The Next Banking Crisis and Economic Collapse Are Closer Than Many Think
These days, Wall Street is beating all records. It’s inexplicable from a rational point of view and this irrationality alone should raise caution. The next banking crisis is around the corner. In fact, more specifically, it is the next U.S. banking crisis, because the next world economic collapse is likely just a banking system crash.
While Wall Street is thriving, it’s an illusion. The next financial crisis, as bad as or worse than the 2007/2008 subprime crash, will begin with a banking system collapse. Many people ignore history today and they do so at their peril. There is nothing catastrophic in this analysis.
Advertisement
We’re not talking about a Mayan December 21, 2012 cataclysm that will bring the end of the world. Rather, the banking system collapse already contains the seeds of its own destruction. You don’t need to be a Mesoamerican anthropology expert to see what’s coming. Indeed, Warren Buffett issued his own warning on the coming banking system collapse.
Are the Banks Headed for a Crisis?
The next banking crisis approaches. This means that the next financial and economic crisis is approaching as well. All the major financial institutions agree: the big banks, the IMF experts, the big economic think tanks. We could be facing the largest bank failure ever, and it could happen in 2017.
In a decree signed on February 3, President Trump gave Treasury Secretary Steven Mnuchin 100 days to come up with ways to make recommendations to amend or scrap The Dodd–Frank Wall Street Reform and Consumer Protection Act. Congress passed this law in 2010 in the wake of the worst financial crisis since the stock market crash of 1929 and the Depression of the 1930s.
Donald Trump described the financial regulation put in place by the Obama administration as a “disaster.” The president says it has unnecessarily made life harder for consumers and businesses. Trump has implied that the regulation has stifled the economic growth of the United States.
The Trump administration also wants to scrap the so-called “Volcker Rule,” named after the former president of the Federal Reserve (Fed), Paul Volcker. This rule bans banks from speculating on their own account. It also prevents them from making equity investments in hedge funds or private equity funds that invest in non-listed companies.
This is one of the big risks that could cause the next banking crisis, should Trump succeed in scrapping those Obama-era constraints. It’s true that the regulations have placed limits on the financial sector. But regulations also have advantages; they are necessary rules to ensure the system has ways to absorb shocks.
While regulatory reductions can make life easier for businesses—in this case, financial institutions—and individuals, they can also weaken the financial system and cause financial crises. Banks have also been increasingly inclined to hedge their risk through derivatives that are traded over the counter, such as the famous credit default swaps (CDS).
The Global Banking Crisis and Financial WMDs
These derivative structures, which use an important leverage effect and manage to commit up to 40 or even 50 times their capital, skirt common sense by taking on too much risk. Without Dodd-Frank or the Volcker rule, this activity would be the banking equivalent of playing with fire. This suggests the upcoming banking crisis will be even more destructive than that of 2008.
History teaches us that banking deregulation destabilizes financial institutions and the entire economy. It is the main contributing factor to modern financial crises. That is why Donald Trump’s effort to dismantle the financial regulation—Dodd-Frank—that President Obama adopted after the 2008 crisis increases the risk of a new U.S. banking crisis and economic disaster.
But you would not know it, because the government and financial authorities prefer to sweep the risks under the proverbial carpet. That is, they spread their risks through financial instruments, which they then sell to investors in the form of derivatives.
Buffett sees the threat in derivatives. He calls them financial “weapons of mass destruction,” or financial WMDs, and he’s getting rid of them. Buffett had warned about the potential for derivatives to cause a financial crisis before Lehman Brothers Holdings Inc. and the markets blew up in 2008. (Source: “Warren Buffett Just Unloaded $195 Million Worth of These ‘Weapons of Mass Destruction,’” Fortune, August 8, 2016.)
Lehman Brothers had $35.0 trillion in derivative exposure before it crashed. Today, Deutsche Bank AG (NYSE:DB) has $75.0 trillion in derivatives. If it blows up, a global banking crisis will be the least of the effects. See the charts below comparing Deutsche Bank and Lehman Brothers.
In fact, Buffett made that call at the start of another period of market euphoria in 2003. If Buffett, an investor whose success needs no introduction, doesn’t trust derivatives, then why should you? Indeed, why should banks? The global banking crisis was essentially a derivatives blowup. There’s a high probability that the upcoming banking crisis will also be rooted in derivatives.
We might be living in the worst moment of recent financial history. Why the worst, you ask? Because the world has seen the limits and dangers of speculation before, yet it always falls into the same trap of overconfidence. This blinds us from reality and prevents us from seeing the next financial crisis or the next money crisis.
