A. Gary Shilling & Co., Stack Financial Management, The Sweeney Agency,University of Chicago Booth School of Business
In all the reporting I’ve done about the 2008 financial crisis, which exploded 10 years ago Saturday, when Lehman Brothers collapsed, I haven’t found anybody who predicted the whole thing.
People warned about subprime mortgage loans, derivatives, and too much leverage, but nobody, to my knowledge, said a bursting housing bubble would cause a global crisis that would lead to the demise of venerable financial firms, require trillion-dollar taxpayer bailouts, and cause a recession that rivalled only the Great Depression in its magnitude.
More than nine million Americans lost their homes and trillions of investors’ dollars went up in smoke as the S&P 500 index SPX, +0.52% and the Dow Jones Industrial Average DJIA, +0.59% both lost more than half their value October 2007 to March 2009. (Both are now up around 300% since then and close to record levels set earlier this year.)
Neither economists, Wall Street analysts, the financial media nor two Federal Reserve chairmen — Alan Greenspan and Ben Bernanke — connected the dots and sounded the warning bell. (Disclosure: I was editor of barrons.com and a columnist before the crisis, and I didn’t see it coming, either.)
But some came pretty close when the “experts” were saying the markets and economy were doing just fine.
• Economist A. Gary Shilling warned his newsletter subscribers about a housing bust and wholesale deleveraging of household debt that would hobble the economy for years.
• Money manager James Stack also told his clients the housing bubble had burst and that a new bear market was coming—while stocks were hitting all-time highs.
• Raghuram Rajan, then chief economist of the International Monetary Fund, said the amount of risk and leverage in the system was much higher than most people thought.
• John Mauldin said a housing bust would lead to a drop in consumer spending, a bear market, and a recession (though at first he thought it would be a mild one), and that credit default swaps (CDSs) posed a systemic risk.
I interviewed all four recently and asked them where they thought the next crisis would come from. The consensus was that it probably wouldn’t be housing but that debt and leverage were still huge issues, although they couldn’t agree on a likely culprit. Here are their thoughts; I’ll share my own views in a future column.
Gary Shilling
The president of consultancy A. Gary Shilling & Co. started writing about a housing bubble in the early 2000s, and his work caught the eye of Greg Lippmann (of “The Big Short”), whose bets against subprime mortgages made Deutsche Bank $1.5 billion to offset long positions the bank had taken.
John Paulson contacted Shilling in August 2006. “He talked about credit default swaps. I didn’t know what they were,” Shilling recalled.
Shilling did some consulting for Paulson’s hedge fund and even invested what “was for the Shillings a major piece of money in this.” Paulson, of course, loaded up on CDS’s and made $4 billion in what has been called “the greatest trade ever.” “We made 15 times our money,” Shilling says.
What he said then: “Subprime loans are probably the greatest financial problem facing the nation in the years ahead.”—January 2004
“The [speculative housing] bubble’s break will cause widespread pain...and be much worse economically than the 2000-2002 bear market.”—June 2006
“We continue to forecast a 25% fall in median single-family house prices nationwide.”—November 2006. (The S&P CoreLogic Case-Shiller 20-City Composite Home Price Index actually fell 34% from its April 2006 peak.)
What he says now: “The ultimate thing that brings down financial markets is excess leverage … So, you look where’s the big leverage, and right now I think it’s in emerging markets.”
Shilling is particularly worried about the $8 trillion in dollar-denominated emerging-market corporate and sovereign debt, especially as the U.S. dollar rises along with interest rates. “The problem is as the dollar increases,” he said, “it gets tougher and tougher for them to service [that debt] because it takes more and more of their local currency to do so.” Of that, $249 billion must be repaid or refinanced through next year, Bloomberg reported.
Jim Stack
Stack is president of Stack Financial Management, which manages $1.3 billion, and InvesTech Research, a newsletter he launched in 1979. Both are based in Whitefish, Mont. As a young analyst, he called the 1987 stock market crash.
As housing prices kept rising, Stack built a proprietary tool called the Housing Bellwether Barometer. He called housing a bubble a year before it peaked and warned of bigger problems ahead for the economy and the markets.
What he said then: “We are officially calling it a dangerous bubble...I see a trillion+-dollar government bailout of the mortgage industry at some point over the next decade.”—July 2005
“Our Housing Bubble Index has dropped into a freefall that rivals the dot-com bust of the late 1990s… We are moving to a full bear market defensive mode.”—July 2007
“We are nowhere near the bottom…It’s only a matter of time…until the housing debacle and credit crisis adversely impact the overall economy, increasing the likelihood of a recession.”—Interview with Equities magazine, November 2007
What he says now: Stack indicates that housing-related stocks “saw a parabolic run-up” in 2016-17, but in January his index “peaked and now it’s coming down hard.” That suggests “bad news on the housing market looking 12 months down the road,” he said.
