Is this correction another 2008 in the making?

Greg Canavan

Fat Tail Investment Research

Every time things get a bit hairy in global financial markets, people start to wonder if it’s the start of another 2008 event.

Just last year, the collapse of China’s largest property developer, Evergrande, was apparently another ‘Lehman Moment’.

The collapse of financial markets around the global following Lehman’s bankruptcy on 15 September 2008 were truly momentous events.

Most people in financial markets, or with money IN financial markets, will remember that time vividly.

I specifically remember Friday 10 October. The ASX200 had collapsed 8.3%. The Aussie dollar was down around 7% and continued to fall after the local market closed.

I met some mates for beers at Macquarie Place, just near Bridge Street, in Sydney.

The place was heaving. There was a lot of nervous energy around. I was young enough not to have enough skin in the game to be REALLY scared. But there was enough fear, and fear of the unknown, for it to remain a lasting memory.

This fear is no doubt seared into the memory of many of us who were around to experience such huge falls.

So when there are momentous events and sharp market movements, the natural tendency is to wonder whether the proverbial is going to hit the fan again. Will there be contagion?

There’s a biological reason for this.

Your fear receptor is called the amygdala. It’s located in your brain near the hippocampus, which is associated with your memory. So when your amygdala is scared by a traumatic event, you don’t forget it in a hurry.

Which is probably why a lot of people ask me if I think this current market correction is another 2008 in the making.

My answer is no.

Let me explain why…

Before I do though, just keep in mind that what follows is pretty simplistic analysis in order to make a broader point. When writing about this stuff there’s a risk of getting bogged down in the details.

The point of this brief wire though is simply to reassure you that we’re not in a 2008 type situation. The conditions just aren’t there to blow up the global banking system.

That doesn’t mean that this bear market won’t be around for a while longer. But the chances of a 50% correction (which is what the GFC handed out) are low in my humble opinion.

Righto, let’s get into it…

In the lead up to 2008, the global banking system was stuffing itself full of real estate assets. You can see this in the chart below. It shows the year-on-year percentage growth in real estate loans made by all commercial banks in the US. That big grey line in the middle is the 2009 recession.

In the decade leading up to the GFC, real estate loan growth averaged 10-15%.

Not only that. The banking system turned real estate loans into collateral, so these loans effectively become ‘money’. The banking system monetized the value of global real estate.

The problem was, it was only seen as ‘money’ while asset values increased. As soon as property prices stopped rising, people headed for the exits.

Property prices began to fall. This rendered banks insolvent, and the rest is history.

As you can see from the above chart, banks haven’t gotten back into the real estate game in a large way. Once bitten, twice shy, as they say.

So what are they doing now?

Well, this is important. It explains why we’re not approaching another 2008 moment.

US banks are loading up on Treasuries, the lowest risk investment and best collateral in the world. Ever since the GFC, US commercial banks have been steadily accumulating US Treasuries and mortgage backed securities (that come with an implicit government guarantee).

But they really picked it up in late 2019 and post the COVID recession. The year-on-year growth rate hit 30% in early 2021 and is still running at over 20%!

In other words, the US banking system is flush with high quality collateral, meaning a ‘run’ on the banks, which is what happened in 2008, is unlikely.

At this point, that is…

Ironically, the greatest strength of the banks is also its greatest weakness.

Nearly all the US treasuries and agency securities have been accumulated post 2008, when yields were very low.

As you probably know, with bonds, when yields are low, prices are high.

The banking sector now has US$4.65 trillion of these assets on their balance sheets. That compares to around US$1.1 trillion in mid-2008.

The big problems are likely to emerge a few years down the track, after another round of fiscal and monetary stupidity will cause a genuine inflation crisis and bond yields to spike. What will that do to the value of the Treasuries and mortgage back securities, and to the real estate market in general?

Prices will fall significantly, leading to huge losses for the banking system.

Right now, the 10-year Treasury yield is still only around 2%. That tells you the bond market doesn’t believe that current high inflation is a long-term problem.

But if the Fed, central banks and governments around the world respond to the next slowdown/recession (which is coming) with more stimulus, it could become a very big problem for the whole financial system.

A bursting property bubble caused the 2008 credit crisis. A bursting government debt bubble is likely to cause the next one. The good news, if you could call it that, is that this scenario is still a few years away.

So don’t let the ghosts of 2008 haunt you just now. There’s plenty to worry about, but another credit crisis isn’t on the cards yet.

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Greg Canavan
Editorial Director
Fat Tail Investment Research

Fat Tail is Australia’s largest independent financial publisher. Greg is Editor of its flagship newsletter, Greg Canavan’s Investment Advisory, where he writes market commentary and looks for out-of-favour ASX 200 stocks on the cusp of a re-rating.

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