When there is no current crisis, much attention is given to predicting the next one. It is common for people to scrutinize riskier activities in search of the cracks that may lead to the next market cycle break.
This time around, assets such as leveraged loans, private credit, and low-income borrowers – among others – have been identified as potential sources of concern. However, it is important to note that the factors that could break the system are often unknown and unknowable to most.
The above comment was made in jest, as the Global Financial Crisis (GFC) was caused by seemingly safe AAA MBS tranches that wreaked havoc on financial institutions. Similarly, the current banking headlines are also the result of highly rated, mostly government or municipal-backed securities that are backing banks into a corner as depositors look for higher-yielding pastures.
Put simply, when everyone is focused on a particular issue, it becomes more difficult for that issue to cause a surprise. Dislocation is often caused by surprise, by definition. Consider constant subprime fear-based headlines, which are likely in part due to the lingering effects of the GFC.
The saying goes that “price is what you pay, and value is what you get.” The point of the above chart is that while higher quality credit may feel safer, a severe dislocation may leave you without appropriate reserves relative to a calmer period. On the other hand, if you lend to subprime borrowers and price correctly, the volatility of these already low-quality customers may not be as severe. Of course, being a subprime lender and pricing poorly can lead to self-destruction.
A senior investor commented last fall, somewhat morbidly yet presciently, that what concerned him was not the cancer risk of a credit default cycle, but the heart attack risk of asset-liability mismatches in light of a rapid tightening cycle. What we are witnessing in real-time are asset-liability mismatches in banks, UK pensions, and other areas that have been the source of recent dislocation. While it remains to be seen whether more asset-liability mismatch-related dislocations will occur, it is likely that they will happen in the least expected places.