The Investment Scientist

Is Another Financial Crisis Imminent?

Posted on: September 10, 2019

How a financial crisis comes about?  I am gonna use a simple styled example to illustrate the key elements that lead to a financial crisis: easy creditleveragecontagionshock amplification.

ABC Shipping has 100 vessels. The market value of a vessel is normalized to 1. (You can imagine that as 1 million dollars.)  Because of easy credit (low-interest rates,) the company uses debt financing to the fullest extent. Banks demand a loan-to-value ratio of no more than 60%, so ABC Shipping borrows 60, and has its own capital of 40.

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Now imagine, ABC Shipping is doing well operationally speaking, but the industry is experiencing a bad year – shipping volume has dropped due to a trade war, and the value of a vessel is now 0.9. ABC Shipping’s balance sheet becomes like this.

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It has violated the loan covenant that the loan-to-value ratio must not surpass 60%. What to do? ABC Shipping has no choice but to sell 17 vessels to pay down its debt. When these 17 vessels go on the market, they are gonna push down the price further, which triggers similar liquidation in other shipping companies. It becomes a financial contagion: the financial problem of one firm spreads to others, causing prices to spiral downward. When the value of a vessel falls to 0.6, ABC Shipping is bankrupt. Banks seize ABC Shipping’s vessels and dump them in the market to recover some of their loan values, causing the price to drop even further.

Does the example above sounds eerily similar to the mortgage/housing crisis in 2008? If you replace ABC Shipping with US households (banks)  and vessels with houses (mortgage-back securities), the example above was exactly what happened during the 2007/2008 crisis.

How can a financial crisis be avoided? One way is (for the government) to tell all banks to ignore the debt covenant, this way, companies are not forced to fire-sell their vessels. This can happen in China since most banks are owned by the state to start with, but it can not happen in the US since most banks here are owned privately.

Another way is for the shipping companies not to borrow to the debt limit. This idea is nice, but in a competitive free-market economy, it is very hard to implement especially when credit is as cheap as it is now. When you have real interest rates near zero and you don’t use them to the fullest extent, you will lose out to your competitors who do.

It is thus a near consensus among economists that financial crises are endogenous to a free market economy. The easy credit that boosts the economy is also the seed of the next financial crisis. To put a positive spin on it, financial crises are a process of creative destruction. Though they can not be avoided, they can be harnessed to build wealth. I’d like to think of them as periodic discounts on asset prices, which are awesome for anybody who wants to accumulate wealth.

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Michael Zhuang is principal of MZ Capital, a fee-only independent advisory firm based in Washington, DC.


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