The Threat Of Contagion
By James Rickards | May 31, 2018 |

Each crisis is bigger than the one before. In complex dynamic systems such as capital markets, risk is an exponential function of system scale. Increasing market scale correlates with exponentially larger market collapses.


---Sponsored Link---
We Have A Copy Of Jim’s Latest Book On Hold For You Right Now
A free copy of Jim Rickards' brand-new book, The Road to Ruin: The Global Elites’ Secret Plan for the Next Financial Crisis, is on hold for you right now. But since you haven’t claimed yours, we have NOT shipped it to your address yet. All you need to do is click here, read the details over and cover the small shipping fee ($4.95) and we’ll ship the special edition to you. You should NOT deposit another dollar in your bank account until you claim and read this book. The government has a secret plan to freeze all of your money that you need to understand and prepare for right now. That’s why I’m urgently trying to reach you. You NEED to claim this free book now… before it’s too late. Click here now for the details.

This means that the larger size of the system implies a future global liquidity crisis and market panic far larger than the Panic of 2008.

Today, systemic risk is more dangerous than ever. Too-big-to-fail banks are bigger than ever, have a larger percentage of the total assets of the banking system and have much larger derivatives books.

To understand the risk of contagion, you can think of the marlin in Hemingway’s Old Man and the Sea. The marlin started out as a prize catch lashed to the side of the fisherman Santiago’s boat.

But, once there was blood in the water, every shark within miles descended on the marlin and devoured it. By the time Santiago got to shore, there was nothing left of the marlin but the bill, the tail and some bones.

An even greater danger for markets is when these two kinds of contagion converge. This happens when market losses spillover into broader markets, then those losses give rise to systematic trading against a particular instrument or hedge fund.

When the targeted instrument or fund is driven under, credit losses spread to a wider group of fund counterparts who then fall under suspicion themselves. Soon a market-wide liquidity panic emerges in which, “everybody wants his money back.”

This is exactly what happened during the Russia-Long Term Capital Management (LTCM) crisis in 1998. The month of August 1998 was a liquidity crisis involving broad classes of instruments. But, the month of September was systematically aimed at LTCM.

I was right in the middle of that crash. It was an international monetary crisis that started in Thailand in June of 1997, spread to Indonesia and Korea, and then finally Russia by August of ’98. It was exactly like dominoes falling.

LTCM wasn’t a country, although it was a hedge fund big as a country in terms of its financial footings.

I was the general counsel of that firm. I negotiated that bailout.  The importance of that role is that I had a front-row seat.

I’m in the conference room, in the deal room, at a big New York law firm. There were hundreds of lawyers. There were 14 banks in the LTCM bailout fund. There were 19 other banks in a one billion dollar unsecured credit facility. Included were Treasury officials, Federal Reserve officials, other government officials, Long-Term Capital, our partners.

It was a thundering herd of lawyers, but I was on point for one side of the deal and had to coordinate all that.

It was a 4 billion dollar all-cash deal, which we put together in 72 hours with no due diligence. Anyone who’s raised money for his or her company, or done deals can think about that and imagine how difficult it would be to get a group of banks to write you a check for 4 billion dollars in 3 days.

Systematic pressure on LTCM persisted until the fund was almost broke. As Wall Street attacked the fund, they missed the fact that they were the creditors of the fund. By breaking LTCM, they were breaking themselves. That’s when the Fed intervened and forced Wall Street to bail out the fund.

Those involved can say they bailed out Long-Term capital. But if Long-Term Capital had failed, and it was on the way to failure, 1.3 trillion dollars of derivatives would’ve been flipped back to Wall Street.

In reality, Wall Street bailed out itself.

The panic of 2008 was an even more extreme version of 1998. We were days, if not hours, from the sequential collapse of every major bank in the world. Of course, the 2008 panic had its roots in sub-prime mortgages, but quickly spread to debt obligations of all kinds especially money market funds and European bank commercial paper.

Think of the dominoes again. What had happened there? You had a banking crisis.

Except in 2008, Wall Street did not bail out a hedge fund; instead the central banks bailed out Wall Street.

And as I mentioned earlier, today systemic risk is more dangerous than ever. Each crisis is bigger than the one before.Too-big-to-fail banks are bigger than ever, have a larger percentage of the total assets of the banking system, and have much larger derivatives books.

The next crisis could well begin in the private bank debt market. The specific culprit is a kind of debt called “contingent convertible” debt or CoCos.

These bonds start out like ordinary debt, but a bank in distress could convert them to equity to improve its capital ratios. The problem is that bondholders know this and start dumping the bonds before the bank can pull the trigger on the conversion clause. This can cause a run on the bank and trigger cross default clauses in other bonds. Far from adding safety to bank capital structures, CoCos can make banks more unstable by igniting panics.

This is just one more example of capital market complexity and it signals the fact that the next crisis will be worse than the last.

Also. new automated trading algorithms like high-frequency trading techniques used in stock markets could add to liquidity in normal times, but the liquidity could disappear instantly in times of market stress. And when the catalyst is triggered and panic commences, impersonal dynamics take on a life of their own.

These kinds of sudden, unexpected crashes that seems to emerge from nowhere are entirely consistent with the predictions of complexity theory.

In complex dynamic systems such as capital markets, risk is an exponential function of system scale. Increasing market scale correlates with exponentially larger market collapses. This means that the larger size of the system implies a future global liquidity crisis and market panic far larger than the Panic of 2008.

The ability of central banks to deal with a new crisis is highly constrained by low interest rates and bloated balance sheets, which despite some movement in that direction, still have not been normalized since the last crisis.

For now, it’s not clear which way things will break next. Markets are still in a precarious position and volatility has returned. Regardless of which direction markets go from here, yesterday’s threat of contagion is a scary reminder of the hidden linkages in modern capital markets.

Next time we may not be so lucky.

We’ve already had a correction this year. But the next correction could turn into a 30% or 40% crash.

The conditions are in place. But you can’t wait for the shock to occur because by then it will be too late. You won’t be able to get your money out of the market in time because it’ll be a mad rush to the exits.

The solution for investors is to have some assets outside the traditional markets and outside the banking system.

This article originally appeared on The Daily Reckoning.

 

Outbrain