Any time there is an episode of turmoil in US and global financial markets the question in the mind of investors is whether this is a period of temporary turmoil or the beginning of a more severe and protracted period of financial market volatility and downturn that could end up into a systemic risk episode.

In the last decade only the LTCM episode in 1998 at the peak of the Asian and emerging markets financial crisis and the bust of the tech bubble in 2000-2001 - that triggered the US recession of 2001 - had systemic implications. Since then we have experienced a variety of other episodes of financial turmoil that have ended up being only temporary shocks. In these episodes of temporary turmoil investors risk aversion sharply rose for a while, volatility indices and gouges of investors risk aversion (such as the Vix, the 10 year swap spread and credit spread) sharply increased; and the financial pressures spilled over from credit/debt markets to equity markets. But in each of the most recent episodes the turmoil was transitory (a few weeks or, at most, a couple of months); once the transitory sources of the financial disturbances disappeared, calm returned to markets and investors risk aversion returned to lower levels. 

One of such episode of temporary turmoil followed 9/11 in 2001 and the collapse of Enron in late 2001. Another episode of transitory turmoil occurred in early 2003 before the US invasion of Iraq when market started to worry about the risks and consequences of the war on the economy. A more recent episode was the one that – in the spring of 2005 – followed the downgrade of GM and Ford by credit rating agencies; that downgrade caused serious but temporary pressures in the credit derivatives markets and in equity markets. Another episode occurred in the spring of 2006 when a sudden “inflation scare” in the US (worries that inflation was rising and that, therefore, the Fed was not done yet with rising the Fed Funds rate) led to a sharp downturn in US and global equity markets and serious pressures on some emerging markets currencies, equity markets and bond markets.  And the final episode – before the most recent turmoil this summer – was in late February 2007 when the combination of a mini-crash in the Chinese stock market, rising worries about the fallout of the subprime crisis and a US “growth scare” affected mostly equity markets in the US.
 

Since most previous episodes of financial turmoil since 2001 have been temporary, the optimistic and consensus view in the markets is that the current financial turmoil will be again transitory and that risky assets – starting with equities – will recover their upward price path once investors’ nervousness abates. That is certainly possible as previous episodes of turmoil since 2001 were mostly contained. But I will flesh out a number of reasons why the current episode of market turmoil may be more serious and protracted than previous ones and why we should worry now about systemic risk.
 

First, most of previous transitory episodes occurred at the time when US and other G7 monetary policy conditions were much looser than today. Starting in January 2001 the Fed aggressively cut the Fed Funds rate that fell from 6.5% to a bottom of 1% by 2004. Next, the normalization of US monetary policy brought back the Fed Funds rate to 5.25%; while at the same time monetary policy has been tightened in all G7 countries and several other emerging markets. And with inflationary pressures being still on the upper limits of many central banks’ comfort zone further tightening is expected (say in the Eurozone, UK, China and many other economies). Thus, in past episodes, easy monetary conditions helped; today instead policy is tighter and on the way to further tightening.
 

Second, following the brief US recession between March and November 2001, economic growth – first in the US, then in other G7 economies and emerging markets – recovered rapidly and has remained high for a number of years. But starting with the fall of 2006 the US has experienced a serious economic growth deceleration that may turn out into a hard landing (either a growth recession or an outright recession). The rest of the world is growing robustly but the clouds over US economic growth are rising.  In previous episodes – like the spring of 2006 or early 2007 – we had an inflation “scare” or a “growth” scare and markets reacted sharply downward. Now, if instead of having a growth “scare” the US were to experience an actual sharp growth hard landing (say a growth recession) the financial consequences would be serious as hosuing, capex spending and private consumption would sharply slow down.
 

