Today, I want to apply the analysis we laid out yesterday to the great financial crisis (GFC). The idea is to see whether it would have given us some advance warning of just how bad that crisis got. If so, the analysis might be useful in identifying future crises that are actually worth worrying about.
To recap, there are four tests. First, is this an immediate problem? Second, is it a surprise? Third, is it big enough to command attention, but small enough to be solved? And fourth, by the time it hits the headlines, is it a real threat or already being solved? Let’s fire up the Wayback Machine and see how these tests would have applied to the GFC.
It’s hard to avoid some lookback bias here (we know what happened, after all). To avoid that as much as possible, let’s start with what happened at a high level.
In the early 2000s, housing prices rose for years, generating multiple headlines about unsustainable valuations and hand wringing about poor mortgage underwriting standards. NINJA (no income, no job, no assets) loans were typical. Those loans got recycled into asset-backed bonds that were sold far and wide. When housing prices started to go down around the country, those bonds went bad—and took down multiple financial institutions with them, starting with an obscure hedge fund. No one knew it, but as it turned out, there was enough bad debt, as well as interconnections between the financial institutions holding it, to threaten the whole system. The consequent unwind of the bad debt rocked the whole system.
The Immediacy Test
Since we know this was a real crisis, the utility of the tests above is not in identifying it as such, but rather in defining when it moved from a potential risk to an actual and immediate one. Running the tests, you could have looked at the housing market itself and the multiple headlines. But, since the problem was not immediate, you would have been years early. The immediacy test would have kept you from acting before you needed to.
The Surprise Test
The surprise test also would have helped. When the market was going up, and everyone expected it to, that was not a surprise. When the market started to soften—nationally, which had never happened before—that was a surprise. When mortgage bonds started going bad, that was a surprise. When a hedge fund that invested in those bonds went bankrupt, that was a surprise. Once the surprises started piling up, at multiple levels, this test would have indicated the problem was becoming immediate.
The Size Test
The size test also would have ratcheted up the worry level. Anyone looking at the surprise turns in the markets could have looked at the volume of assets tied to mortgages and said here is a real problem. Some traders, famously, did just that and made a fortune betting on trouble once the crisis started. Although it was not totally clear at the start of the crisis just how big it was, there were enough hints to start taking it very seriously.
The Solvability Test
And the final test—is this being solved—is the capstone here. As the crisis deepened, the Fed, the Treasury, and the White House all argued over whether they had the legal authority, much less the means, to stabilize the situation. Congress initially failed to vote to allow a rescue. Not only was the problem not being solved, but no one seemed to know whether it could be solved or even whether it should be.
Looking at these tests, they would have helped prevent premature action but also led to action when the situation started to worsen. While this is certainly 20/20 hindsight, I personally was one of the people calling out the rising risks at the time, to the extent I was referred to as “Eeyore.” I had no idea how bad it would get, of course, but it was clear there was a big problem. The tests worked.
What About Evergrande?
What can those same tests tell us today? The worry is that Evergrande could be another GFC, that it could be the equivalent this time of the Lehman Brothers bankruptcy. I don’t think so, at this point, but it is certainly worth considering. Let’s run through the tests again and see where we are.
First, is this an immediate problem? Yes, it is. Evergrande has bond payments due and apparently does not have the money to pay them.
Second, was this a surprise? Yes, it was. While the generally weak condition of the Chinese real estate market was well known, for one of the leading developers to have to default on its debt was a shock. So far, two for two.
Third, is this big enough to command attention but small enough to be solved? The answer to the first is a definite yes. The answer to the second is probably yes, but here is where the risks start to mount. No one seems to know the full extent of the debts associated with Evergrande, or with other developers, and how they tie into the Chinese financial system. There is a possibility that this could be much larger than what we currently see, and there could be systemic risks.
This brings us to the final test where either this is a real risk or it will be solved quickly. During the GFC, the U.S. government was caught napping and did not have the knowledge or the tools to solve the problem. It was trying to fix the engines while the plane was flying. With Evergrande, the Chinese government has a much wider range of tools, both coercive and financial, available. Even more important, it has the lessons from the U.S. during the GFC to know it has to act forcefully to contain the risks, if necessary. This should not be a systemic crisis.
Those tests, however, also give us some guidelines about how to watch for things going wrong. If we see more surprises, that will raise the risk level. If the scale of the problem continues to rise, despite official action, that will raise the risk level. If, most important, the Chinese government looks to be unwilling or unable to contain the risk, that would ratchet up the risk even further.
Red Flags to Watch For
Watch for surprises, with other companies facing problems and especially problems popping up elsewhere in the Chinese financial system. Watch the Chinese government. Will it take control? And does that solve the problem? China knows this type of event can metastasize. If the government can control the problem, it will. If surprises keep appearing, then maybe it can’t. And that is a risk worth knowing about.
What the tests are telling us is that the crisis is not—at the moment—immediate or significant. What they also provide, however, are red flags to when and if that might happen. Eeyore is not here yet, but he is waiting in the wings.