As much as Buffett is an investor, he’s also an avid student of history. History is rich in insights; they don’t predict the future, but they do help us understand what the future might bring. Anyone who invests their savings, no matter how large or small, should learn about “Tulip Mania.” The next time you develop a curiosity about the largest bank failures, keep it in mind.
What Will Happen If the Banks Collapse? A History Lesson
One of the most famous financial crises in history is that of the tulips. The first true speculative bubble in history occurred between 1634 and 1637. Unlike the most recent global banking crisis, in which derivatives played a major role, flowers caused the tulip bubble. As the name suggests, they were tulips.
At the height of their value in the late 17th century, two tulip bulbs (imported from the Ottoman Empire) could buy their owner an apartment in downtown Amsterdam. But, that value didn’t last long. Prices crashed, plunging the Netherlands into a long depression. Banks, alas, are acting like the tulip bulb traders of ye olde Amsterdam.
The comparison between derivatives, which banks originally used to hedge risk, and tulip mania becomes clearer when you realize this fact. Banks no longer use derivatives to hedge their risk, but to speculate. Therefore, derivatives expose them to almost incalculable risk.
What should infuriate the average investor most is that if—or, rather, when—the banks lose out, they don’t pay for their reckless behavior with their customers’ savings. It’s you, the average hardworking citizen, who pays. The citizen, through the taxes—and tax increases—he or she has paid, allows the government or the State to bail out some major banking giants.
That’s what happened in 2008 and 2009, of course. That’s also why they describe some banks as “too big to fail.” To help resolve the largest bank failures last time, the world watched in disbelief as the government bailed out the banks—the very same ones who demand you pay fees for using a banking machine and other mysterious service charges.
The tulip is a flower of Middle Eastern origin; it was popular in Turkey. Dutch florists imported it to Europe, but it was in the Netherlands where the appreciation of this flower reached its peak. The Netherlands also had one of the most sophisticated financial systems—and eventually banks—in the 17th century.
The Dutch started to cultivate tulips in late 1500. The exotic appeal and rarity of this flower meant that it quickly acquired a status symbol. It wasn’t long before the Amsterdam stock exchange started to trade tulip bulbs. Indeed, tulips were not something you would gift to a dinner host; they were veritable investment instruments to include in what accounted for a portfolio at the time.
That and the fact that in Europe, few had ever seen a bulb meant that it quickly became a kind of symbol of wealth. It’s still hard to believe now—just as future students of economic history will wonder about the ludicrous risks we take today—but tulip bulbs were sold as solid investments for the future.
Those buying bulbs were betting on their future financial appreciation: bulb futures. The first great financial crisis literally blossomed out of this phenomenon. The bulb became such a coveted item that people were willing to spend more than 3,000 florins to acquire one. Consider that the average monthly salary was 15–20 guilders.
Are the Markets Wiser Today? Not Really
Tulips became so valuable that lands previously used to produce useful crops like wheat were converted to cultivate tulips. The whole bubble seems like the product of folly now. But stop for a moment to see what banks are doing now. Is the stock market any less crazy? Are speculative instruments like derivatives any less crazy?
Shortly after tulip mania, European investors drawn by the possibilities of the new continents and lands that had been discovered just decades earlier bet their savings on the South Sea Shipping Company. It had exclusive shipping rights to South America. Thousands were attracted by soaring bonds issued by South Sea, including Isaac Newton, who lost a fortune.
And those were the first bubbles, coming in ever shorter succession. But the point is that speculation always gets out of hand until reality sets in. While few had the money or financial foresight to invest in the past, the number of people investing and speculating has multiplied exponentially. Any financial crisis today would wipe out the savings of millions, if not billions, of people.
A correction is looming now, and it will be bigger than the last. This is not some financial millenarian catastrophe along the same lines as the “Y2K” debacle. The 2008 financial crisis might have been worse than the 1929 crash. Its effects are still with us, but it seems not the lessons. In some ways, crashes are necessary cyclical events.
The problem lies more in the scale of the crash and how many are affected. The weight of the next one will be amplified by the current geopolitical and technological conditions. But, as in the case of the tulips, the longer the speculative bubbles linger, the more they swell and the harder they burst.
If you like banks and banking stocks but still want to avoid getting into a tulip mania situation of your own, consider the following: You’ll Never Guess Which BIG American Bank is Going Bankrupt NEXT.
