Wall Street’s Ticking Time Bomb

I remember the day Lehman Brothers failed.

I was in my home office in South Louisiana on that September morning in 2008, writing for the Money & Investing section of The Wall Street Journal. Up popped news on CNBC that one of America’s most storied investment banks had succumbed to America’s debt-fueled housing crisis. Oddly, the stock market rose that day — though six months later it would be a shocking 40% lower.

Within days, Merrill Lynch and Washington Mutual would fail as well. America’s financial sector was unraveling, and as a financial writer, I was on the front lines as it was happening.

It was at that moment that “too big to fail” became a national catchphrase.

A decade later, that crisis seems an epoch removed from modern America. “Too big to fail” is still tossed around a bit, but, by and large, Americans assume the crisis has passed and (assuming anyone paid any attention to various “stress tests” performed in recent years) our banks are now fine.

If only that were true…

Beware the Big Five

Back before America’s housing collapse plunged the world into an economic abyss, America’s top five banks (JPMorgan Chase, Bank of America, Wells Fargo, Citibank and U.S. Bancorp) controlled about 35% of the assets here at home.

Today, they control nearly half of America’s banking assets.

Back in the early ’90s, when I began my career writing about and analyzing finance and investing, America’s “Big Five” held between 10% and 15% of our country’s assets.

Over the years, these five have become mega banks, so gargantuan in size that their heartbeats now regulate the body economy of America.

What was once “too big to fail” is now so much bigger that it raises a troubling question in my mind: Are these banks so large that they are now too big to save in the next financial crisis?

And make no mistake … the next financial crisis isn’t an idle worry. It’s a very real probability.

See, the thing is, while we’re a decade removed from the financial crisis that started us down this path, we are by no means off the path. We’re just deeper into the woods, so lost at this point that there is no way out.

I don’t say that to be melodramatic or to scare you. I say it because the facts support it. (And because if you’ve been following my writing for any length of time, you probably already own physical gold, so you will be protected when it all goes pear-shaped.)

Bank-held derivatives have swelled to roughly $200 trillion from about $155 trillion just before the financial crisis hit, according to data from the Office of the Comptroller of the Currency (the OCC), which tracks this information quarterly. One might argue that a growing economy (which implies a growing banking sector) naturally leads to growth in the derivatives market. But derivatives have been growing 2.5 times faster than the economy — meaning the risk inside the banking sector is growing asymmetrically.

And that’s a problem.

The Derivatives Nightmare

What scares me the most is this statistic, also from the OCC: Nearly 77% of those bank-held derivatives are tied to interest-rate movements.

We all know that U.S. interest rates are on an upward arc now, and while banks might be able to manage a moderated ascent, what happens if we get a black swan event that sends interest rates spiking?

Derivatives are two-way bets with payoffs that are often asymmetrical. There is a winner and a loser, and, in a black swan moment, the winner can be on the hook for a sum of money so unexpectedly large that it taxes or even destroys the loser’s ability to meet its obligations.

That is effectively what caused the financial crisis to begin with — derivatives began to sour as interest rates increased and slammed U.S. homeowners who had been using their houses as ATMs. When rates spurted higher, mortgage payments on adjustable-rate mortgages and home equity lines of credit rose beyond consumer’s ability to pay … and the world of bankers fell apart.

A similar storm is potentially brewing…

A Consumer Addicted to Debt

The U.S. consumer, mistakenly regarded as a bastion of strength, is, in fact, a frail liability surviving on the good graces of American Express, MasterCard and mortgage bankers.

Consumer credit card debt is back to precrisis levels of $1 trillion, and any increase in the fed funds rate, the interest rate the Fed pushes and pulls on to modulate the economy, flows through as higher interest rates on all that credit card debt.

Meanwhile, homeowners are back to using their houses as ATMs. More than 40% of all home refinancing activity today includes cash-back of at least 5%, more than triple the trough level of a few years ago, says government-sponsored home lender Freddie Mac.

By the time 2016 data is compiled, consumers — through cash-out refinancing and home equity lines of credit combined — will have pulled something north of $80 billion out of their homes to repay credit cards and to use for other consumer detritus. That’s a 50% increase in borrowing from the trough.

Again, rising interest rates will bite many of these borrowers. And if Trumponomics throttles the economy, housing prices and employment will fall off, leaving increasing numbers of consumers unable to meet their payments … and that will flow through to the banks and many of the derivatives they own.

Protection From the Explosion

All of this combined is, to me, just one of the reasons that risk runs excessive in the system today.

We not only have an untested president with an untested administration now shepherding the country, but we also have an exceedingly strong dollar choking American multinationals and a stock market at exceedingly rich valuations gasping for oxygen.

We skate along the edge of a likely recession as Trumpian economic and trade plans take shape; we have Europe slipping toward populist leaders in key countries who could foment the end of the European Union and the euro.

And here are our banks sitting atop a derivatives powder keg that, if lit, would cause magnitudes more damaging than what we saw in the last crisis.

There are two courses of action here:

  1. Own physical gold — not as an investment, but as an insurance policy.
  2. And put stop-loss orders on all of your stock positions to preserve gains (or limit losses) in the event a black swan lands.

Until next time, good trading…

Jeff D. Opdyke
Editor, Total Wealth Insider