers who are hurt by the disruption. Stay tuned.



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