Is Everything Now Too Big To Fail?

November 8, 2017

Is Everything Now Too Big To Fail?

  • Today, we’ll discuss how the “too big to fail” concept has evolved since it was first used back in 1984.
  • The U.S. stock market to pension funds relation shows that even the stock market is simply too big to fail.
  • In Europe, the situation is even worse. Everything there is too big to fail, from countries to corporations to junk bonds.



Introduction

“Too big to fail” is a concept that you probably recognize from the 2009 financial crisis when many corporations, particularly financial institutions, were considered too big to fail due to the negative impact their demise would have on the whole economic system.

In order to prevent massive negative effects on the economy, and also to prevent a 1930s depression-style situation, governments intervened and bailed out the distressed assets.

What few know is that the too big to fail trend started back in the 1980s, more precisely in 1984 when the Federal Deposit Insurance Corporation (FDIC) intervened to save the then 7th largest U.S. bank, Continental Illinois. However, the bulk of government interventions happened in 2009 when many governments intervened to save their, and the global financial system.

It’s interesting how nothing has really changed since 2009, and the concentration of assets with the top 5 banks in the U.S. has even increased making them even bigger than they were in the financial crisis.

Figure 1: Top 5 U.S. banks hold even more assets than in 2009. Source: FRED.

Now, most global banks aren’t as stretched now as they were in 2009, not because they are now behaving much better, but simply because there has been so much liquidity provided by governments that practically no bank can fail now.

Figure 2: Number of bank failures in the U.S. Source: FDIC, author’s chart.

The number of failed banks now is minimal to what was seen around 2009. This is because the FED and other central banks have simply injected so much liquidity into the system, that going bankrupt is a pretty difficult thing to do nowadays.

Figure 3: Central bank asset purchases in the last decade. Source: Deutsche Bank.



The FED has stopped adding to financial markets and has started slowly increasing interest rates, but that is of little importance as the ECB and BOJ continue with their activities and show no intention of stopping. As the financial world is heavily interconnected, as long as global central bank activity is positive, there is nothing to be afraid of.

However, the huge liquidity injections lead me to believe the financial system has become so distorted that now, not only are banks too big to fail, but practically everything related to finance is too big to fail. Therefore, central banks will have to continue with their quantitative easing policies with a pause here and there to make it look like everything is under control.

The Stock Market Is Too Big To Fail

Total pension assets in the U.S. in 2016 were $21 trillion and were 121% of U.S. GDP.

Figure 4: Pension assets per country in 2016. Source: Willis Tower Watson.

As 70% of that money is in stocks and bonds, it’s clear that the stock market is now at a level that is simply too big to fail. Imagine what a 50% stock market decline would do. It would bring stocks to the average historical valuation do to the pension fund system, especially if the stock market stays depressed for longer.

Figure 5: Pension fund asset exposure. Source: Willis Tower Watson.

So a 50% stock market decline would erase 23% of U.S. pension fund assets, or almost $5 trillion, or 27% of U.S. GDP. Will the FED or elected officials allow it? I don’t think so. Therefore, as soon as there are any signs of a market crash, the FED will do what the BOJ is doing, i.e. buying ETFs, funds, and stocks to keep the market at high levels because it’s simply too big to fail.

Additionally, the market cap to GDP ratio is where it was back in the 2000s, and we all know how that ended.

Figure 6: Market cap to GDP. Source: MarketWatch.

The situation now is even worse than it was in the 2000s because much of the high market caps back than were thanks to just small fractions of a company being pumped to high prices, which isn’t the case now as most of a company is owned by a pension fund.

The situation isn’t better in Europe, but let me focus on bonds there. The yield on European junk corporate bonds is now lower than the 10-year U.S. Treasury yield.

Figure 7: U.S. 10-year Treasury and European junk bond yield. Source: Deutsche Bank.

The junk bonds yield being below 2.5% means that not even high-risk junk businesses are allowed to fail or, God forbid, countries to fail. For example, Italy, which has a debt to GDP ratio of 132%, has to pay just 152 basis points more than Germany on a 10-year period. Germany has a debt to GDP ratio of 68%.

Figure 8: Italian and German 10-year bond spread. Source: Wall Street Journal.



Therefore, I find it highly unlikely that the ECB will allow for any kind of higher interest rates because what it has created is simply too big to fail.

Despite the huge asset purchases, negative interest rates, and a 2.5% junk yield, the European economy has been growing at an average rate far below 1% in the last 10 years. Thus, government debt ratios, bond markets, stock markets, housing markets, everything is too big to fail in Europe.

Conclusion

The social pain that any kind of financial collapse, or even just a significant change in interest rates, would cause is so huge that the current financial system created by central banks is simply too big to fail. As such, we can expect continuous central bank intervention over the long term.

Don’t be fooled by the FED’s temporary tightening and asset sales. These will revert at the first sigh of trouble.

Inflation also has to be prevented because an higher expected yield on stocks would result in a sharp stock market decline, which is something no one could stand.

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