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Learning from Lehman: Is the next crash coming?

Sophie Schimansky
September 13, 2018

A decade after the Lehman Brothers' bankruptcy, the US economy is growing. Americans feel safe and are even optimistic. But economists warn that appearances are deceptive.

US dollars being processed at the US Treasury
Image: Getty Images/AFP/E. Hambach

It's been 10 years since the bubble burst on the US real estate market and plunged the economy into recession. The stock market crashed and nearly $7 trillion (€6 trillion) of investments went up in smoke. Within two years, nearly 9 million Americans lost their jobs. The American taxpayer paid the bill, and the legislature came up with the Dodd-Frank Act to tighten the rules for the financial industry.

Central banks around the world flooded the markets with money and cut interest rates to zero in the hope that companies would borrow cheap money from banks in order to invest. Consumers were expected to consume which would then boost the economy. In the end, the plan worked.

The US economy has grown over 4 percent in recent quarters. American companies are reporting record profits each quarter, the labor market is nearing full employment and Wall Street prices are going from one record high to the next. In the past few weeks, two US companies, Apple and Amazon, have cracked the $1 trillion market valuation ceiling. The Consumer Confidence Index is at a 10-year high and American President Donald Trump has been celebrating the great results on Twitter. Even the US Federal Reserve has repeatedly expressed optimism about the economy.

The record debt

But there is also bad news. Through the recent looser monetary policy, the global debt burden of households, corporations and governments has grown by 74 percent from the eve of the financial crisis through 2017. This year it reached a record $247 trillion, according to a new study on global debt by the consultancy McKinsey.

Read moreLehman Brothers: Looking back at the basics

By comparison, the entire US economic output is around $19 trillion a year. Alone in the first quarter of this year, the mountain of debt grew by 11 percent compared to the previous year, according to the Institute of International Finance. And there is a connection between the overheating of the credit market and a subsequent economic downturn, says Itay Goldstein, who teaches finance at the University of Pennsylvania.

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Risky corporate bonds

The zero interest rate policy also has another effect. It makes risky loans with higher yields more attractive. These are usually called junk bonds, junk loans, or somewhat more tamely "high-yield bonds."

They have a high risk of default, often because the issuing company is in trouble. And among loans there are a lot of these junk bonds. The value of junk bonds issued worldwide has recently been around $2 trillion a year — or two and a half times higher than in 2007.

"Investors all of a sudden have maybe a more positive outlook for the economy, they have greater appetite for risk and as a result they shift their investments towards the high yield funds, the high yield bonds," said Goldstein.

To find out more, Goldstein has been watching to see to what extent institutional investors such as Vanguard or Black Rock have redirected their investors' money in times of economic upswing from safe to riskier assets such as junk bonds. Looking at the current popularity of junk bonds, investors seem to be feeling pretty safe.

Ex-Lehman analyst: Banker without a bank

These massive mountains of debt become dangerous when defaults increase. And this is becoming more likely as interest rates are currently rising since most of that debt will be repaid by companies taking on new debt at new, higher interest rates. The results are cost increases.

Read moreECB pulls plug on eurozone stimulus – What does it mean?

To make matters worse this leads to higher interest rates on credit cards, and car and home loans for consumers. And when in doubt, ordinary consumers shy away from spending or taking out more credit and tighten their belts. They keep their money under the mattress and it doesn't end up in the companies' cash registers, which is a double burden for them, because in addition to rising costs their revenues fall. This time the banks are not the problem.

"The banks are good, definitely better than they were before the financial crisis hit. Dodd-Frank is not perfect, as almost no piece of regulation is. But it helped to control and stabilize the banks," said Susan Lund, one of the authors of the McKinsey report. According to her, businesses around the world have accumulated a total of $66 trillion in debt. Economists warn that this huge debt pile will be the main problem the next time around — in combination with rising interest rates, a possible fall in consumer demand and a depressed economy.

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Inflated share prices

The stock market is a clear reflection of this high level of risk, because companies have done one thing above all with their borrowed money: bought back their own shares. Share buybacks are currently at record levels and the 500 companies listed in the main Wall Street S&P 500 index will invest $1 trillion in their own shares this year. This helps explains the record prices on Wall Street, since companies themselves simply increase demand for their own shares. As a result, earnings per share rise, making them look even more attractive.

The current phase of recovery is the second-longest in American history. But the economy grows and shrinks cyclically, say economists like Lakshman Achuthan, the founder of the Economic Cycle Research Institute, which studies economic cycles.

Read moreChina is United States' biggest creditor once again

A crisis like the one in 2008 was followed by low interest rates. Consumers, companies and even countries took out cheap loans, debts increased and the economy grew. In order to prevent the economy from overheating in the form of high inflation, central banks increased interest rates and the circle closed.

Achuthan says a slowdown in the American economy is imminent and some investors seem to agree. Billionaire investor Ray Dalio, the founder of the world's largest hedge fund, Bridgewater Associates, believes the US economy is not yet in a bubble, but that it might not take long to get there. He sees the risk of a recession before the next presidential election in 2020 as "relatively high," perhaps around 70 percent.

Lehman Brothers: Lessons learned