The trajectory of the $87 trillion global economy seems to be on a collision course with economic variables that were once thought to be safe or “conforming” to long range financial models. Over the last two decades, the first major shoe to drop marking a correction in this view was the global financial crisis of 2008, which revealed the double-jeopardy inherent in leveraged debt. On the one front, homeowners with little equity in their properties while using those properties to fuel credit driven expansion proved to be unsustainable. On the other, large financial institutions repackaging these loans in shoddy synthetic structures and then reselling them to counterparties under the guise of high credit quality and risk transfer inflated systemic risk. At the same time these very institutions held large swathes of real estate assets to balance long-term liabilities under the guise of perennial appreciation was a double-jeopardy large enough to topple the global economy. Trillions in corrective spend later in the form of quantitative easing, asset buy backs and low interest rates, every central bank and economic policy arrow was thrown at the hydra of toxic assets, leverage and systemic financial interconnections hiding in plain sight. Where are these preconditions in the global economy residing or, better still hiding today? Looking for examples of economic double-jeopardy can offer clues of where systemic risk is likely to rear its ugly head next.
In technology circles the term vaporware denotes technology promises masquerading as real value. In many ways, notional value is the economic equivalent of vaporware, especially under conditions of systemic distress. One of the reasons so many bank fire sales and rescues occurred during the financial crisis is because all the would-be suitors were under similar distress. Therefore, the valuation of underlying safe assets in good times hardly holds when an economic system is shocked. Yet so much of the way the economy and many other assets and liabilities are recognized is through their notional value, which can be here today and gone tomorrow. The case of the high frequency trading firm, Knight Capital, which killed itself due to a “rogue” trading algorithm in a matter of minutes illustrates the risk. In the stock market, the directionality of notional value is generally correct, but often the inflationary effects, volatility and market distortions are not. The same holds true with company valuations where the rise of vaporware unicorns like Theranos or the billions squandered in peak crypto initial coin offerings (ICOs) because investors are willing to believe the hype and invest largely on false promises. In systemic financial risk if leverage is the powder keg, notional value is the accelerant from which bank runs and economic failures are created. Too much of the world’s so-called safe assets hinge on the false assumption that notional value or notional security are in fact backed by anything.
This double-jeopardy in turn is compounded by the growing fallacy that data is the new oil and the world’s most important asset class. If notional value is problematic, the mismatch between the billions spent each year on digital transformation, cybersecurity and privacy and the fact that data has no generally accepted accounting valuation is a modern economic conundrum leaving trillions in financial exposure unrecognized, undisclosed and, consequently, unhedged. Data in an enterprise performs similarly to cash liquidity in a bank. In short, you only know its true worth (or risk) when everyone is claiming it. By this measure, rather than singularly looking at banks as systemically important requiring them to undergo financial stress tests, create living wills and subjecting themselves to greater disclosure – not that the system is any safer as a result – perhaps systemically important technology firms should undergo similar treatment. On this basis, there are many systemically important firms hiding in plain sight, such as the concentration of payroll providers or consumer credit bureaus like Equifax, which is responsible for the Exxon Valdez oil spill of data.
Herein lies a subtler more technical double-jeopardy in the economy, which is especially true among large asset holders such as pension funds, insurance companies and hedge funds, among others. All financial balance sheets aim to strike equilibrium between assets, liabilities and equity. However, this assignment is much more gratifying and accurate the shorter the horizon of the balancing act. Large asset holders have a long financial tail and an increasingly short horizon, which is why many large traditional companies are in fact pension liabilities that also fly planes or make cars. Looking at this asset-liability mismatch more carefully, as shown in the table below for different classes of insurance, reveals how the double-jeopardy has crept up on many of these players, making them at once too big to fail and too big to hide. Due to advances in medical care, longevity risk is straining life insurer and pension actuarial models that presupposed a lower life expectancy by 20 years or more. Property insurers are having a particularly tough time finding asset-liability balance as many of the center city properties they own and residential properties they insure are in the line of sight of increasingly frequent and severe climate risks that are leveling entire communities at a time – and doing so at a greater frequency and severity than modeling suggested. These same insurers are contending with the emergence of an asset-light millennial consumer who in many ways are foregoing the traditional asset buildup of their forbearers in favor of side-hustling, ride sharing and fractionalizing access to everything they want (from renting the runway to luxury watches) in a new form of personal effects credit that negates the need for more insurance, especially the annualized pay-before-you-go kind.
Unsurprisingly, an alarming number of insurers are showing persistency on systemic financial risk rankings comprising 4 of the top 10 in the U.S. as tracked by NYU’s Volatility Lab. Meanwhile unsustainable debt levels and leverage have not gone away since the financial crisis, they just found a new host in the twin burden of consumer and sovereign debt. In the U.S., credit card debt has crossed the $1 trillion-dollar threshold. Student loan and other consumer debt conspires to create a $4 trillion-dollar hole from which the population, particularly the poor and increasingly squeezed middle class, must climb out of in order to reach parity. They are doing this while earning less in real terms while spending more via credit in compounding terms. Every facet of the American Dream is fleeting because households must stand on increasingly perilous debt structures in order to reach their goals and satisfy their wants. This same pattern holds true in Europe and other advanced economies, which explains why economic nationalism is politically en vogue and populism is socially de rigueur.
As with the last major financial crisis, which taught us that complex systems fail in complex ways, we should be weary of where patterns of financial double-jeopardy appear. They are good indicators of where unchecked systemic risks can reside, the biggest of which is the lack of risk-adjustment and recognition of the effects of climate change, pandemic threats, cyber risk and the erosion of institutional trust on the world’s balance sheets. In order to calibrate these risks and untangle the knots of systemic connections, investments in mitigation and systemic resilience must happen in lockstep with divestments from harmful assets or at a minimum acknowledgment of their insidious effects. Both activities need urgency to unravel the world’s most complex double-jeopardy. Find the double-jeopardy, find the risk.