But the biggest danger, Stack told me, is from low-quality corporate debt. Issuance of corporate bonds has “gone from around $700 billion in 2008 to about two and a half times that [today].”
And, he added, more and more of that debt is subprime. Uh-oh.
In 2005, he pointed out, companies issued five times as much high-quality as subprime debt, but last year “we had as much subprime debt, poor quality-debt issued, as quality debt on the corporate level,” he said, warning “this is the kind of debt that does get defaulted on dramatically in an economic downturn.”
Raghuram Rajan
As the IMF’s chief economist (he has since served as chairman of the Reserve Bank of India and teaches finance at the University of Chicago Booth School of Business), Rajan presented a paper at the Federal Reserve Bank of Kansas City’s annual retreat at Jackson Hole, Wyo., in August 2005.
It was the Maestro’s final appearance at Jackson Hole and, Rajan later recalled, some papers “focused on whether Alan Greenspan was the best central banker in history, or only among the best.”
Rajan turned out to be a party pooper, questioning whether “advances” in the financial sector actually increased, rather than reduced, systemic risk. Former Treasury Secretary Larry Summers called him a Luddite. “…I felt like an early Christian who had wandered into a convention of half-starved lions,” he wrote. But though delivered in genteel academic lingo, his paper was powerful and prescient.
What he said then: “Managers…have greater incentive to take risk…because the upside is significant, while the downside is limited.”
“Moreover, the linkages between markets, and between markets and institutions, are now more pronounced. While this helps the system diversify across small shocks, it also exposes the system to large systemic shocks…”
“The financial risks that are being created by the system are indeed greater… [potentially creating] a greater (albeit still small) probability of a catastrophic meltdown.”
What he says now: Rajan believes “there has been a shift of risk from the formal banking system to the shadow financial system.” He also told me the post-crisis reforms did not address central banks’ role in creating asset bubbles through accommodative monetary policy, which he sees as the financial markets’ biggest long-term challenge.
“You get hooked on leverage,” he said. “It’s cheap, it’s easy to refinance, so why not take more of it? You get lulled into taking more leverage than perhaps you can handle.”
Rajan also sees potential problems in U.S. corporate debt, particularly as rates rise, and in emerging markets, though he thinks the current problems in Turkey and Argentina are “not full-blown contagion.”
“But are there accidents waiting to happen? Yes, there are.”
John Mauldin
The Dallas-based chairman of Mauldin Economics is best known for his free weekly e-letter “Thoughts from the Frontline,” which has a million subscribers. Mauldin started worrying about housing very early, sometimes featuring commentary from Gary Shilling during the run-up to the crisis.
What he said then: “A slowing of the housing market, and thus the economy, is in our future… This in turn suggests that as growth in consumer spending slows, a bear market in equities is a high-probability outcome.”—March 2006
“…The stock market is going to be under considerable pressure next year. The average drop of the markets is about 40% before and in a recession….Dow 9,000 is a real possibility, if not probability”—December 2006. (The Dow bottomed at 6,547.05 in March 2009.)
“The one true risk that is simply not knowable at this point is in the Credit Default Swap (CDS) market….The CDS market is huge, in the hundreds of trillions of dollars and growing dramatically… There is no agency overseeing counter-party risk. This is the one true systemic risk that I see.”—July 2007.
What he says now: Mauldin estimates the world has almost “half a quadrillion dollars,” or $500 trillion, in debt and unfunded pension and other liabilities, which he views as unsustainable.
But the flashpoint for the next crisis is likely to be in Europe, especially Italy, he maintains.
“I think the choice of Europe is…going to have to put [all the debt] on the balance sheet of the European Central Bank,” he said. “If they don’t, then the euro zone breaks apart and we’re going to get a 50% valuation collapse.”
“Greece,” he said, “is a rounding error. Italy is not…. And Brussels and Germany are going to have to allow Italy to overshoot their persistent debt, and the ECB is going to have to buy that debt.
If it doesn’t happen, the debt triggers a crisis in Europe, [and] that triggers the beginning of a global recession”
But, he added, “there are so many little dominoes, if they all start falling, one leads to the next.”
The U.S. economy and markets are doing very well now, but make no mistake—there will be another crisis. Your guess on where or when it will happen is as good as mine.
Howard R. Gold is a MarketWatch columnist and founder and editor of GoldenEgg Investing, which offers exclusive market commentary and simple, low-cost, low-risk retirement investing plans. Follow him on Twitter @howardrgold.