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Another Financial Crisis Is Looming—Here's Why and How It Will Play Out

Thanks to bank misconduct, odds are that big trouble is on its way.
 
 
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Bloomberg financial reporter Bob Ivry has written an entertaining new book, “ The Seven Sins of Wall Street,” which, instead of rehashing the various illegal activities that triggered the financial meltdown, focuses on what the banks have been up to since the crisis. Much of it would be familiar to readers of this space: the  Bank of America whistle-blowers who were instructed to lie to homeowners, and received gift card bonuses for pushing them into foreclosure; the  London Whale derivatives trade that lost JPMorgan Chase more than $6 billion; the investment banks who traded commodities while also  operating physical commodity warehouses and facilities; and more. All the while, megabanks continue to  enjoy subsidies on their borrowing costs because of the (accurate) perception that they will get bailed out in the event of any trouble.

The odds are that trouble will present itself soon.

Ivry’s opening quote in the book comes from Jamie Dimon, whose daughter asked him, “’Dad, what’s a financial crisis?’ Without trying to be funny, I said, ‘It’s something that happens every five to seven years.’” A quick check of the calendar reveals that we’re almost six years out from the bursting of the housing bubble and the fall of Lehman Brothers.

So are we on the precipice of another financial crisis, and what will it look like?

To be sure, danger still lurks in the mortgage market. The  latest get-rich-quick scheme, with private equity firms buying up foreclosed properties and renting them out, then selling bonds backed by the rental revenue streams (which look suspiciously like the bonds backed by mortgage payments that were a proximate cause of the last crisis), has the potential to blow up. And continued shenanigans with mortgage documents could lead to major headaches. A new court case against Wells Fargo  uncovered a bombshell, a step-by-step  manual telling attorneys how they can fake foreclosure papers on demand; the fallout could throw into question the true ownership of millions of homes. Even subprime mortgages are in the midst of a  comeback, because what could go wrong?

However, in this era of the government-backed housing market, new mortgages have largely gone through Fannie Mae and Freddie Mac, and the mortgage giants have diligently scrutinized them for defects. As a result, mortgages originated in 2013 have actually  performed quite well. Industry types grouse that this leads to “tighter” credit; you could also call it “safer” credit, without the tricks and traps that preyed upon low-income Americans in the last decade.  Proposed legislation to eliminate Fannie and Freddie could change this dramatically and return us to the Wild West show, but for the moment, financial risk may be located somewhere other than mortgages.

That’s not to say that Wall Street firms have been choir boys. The risk is merely harder to see, and you can’t just look at the banks. In fact, banks have reduced their stake in many normal banking activities, leaving things like small business lending to the  shadow banking system. This is the broad term given to hedge funds, private equity firms and the labyrinthine deals they initiate to move money around. These less-regulated entities have increased their overall portfolios  60 percent over the past five years, bingeing on  subprime loans to businesses that could not otherwise access traditional credit. Nontraditional leveraged loans, issued to companies that end up with large amounts of debt, have  fewer protections for lenders and carry much more risk.

Typically lenders sell these loans off into the capital markets, where years of ultra-low interest rates have encouraged investors to search for any deal that will make them a bit more money. Thus we have seen an  explosion in junk bonds, speculative investments in risky companies that return a high reward. Just as with subprime mortgages, these junk bonds feature shoddy underwriting, with money handed out to businesses that should in no way get an infusion of cash. Got an idea for a vegan restaurant on a cow farm? A lingerie shop in a nunnery? No problem, the shadow banking system will fund you! The junk bond market has doubled to nearly $2 trillion since 2009, causing more cautious investors to head for the exits, wary that the market could turn quickly. If losses mount and some of the bigger shadow banks take a hit, they remain so interconnected to the traditional banking industry that the risk could spread.