Recession, Insolvency, Derivative Risks: Why Looming US Crisis Could be Worse Than in 2008

Troubles engulfing three US banks and one prominent European lender have triggered recession fears as corporate bond buyers have got cold feet, with banks expected to tighten lending terms and the Federal Reserve proceeding with aggressive hikes.

The collapse of Silicon Valley Bank (SVB), as well as the banks Signature and Silvergate was followed by a Credit Suisse crisis, seeing other bank stocks tank and concerns over the stability of the Western banking system growing.

"The failure of the three US banks is not in themselves a threat to the financial system," Dr. Paul Craig Roberts, an American economist and author who was assistant secretary of the Treasury in the Reagan administration and associate editor of The Wall Street Journal, told Sputnik. "Two of the banks were involved with crypto-currencies, which are too volatile for a bank's balance sheet to remain solvent. The other bank, Silicon Valley Bank, was pushed into insolvency by the Federal Reserve's policy of raising interest rates. If this policy continues more banks will be pushed into insolvency, and there will be a banking crisis."

"The reason the Federal Reserve's policy is pushing banks into insolvency is that during the decade of low interest rates, the financial assets acquired by banks that are their assets, such as bonds, have lower interest rates than current interest rates. When interest rates rise, existing financial assets with lower interest rates fall in value, thus reducing the asset side of banks' balance sheets, but the liabilities side does not decline," the US economist continued.

As a result, banks find themselves insolvent or approaching insolvency, the former Treasury official explained. Once depositors notice that, they rush to withdraw their funds, forcing the banks to sell their depreciated assets in order to pay depositors. Eventually, the sale of the banks' assets further reduces their value, and the banks fail.

"To avoid this panic, the Federal Reserve has announced that the central bank will supply the necessary cash so that all banks can meet withdrawal demands, and the Treasury has announced that all deposits, regardless of size, are insured against bank failure," Dr. Roberts underscored. "These two policies should suffice to prevent a general run on the banks."

Is US Heading to Recession?

The US mainstream media largely lauded the Biden administration's response to the collapse of the SVB, describing "the 72-hour scramble to save the United States from a banking crisis."

At the same time, however, the US press is warning that the stress in the financial system may have powerful effects on growth.

"We are far from a recession," Ayse Kabukcuoglu Dur, assistant professor of economics at Poole College of Management, NC State University, asserted to Sputnik. "The collapse of the Silicon Valley Bank (SVB) raised questions about the vulnerability of the banking system but 2023 is different from 2008 thanks to the post-2008 financial reforms. The financial system has been more strictly monitored and regulated compared to the pre-2008 period."

However, J.P. Morgan warned on Wednesday that tighter monetary policy could push the US into recession later this year. "A very rough estimate is that slower loan growth by mid-size banks could subtract a half to a full percentage-point off the level of GDP over the next year or two," the financial institution wrote in its statement.

Investors appear to be sharing the Wall Street heavyweights' concerns: earlier this week, the markets saw plummeting bond yields, tanking oil and stock prices, and a sharp jump in volatility. US media outlets assume that the potentiality of curtailed lending, loss of appetite for corporate bonds among buyers, and raising borrowing costs due to the Federal Reserve's aggressive rate hikes could put the brakes on growth and open the door to a recession.

Furthermore, judging from the recession of 2001 and global financial crisis of 2008, every time when confidence in the financial system has taken an abrupt downturn, unemployment has tended to go up sharply. Indeed, investors and lenders typically started to withdraw to safe havens, consumers reduced spending, and companies began cutting employees.

Crisis Worse Than 2008 Collapse

"The difference between the current situation and the troubles that developed into the 2008 collapse is that the 2008 collapse was caused by the failure of the financial system and its regulators to understand the risk in derivatives. These risks were extreme, and blew up the financial system," Dr. Roberts said.

According to the US economist, the current situation has the possibility of being worse than the global financial crisis.

"This time there are two possible causes of financial collapse," he explained. "One is the Federal Reserve's policy of raising interest rates. As I explained above, this causes existing financial assets on banks' balance sheets to decline in value. If the Federal Reserve doesn't cease raising interest rates, more banks will be pushed into insolvency."

The other danger is derivatives, according to the economist. A derivative is a financial contract whose value is dependent on an underlying asset, group of assets, or benchmark.

"The five largest US banks have derivative exposure many times greater than their capital base. No one knows what the risks in these derivatives are. But here you can see the size of the derivatives," Dr. Roberts noted, referring to the list of American banks ranked by derivatives.

Derivatives as 'Financial Weapons of Mass Destruction'

Some financial analysts have described derivatives as bets in a giant casino in which players hedge against a variety of changes in market conditions. Back in 2002, American business magnate Warren Buffett wrote that derivatives are "financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal." Buffett warned that derivative businesses had been expanding "unchecked," with central banks and governments having no effective way to control or monitor the risks posed by these contracts.

According to analysts, the problem is that the amount of these loosely regulated speculative bets have reached hundreds of trillions of dollars, with around 90% of them being concentrated in four big American banks, namely J.P. Morgan Chase, Goldman Sachs, Citibank, and Bank of America. According to the Bank for International Settlements (BIS), the derivatives bubble may be as much as $600 trillion. If it bursts, this could throw the financial system into mayhem.

In particular, in 2021, the derivatives instruments triggered Archegos Capital Management's $20 billion liquidation and shook global financial markets. While some banks, like Goldman Sachs and Wells Fargo, escaped losses by quickly liquidating their exposure to Archegos, others like Credit Suisse faced billions in losses.

"The existing trillions of dollars of derivative bets were made when interest rates were lower," Dr. Roberts noted. "When these contracts are reset, it will be at higher interest rates, so the value of the bets would be adversely affected. Indeed, derivatives have become extreme risks with no productive purpose. How serious the situation is depends on whether Federal Reserve policy continues to undermine the balance sheets of banks and on the derivative risk."