Systemic Risk
By: David Aron Levine
Tags: Bitcoin, Economics, Finance

The most likely scenario for Systemic Risk emerging remains that Bank Stocks (like Deutsche Bank) across Europe are correct and that Sovereign Credit prices (meaning government bond yields) are incorrect. In other words, Sovereign Credit yields should be higher in Europe than they are and European Banks prices reflect this fact: that their balance sheets are already insolvent because the mark-to-market impact of more properly priced European Government Debt would wipe out their equity.

If this scenario plays out in a violent, or quick fashion, it seems quite plausible that the European Financial System would collapse as counter-parties refused to transact with one another and the backstop of the ECB itself would be called into question given its own relative instability politically and financially. In such a scenario, it seems that Financial System contagion would spread immediately to the United States (and globally) given the interconnected nature of the Financial Markets.

Unfortunately, sorting through the aftermath of such an event would likely not happen quickly nor efficiently. In Europe, given the many conflicting National Interests and increasing Populism, it seems quite likely it would take weeks if not months to ultimately resolve such a Systemic scenario. If the above scenario happens, the U.S. Financial System would likely need another bail out similar to what it received in 2008, which was $100's of Billions. It seems almost impossible that such a bail out would happen quickly. More likely, it would result in Violent — maybe even physically violent — disputes lasting many weeks, which would lead to the U.S. Financial Markets being shut down. It seems plausible during this time that banks would not be open, even ATM machines might stop working due to a “run” on cash in the short run.

Hopefully, in such a scenario countries like China and Russia would not use the vulnerability of the West to their advantage and move in an aggressive fashion to make military advances, but that also seems possible. Perhaps it would be strategically wise for them to attack when their Western enemies are vulnerable as their Financial Markets come under pressure.

While the collapse of the European Financial System, spreading to the U.S. Financial System, is the most likely Systemic Risk on the horizon it is not the only one. As China’s Economy continues to slow down, causing many industries to suffer, it seems that China is in an increasingly vulnerable position. They cannot afford to allow their Economy to slow too much or the Chinese People might prove to be problematic for their government. Unfortunately, propping up gigantic economies that are dependent on global trade is not always easy, especially when you are in a trade conflict with your largest trade partner. If China is unable to stem the decline of its Economy through its typical financial interventions (stimulus, tax changes, liquidity injections and other approaches), it is difficult to know what the consequences might be. China clearly has a large amount of debt in its financial system, much of which is likely unsustainable nor supported by fundamentals, especially if they slow precipitously. Beyond that, China has clear military intentions such as control of the South China Sea as well as control of Taiwan. It is hard to know whether China would activate a military strategy as an alternative course of action to rally unity in its populous under a slowing financial market scenario, but this also seems plausible.

In other words, there is deep uncertainty regarding China, and there are likely many scenarios where China becomes a source of Systemic Risk.

Beyond these scenarios there are of course other potential Systemic Risks.

Unfortunately, the System is vulnerable to these future Systemic Shocks due to the fact that Systemic Risk was underpriced for the last decade by Central Banks in the aftermath of the 2008 crisis.

What is so staggering about that fact is that we learned in 2008 that Systemic Risk exists. We also learned that one of the clearest ways for it to emerge is if Debt is mispriced at scale in a way that is interconnected across our Financial System.

Leading up to 2008, Corporate Credit, Consumer Credit and especially Mortgate Credit was mispriced across the System. Securitization added leverage to these asset classes in a way that ultimately threatened the viability of the System when prices corrected.

This Cycle is far worse however:

Government Debt prices have been mispriced across markets (in addition to the Corporate Credit and others). There are many ways to envision this but the many Trillions In negatively yielding government debt is the most obvious.

Negatively yielding debt should not exist. This is a fictional creation by Central Banks and represents one of the more. vious distortions created this Cycle.

Unfortunately we are likely nearing the Moment when Systemic Risk emerges causing the financial system to freeze up and markets to fail. It seems quite likely this will occur in 2019, although it could be extended. Time will tell.

Sadly, there seems to be no way around its emergence. It is simply a matter of time.