A financial cycle seems to be coming to an end. As with many trends, banking (and the supply of money) and its impact on our economy are cyclical. There are a great many texts that engage with this relationship and the cycles, and you can see it here on our list of resources for people who wish to learn about finance.Why are we approaching the end?
These cycles can be observed since governments permitted banks to create money and central banks to oversee that process. In short, every country's most basic resources are land (accessible land, through good infrastructure) and people (and their productivity). Money (as we explain in our essay on money) is simply the mechanism through which we transact in the economy: exchange our work for goods we need.
Banks control the supply of that money, and its creation. Money is created every time a private bank makes a loan (as we explain in our essay on the banking system here). The demand for loans is impacted by interest rates. Banking crisis take place when their loans, mostly linked to real estate, incur losses greater than the equity capitalisation of the bank.
In modern finance, following these banking crisis, interest rates and other mechanisms to supply money are kept artificially easy (i.e. money supply is encouraged) to stimulate the economy and to render assistance to a crippled banking system. The exception to this was 1929, and the failure to act by central banks then is attributed to the depth of the depression and the political crises that ensued.
The Great Financial Crisis occurred in 2008, and we are now at the tail end of that cycle of monetary easing and this year has been one of pervasive tightening. Central banks, led by the Federal Reserve (the US central bank), are hiking rates aggressively, and so reducing money supply (or the rate of money creation). The last time we saw this type of environment was the late 90s, where once again banks were recovering from a property and land crisis in the late 80s and through the 1990s, low interest rates were gradually being increased.
Then, as now, emerging market countries with hard currency (mostly dollar) debt defaulted (Mexico in 1994, Russia in 1998, and the Asia crisis in 1997). The rising rates put pressure on markets, that eventually had a blow off top with the tech boom, before a crash in the early 2000s. We expect a similar patter to follow now.It will be worse this time
In 2004, Warren Buffet described certain derivatives as 'Weapons of Financial Mass Destruction', during the take-over of Gen Re (an insurer that was active in CDOs). Buffet, with hindsight rightly, insisted the insurer remove all those products, and four years later the Great Financial Crisis would prove it to be another astute decision by the legendary investor.
The difference today is that many of the innovative financial products that created leverage in the 1990s were in their infancy, whilst today, like all knowledge, they have proliferated. Not all management teams behave like Warren Buffet, and leverage has likely seeped its way into corporate and investing nooks and crannies that we have yet to fully consider.
This means that unlike the end of the Dot.com bubble, as a result of this growth in innovative and leveraged products, this time around we have the potential for even more material losses than in ‘99.
The most observable parallel to contrast this new world of leverage to the old would be to compare banking crisis. The banking crisis of the late 80s and early 90s, was another property based lending bubble (like the GFC), and whilst it damaged the economy, it was not as catastrophic as 2008.
Similarly, the next crisis will be more similar to the ‘99 tech bubble, but of course it will likely be several orders of magnitude larger do to the influence of leveraged products.
Banking crisis are usually worse than asset based cyclical crashes. The reason for this is that banks are essential utilities in the plumbing of the monetary system. Their failure necessitates state intervention (as the US did in the 90s to nationalise the mortgage agencies). However, the non-bank related asset bubbles are also very damaging, especially if this time around we find the pervasive use of leverage in many companies and investment structures. Timing the end of the cycle
Aside from the structural signs set out above, there is also a cacophony of market observers who have turned very negative on the prospects for asset prices and many are calling for a major crash.
Contrarians argue that this pervasive negativity sets up the market for a last gasp rally (similar to the ‘99 tech boom). An aspect of the 1999 metaphor was that the markets actually went up, a lot in a very short period of time (six to nine months), first (before it crashed). I.e. the Federal Reserve, like today, was raising rates, which was causing waves in the markets, but once the Fed paused, the markets made a euphoric last gasp rally (know today as the dot.com bubble, that sucked many investors in. Could the same happen again today? Well the markets certainly have a very similar set up, so it shouldn't be written off. These euphoric rallies are short but extreme and investors get quite giddy.
In any event, timing the exact end of the cycle is very challenging, and best left to those unusual and exceptional investors that will no doubt become famous icons of investing in the aftermath of the crisis.
For the rest of us whose careers are more dependent on being aware of the big trends (rather than timing markets to the precise moment), will help to guide our respective careers and businesses toward the next potential hotspot. Why does this matter to litigators?
It matters to banking litigators as litigation is a function of two things: opacity (of contract) and losses. When individuals and institutions incur losses and it is not clear who is at fault, there is a high likelihood of litigation. In this cycle there are some asset classes that will be similar to the 1999 Tech crisis, and there will be others that are new.
Blockchain or crypto is the most obvious comparison to the internet bubble. A new technology, that undoubtedly has value in that it is an evolution of the web with new features, but whose monetisation mechanism remains unclear. Other familiar asset classes, like emerging markets, corporate bonds and loans, commercial property will also be in the firing line. There will also be some new asset classes, like the leveraged ETF sector that haven't been properly tested by a serious crisis.
In this series on litigation hotspots, we will identify and discuss the different asset classes we think are worth keeping an eye on. We will also have tips for how to carry out business development to target these audiences better, to give you an edge over your peers.
Law firms and barristers who are ready for the crisis and have their business development assets aligned, will likely benefit from the next wave the most. In this series of articles we identify the sectors that will most likely be impacted and take a deep dive into each one, with our recommendations of marketing strategies for lawyers. Join our LinkedIn group to be notified of the next article in the series. Related articles:What is a Blockchain and why will it change the world?Interesting books on this issue:
The Secret Life of Real Estate and BankingProgress and Poverty: An Inquiry Into the Cause of Industrial Depressions And the Increase of Want with the Increase of Wealth - The RemedyLords of Finance: 1929, The Great Depression, and the Bankers who Broke the WorldInterested in future articles. We don't bulk email clients (as we think our clients get too many emails already), so to be notified of new content, connect to us on LinkedIn, and we will invite you to a group where our articles are posted. Or alternatively send us an email and we will connect to you.
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