Could the Great Financial Crisis Happen Again?

Posted by Brad McMillan, CFA, CAIA, MAI

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This entry was posted on Mar 14, 2018 12:40:19 PM

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great financial crisisToday marks the 10th anniversary of the failure of the Wall Street firm Bear Stearns, widely considered the opening act of the great financial crisis of 2008. Bear was done in, so the story goes, by a mix of ill-considered bets on mortgage securities and excessive borrowing. After it went down, banks started to look around to see what other companies might fail—and found that they really couldn’t tell. As a consequence, each bank started to pull back individually, and the flow of liquidity that supported Wall Street fell apart. As each bank pulled away, the fears of collapse started to turn into reality, which only worsened the problem. The downward spiral led to what we now know as the great financial crisis, from which we have been recovering for the past 10 years.

Putting the crisis in this way highlights what we need to consider when we ask, could the great financial crisis happen again? There are three major pieces—liquidity, transparency, and leverage—that combined to sink the system then. So, let’s see what we know about them today.

Liquidity, transparency, leverage

Bear was a leading player in mortgage-backed securities. Its holdings were large enough (and obscure enough, in some cases) that other banks couldn’t really get a handle on just what they were worth. This brings us to transparency.

When you have doubts about the value of the holdings, you are not likely to lend against them. This brings us to leverage.

Bear, and much of Wall Street, was trapped in just this net. When Bear and other firms needed to borrow, other banks wouldn’t lend. When they needed to sell? The buyers were not there. Bear lost its financial foundation in a matter of days.

How do things look today?

Today, things are more solid. First, banks are required to hold more capital, which is to say they are less leveraged and have a stronger financial foundation. As such, in a crisis, other banks are more likely to keep lending because they know there is a solid base of assets to back up any loan they make.

Second, banks now hold less in the way of trading assets, so are less exposed to any declines—even if they are large. The combination of a more financially secure institution with less risk exposure means a Bear Stearns moment is materially less likely today. The follow-up freeze of liquidity is even less so. The system is simply more stable and more secure.

If something does fail, which is certainly possible, we now have a process to follow. This was not the case in 2008. Back then, regulators and government officials had to make things up on the fly. Today, we have a process for orderly liquidation: the government has the legal ability to go in, shut a firm down, and then reopen it for orderly liquidation. This should reassure potential lenders and help stave off the kind of chain collapses that could result from uncontrolled business failures.

Overall, the system is much more solid from a financial perspective, and the provisions for failure are much more defined at the regulatory level. As such, a repeat of the crisis looks unlikely. This makes sense because you rarely get hit by the bus you are watching for. After 2008, regulators and the banks themselves are certainly looking out for the risk factors that clobbered them back then.

Not out of the woods yet

We are not completely out of the woods, however. The orderly liquidation procedures have never been tested in a crisis environment. As part of the reforms, the ability of regulators to make up policy on the fly has been curtailed. Plus, there are certainly risks in the system—although not the same ones we saw in 2008. At some point, those risks will surface, and we will see another crisis. But it will not look like that of 2008.

This, however, is actually normal. If you look back at history, financial crises are a pretty regular feature of life. The difference in 2008, though, was that the crisis was a real one. It shook the system as a whole, which was something we had not seen in decades. As of now, the financial system is solid enough that the next “crisis” will not do the same.

So, could it happen again?

While we will certainly see financial problems, probably in the next recession, the great financial crisis is likely to remain as unique as the Great Depression. Could it happen again? In theory, yes. In practice, probably not.

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