Third, between 2001 and 2006 the debt, credit and financial excesses of important sectors of the economy were contained; today they are not. At the time of the 2001 recession the balance sheets of the corporate sector were weak but those of the household were relatively sound. Today, instead, after six years of excessive borrowing and two years of negative savings the balance sheets of the household sector are weak and fragile. At the same time the process of releveraging of the financial and corporate system (hedge funds, private equity, prop desks, LBO and share buyback activity) has led to significant increase in the amount of debt and leverage in the private sector. As suggested by Ed Altman – the leading academic expert of corporate distress - corporate defaults have been kept at a much lower levels (0.6%) than justified by current corporate financial fundamentals (2.5%) only because of the slosh of liquidity that allowed potentially distressed corporations to refinance their debts or do out-of-court restructuring plans.  In the last few years a credit boom – if not a bubble – stimulated asset prices in a typical Minsky-style credit-driven asset bubble. The easy monetary conditions after 2001 and the continued wall of liquidity coming from highly saving and forex-accumulating emerging markets fed a US and partly global asset bubble and a credit/debt bubble. Thus, the excessive leveraging of households, some parts of the corporate sector and many financial investors is a new source of financial fragility and systemic risk.
 

Fourth, the housing bubble has already popped in the US and is at risk of popping in other bubbly housing markets (UK, Spain, Ireland, Australia, New Zealand, and Iceland to name a few cases). The fallout of the US housing recession has been twofold. First, spillover to other sectors of the economy (auto recession, weakness in durable goods and housing related sectors, weak capex investment of the corporate sectors, slowdown of private consumption among overstretched US households). Second, spillover to other financial markets as: a) this is not just a subprime problem but increasing a near prime and prime mortgage problem; b) there is now a liquidity and credit seizure in a variety of credit markets (LBOs, CDOs, CLOs, etc).
 

Fifth, we are now reaching a point where the distress of many and different economic agents may lead to a systemic effect. Some have argued that the growth of credit derivatives has diffused financial risks among many different agents and in a variety of countries reducing systemic risk. That is why – it is argued - the risk of one huge LTCM blowing up and causing systemic risk are limited. But the experience with previous episodes of systemic risk (the S&L crisis where hundreds of smaller financial institutions went belly up causing a credit crunch and the 1990 recession; the tech bust of 2000-2001 where hundreds of smaller tech and internet companies went belly up and triggered the 2001 recession) suggest that the LTCM type of systemic crisis (one large institution getting in trouble and taking with it most of the financial system) is the exception rather than the rule: many and different agents and institutions getting in trouble can lead to systemic effects especially after a period of asset bubbles driven by a credit/debt bubble.
 

And today there is a variety of economic and financial agents that are under financial pressure if not outright distress. Specifically, hundreds of thousands of subprime and near prime households will default on their mortgage and their homes will end up in foreclosure; the ability of the financial and legal system to manage such a surge in bankruptcies is severely limited. Also, over fifty subprime lenders have now gone out of business and now some of the larger lenders – see AHM and Accredited Home Lenders Holdings Co.  - are also in trouble and near bankrupt; the mortgage rot is spreading from subprime to near prime and Alt-A (see Countrywide, IndyMac, etc.). Now, there are news of massive losses among major US home builders and rumors that some may be near bankruptcies. There are already half a dozen mid-sized hedge funds – between US, Australia and Europe – that have gone belly up; and every day financial institutions across the world are reporting large subprime-related losses as a lot of the RMBS and CDO were bought by foreign investors.  And in a world where most investors in these illiquid instruments (RMBS, CDOs, CLOs, etc.) are marking to model rather than marking to market the extent of the eventual losses is unknown and the number of financial institutions that will go belly up is also unknown and likely to surprise on the upside. Systemic risk episodes often occur with a death through 1000 cuts rather than one single major – a’ la LTCM – blow.

{ Friday Update:

NEW YORK (Reuters) - Bond market turmoil sending investors fleeing from risk may be a worse predicament than the 1980s stock market fall and Internet bubble burst, Bear Stearns Chief Financial Officer Sam Molinaro said on Friday.

"These times are pretty significant in the fixed income market," Molinaro said on a conference call with analysts. "It's as been as bad as I've seen it in 22 years. The fixed income market environment we've seen in the last eight weeks has been pretty extreme."

"So, yes, we would make that comparison" to market events that also include the debt crisis of the late 1990s, he said. }