The last recession wasn’t also called the Global Financial Crisis for nothing.
Delinquencies, defaults, and trading losses put huge strains on the banks, which in turn had less money to lend and the money that they did lend came at extraordinarily high interest rates. The high levels of leverage made the banks vulnerable, and elevated values-at-risk (VAR) had trading desks collapsing all over Wall Street. That slammed even the most credit-worthy consumers and businesses. And so things spiraled.
Could such a credit crisis happen again?
Perhaps, but the way it happens next time around will probably be different.
In a note to clients, Citi credit analyst Stephen Antczak examines sources of contagion risk in the bond market.
“Conventional sources of contagion risk seem unlikely to be catalysts for spreading fundamental risk at this stage,” Antczak wrote. By “conventional,” he’s referring to the banks. “[T]he financial sector, which often plays a key role in transmitting weakness across assets, is in a much less vulnerable place now than in the recent past.”
Indeed, since the financial crisis, both regulators and investors have demanded banks to be less risky. And so leverage and VARs have come down everywhere.
“But investor sentiment is another, albeit less conventional, factor that can cause fundamental risks to spread, and in the current environment this catalyst may be a bigger problem than usual,” Antczak added.
In addition to explaining how the “very whippy price action in recent trading” is bad for sentiment, Antczak noted that the mix of investors in the corporate bond market has shifted significantly.
“Figure 7 shows that the buyers of corporate bonds have been dominated by three investor types in recent years — mutual funds, life insurers, and foreign investors,” he added. “The holdings of these three investor types are up about $US2.8 tn in the post-Lehman era, while all others shrank by over $US1 tn.”
The issue here is that these players tend to be a bit more homogenous in their trading and investment decisions. That means if the tide turns in the market, a whole bunch of these holders could start dumping their positions all at once.
“The problem is that Mutual Fund ABC and Mutual Fund XYZ, for example, tend to have similar objectives, constraints, and concerns,” Antczak explained. “They share a similar mindset, and if one is wary about extending liquidity to an issuer(s) then others probably are as well. Investors that approach the world with meaningfully different views (e.g., hedge funds) make up a much smaller part of the market now.”
To be clear, Antczak and his team are very far from predicting imminent doom. But he advises clients not to ignore the risks.
“Concentrated problems can become widespread problems if sentiment worsens, and sentiment can change very quickly,” he said. “Don’t get too complacent.”