When to Worry — An Asset-Liability Management Perspective on Financial Macroeconomics

At the end of the day, the world is net flat.  Every asset is owned 100%; every liability is someone else’s asset.

If everything is 100% owned, why are there ever crises?  Financial companies owning illiquid assets financed by short, liquid liabilities.  Liquidity crises are credit crises; a company going through a liquidity crisis did not do sufficient stress testing to realize that they were weakly financed.

Crises are never accidents, aside from things like Hurricane Katrina and Superstorm Sandy.  And guess what?  How many insurers failed from those two events?  None.

Crises happen because things are inverted.  Under ordinary circumstances, prudence dictates that long-term assets be financed by equity or long-term debt.  Before a crisis, long-term assets are owned with short-term debt, and wealthy guys like Buffett and Klarman hold cash and shun long-term assets.  That’s inverted.  Those that should not be bearing risk are bearing risk, and those the could bear risk aren’t.  Why?  Because the prices on risk assets are high, and smart investors lighten the boat as the envious buy into momentum at the end of a doomed rally.  Ben Graham’s weighing machine takes over from the voting machine.

So what are reasons to worry?  Here are a dozen, not in any order:

  • The combined balance sheets of investment banks grow, and the complexity of their assets rises.
  • The repo market grows, as less liquid assets are financed by very liquid liabilities.
  • Poor-to-middle class people begin taking risk by buying homes, or speculating in stocks.  These people have weak liability structures, because they live paycheck to paycheck.
  • Mortgage finance moves to ARMs or even more exotic loans.
  • Downpayments on homes get low.
  • Rich hold more cash while the poor and middle-class borrow.  The rich can take losses — they have long time horizons.  When they play defense, it is a time to be concerned.
  • In a given sector there has been a large increase in debt, and there are concerns over ability to repay.
  • Shadow banking has increased dramatically.
  • Financial commercial paper issuance has increased dramatically.
  • People rely on certain large financial firms to not default, even if they have taken on too much credit risk relative to their capital.  (Think of Fannie and Freddie.)
  • Increased financial complexity makes everything opaque.  Bad things happen in the dark.
  • The credit cycle gets long in the tooth, and credit spreads/yields tighten to levels that are far too low for the risk taken on.

Now, I leave aside pure macroeconomic concerns like the possibility that the Fed might face a greater problem with stagflation than it did in the ’70s.  When long illiquid assets are financed by short liabilities, all sorts of bad things can happen.  Keep your eyes open.  Hey, aren’t Buffett and Klarman letting cash levels rise?