Financial risks lurk in new market securities and shadow banking.
The following is part of a series marking the 10 year anniversary of the financial crisis.
The severity of the financial crisis hit home to John Taft, vice chairman of Baird, when a well-regarded $65 billion money market fund, known as the Reserve Primary Fund, was forced to liquidate because of investor panic immediately following Lehman Brothers collapse.
Taft was the CEO of RBC Wealth Management at the time.
His customers had at least $1 billion deposited in the fund. The investment vehicle held a small amount of commercial paper in Lehman Brothers, which became worthless after the bankruptcy. Investors pulled money from the fund, fearing it would become insolvent. The board froze redemptions after its assets fell by two-thirds in the space of one day.
“That almost brought the financial system to complete collapse,” says Taft. “It was the worst moment for me.”
The ultimate lesson learned from the financial crisis was that the system operated with too much borrowed money, says Taft. The shoring up of core capital held by regulated financial institutions, which is close to double what it used to be, “accounts for 80% of the improved conditions in the financial services sector,” he says.
Nevertheless, there are areas of the financial market that pose a concern today. One segment that has seen phenomenal growth are exchange traded funds. This year, the total value of funds invested in ETFs is expected to exceed $5 trillion.
ETFs are similar to mutual funds, which hold baskets of various financial securities, such as stocks and bonds. The main difference is they are traded on stock exchanges.
“There is a lot of money in ETFs. In some cases, the investments are relatively illiquid. It is uncertain how they will behave. If enough investors lose money, then you could have systemic problems.”
Taft also points to the shadow banking system, where unregulated financial firms operate, such as private equity and hedge funds. Costly regulations put on banks after the financial crisis pushed a lot of lending into these non-regulated areas of the financial markets.
“These less regulated, non-bank lenders are making higher risk corporate loans and mortgage-based loans,” he says.
The low interest rate environment has led to a borrowing frenzy in the corporate world. But Taft does not see the level of corporate debt posing an issue right now. He does think investors are not getting paid enough for investing in riskier debt.
“There is no question the high-yield bond market is growing and is probably mispriced,” says Taft.
But for now, nothing screams out at him as too alarming. “Today, I don’t see any types of systemic stress.”
Read more in this series on the financial crisis:
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