Financial engineering that preceded the last two financial crises is back, International Monetary Fund warns
By Ambrose Evans-Pritchard, in Washington
2:28PM BST 15 Apr 2015
The so-called 'flash crash' on US bond markets last October and the collapse of the Swiss currency floor in January showed how quickly liquidity can vanish, acting as "a powerful amplifier of financial stability risks."
An illusion of liquidity has beguiled financial markets across the world and spawned some of the worst excesses seen on Wall Street in modern times, the International Monetary has warned.
Investors are borrowing money to buy shares on the US stockmarket at a torrid pace and are resorting to the same sorts of financial engineering that preceded the last two financial crises.
"Margin debt as a percentage of market capitalisation remains higher than it was during the late-1990s stock market bubble. The increasing use of margin debt is occurring in an environment of declining liquidity," said the IMF in its Global Financial Stability Report.
"Lower market liquidity and higher market leverage in the US system increase the risk of minor shocks being propagated and amplified into sharp price corrections," it said.
The report said there are clear signs that underwriting standards are deteriorating in a pervasive search for yield. So-called "covenant-light loans" with poor protection for creditors now make up two-thirds of all new leveraged loans in the US.
The ratio of non-financial corporate debt to underlying assets has reached 27pc, even higher than it was just before the Lehman crash in 2008. Issuance of "second lien" loans that face a likely wipe-out in cases of default are running near record levels once again.
This is becoming hazardous as the US Federal Reserve prepares to raise rates, a move that risks a spike in global borrowing costs and may cause liquidity to dry up almost overnight. "A sudden shift in market views that unwinds compressed premiums and sends yields higher could trigger a market liquidity shock," said the report.
The so-called 'flash crash' on US bond markets last October and the collapse of the Swiss currency floor in January showed how quickly liquidity can vanish, acting as "a powerful amplifier of financial stability risks."
The risk of seizure has been made worse by new regulations that effectively force market makers and dealers to hold much lower inventories, or to drop out of the business altogether.
The IMF said that large inflows of money into mutual funds have "provided an illusion of liquidity in credit markets" but this will be no protection in a major shock.
The report warned that distress in the global oil industry could be the trigger for the next storm. Lending to the oil and gas industry reached $450bn last year, double the pre-Lehman peak. New bond issuance graded at `junk' level have almost tripled to 45pc. The total debt outstanding is now $3 trillion.
Defaults in the energy sector tend to lag oil price crashes by around twelve months since drillers typically hedge their output on the futures markets for a while. "Aftershocks for the corporate sector may not yet have fully filtered through," said the IMF.
The slump oil prices is a powerful shot in the arm for world economy. It rotates vast sums of surplus capital from the oil-states into consumption, countering the chronic lack of demand that has held back global growth since 2008.
Yet there is a dark side for investors. The IMF said the oil states have accumulated $1.1 trillion over the last five years in foreign reserves alone, "an important source of funding for the global banking sector and capital markets."
These states hold $2 trillion in US assets, with $1.3 trillion concentrated in equities and $580bn in US Treasuries, and $230bn in credit. They are already having to draw down on this wealth to plug holes in their budgets at home, extracting a net $88bn last year. This could have "market repercussions" if it accelerates, said the report.
The IMF itself is in a delicate position. It is has been a cheer-leader for ultra-loose monetary policy to stave off global deflation and prevent debt-dynamics spinning out of control in Europe, Japan, and the US. Yet many of the risks now emerging are a direct result of quantitative easing and zero-rates.
A third of all sovereign bonds in the eurozone now carry negative yields. This is causing havoc for money markets and for the life insurance industry, which has locked into commitments stretching out for thirty years that are becoming untenable.
"A prolonged low interest rate environment will pose severe challenges for a number of financial institutions. Weak European midsized life insurers face a high and rising risk of distress. The failure of one or more midsize insurers could trigger an industry-wide loss of confidence," it said.
"The industry has a portfolio of €4.4 trillion in assets in the EU, with high and rising interconnectedness with the wider financial system. A large mark-to-market shock could force life insurers into asset reallocations and sales that could engulf the financial system," it said.
The IMF does love to keep us awake at night.
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