Don’t Get Complacent: Odds Of Financial Crisis Still Uncomfortably High

Don’t Get Complacent: Odds of Financial Crisis Still Uncomfortably High

A Financial Crisis Could Be Brewing

Not too long ago, there were two bank failures in the U.S. They made the headlines, sent out shockwaves of fear, and led many to wonder if a financial crisis was brewing.

However, we also heard a lot of statements like, “It’s nothing like 2008.” The government and the Federal Reserve jumped in quickly to help calm the situation. Now you might be wondering if it’s time to let your guard down. The worst is behind us and we can move on, right?

Here’s the truth: the odds of a financial crisis are still uncomfortably high.

How a Financial Crisis Begins

Here’s a little overview of how a financial crisis works. First, it starts out like a snowball being let go from a mountaintop. Initially, the snowball is small, but as it gains momentum and collects more snow, and grows, it becomes deadly.

Go back to the financial crisis of 2008–2009. The global financial system didn’t break overnight. The problems in the banking sector had already begun in 2007. They began with egregious bets on the housing market that resulted in huge losses. Lending came to a grinding halt as interest rates soared and the economy slowed down.

In the early stages of the financial crisis of 2008–2009, everything else was disregarded. For example, in early 2008, Bear Stearns, a famous investment house, collapsed. At the time, very few saw that as a systematic problem. The majority consensus was that things were under control.

By September 2008, as Lehman Brothers collapsed, it became clear that the financial system was in trouble. Mind you, before Lehman Brothers collapsed, a bunch of banks went under or were forced to be acquired by others. And the bank failures didn’t stop there.

So, if we go back to our snowball analogy, the housing market, higher interest rates, and lending coming to a grinding halt was the snowball at the peak of the mountain. Lehman Brothers collapsed at the moment when the snowball became so big it would destroy anything in its path.

Slow Economy, High-Interest Rates, & Dismal Loan Volumes Say Financial Crisis Ahead?

Fast-forward to now: there’s a lot of evidence that the U.S. economy is slowing down.

Interest rates have surged. At times, the financial world focuses too much on the Federal Reserve, but you must also look at the bond market. It has seen black swan event-like trading over the past year or so. No one had predicted that the yields on bonds would skyrocket as much as they did.

And it’s starting to look like lending is tightening.

The Federal Reserve Bank of Dallas publishes the results of the “Banking Conditions Survey” that’s done twice each quarter. Banks are asked how conditions have changed when it comes to their loan volumes, nonperforming loans, and loan pricing. This survey gives us an idea about how banks see the current financial conditions.

For March 2023, the Federal Reserve Bank of Dallas reported that loan demand dropped for the fifth consecutive period. Loan volumes also fell, due to a sharp decline in consumer loans. Furthermore, credit standards and terms had been tightened. (Source: “Banking Conditions Survey,” Federal Reserve Bank of Dallas, last accessed April 11, 2023.)

According to the Federal Reserve Bank of Dallas, “Banking outlooks continued to deteriorate, with contacts expecting a contraction in loan demand and business activity and an increase in nonperforming loans over the next six months. Some contacts cited waning consumer confidence from recent financial instability as a concern.” (Source: Ibid.)

As Odds of Financial Crisis Remain High, Investors Should Beware

Dear reader, looking at what’s been happening in the financial sector, I can’t help but say: don’t be complacent. The snowball may have just left the peak of the mountain.

Let me be clear: I’m not rooting for a financial crisis. In times of a financial crisis, you get severe volatility and a lot of wealth destruction. I just want you to know there are risks that shouldn’t be ignored.

If a financial crisis becomes a reality, what will the Federal Reserve do? If the Fed starts cutting interest rates, what will happen to the inflation that still needs to be pushed down a bit? Moreover, if the Fed starts cutting rates, how low will they go? Could we possibly see negative interest rates in a matter of a few quarters?

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