The predictor of virtually every major financial crisis during the last 200 years has been runaway private debt fueled by lending institutions and their leaders’ fierce ambition, according to Richard Vague, founder and managing partner of the venture capital firm Gabriel Investments.
In an interview with ThinkAdvisor, the former banker discusses his years-long research into these crises, which culminated in a new book, “A Brief History of Doom: 200 Years of Financial Crises” (University of Pennsylvania Press-May 2019).
Vague’s detailed analyses of 43 financial calamities in six of the biggest countries worldwide over two centuries show that lending misbehavior sparking rapid, excessive private-loan growth and subsequent overcapacity has been, unfailingly, the prelude to these meltdowns.
What’s more disconcerting is that the long-term global trend is toward ever-higher levels of private-sector — household and business — debt. Indeed, in a May 20 speech, Federal Reserve chair Jerome Powell expressed concern over growing business debt. “Could the increase in business debt pose greater risks to the financial system than currently appreciated?” he asked. “My colleagues and I continually ask ourselves that question.”
Before the 2008 crisis, the Federal Reserve sent Americans misleading signals, insisting that the U.S. economy was in good shape, Vague maintains. But the Fed was not including private-debt growth — that is, the rapidly rising rate of bad loans — in its models, and neither did mainstream economists, he says.
As for this former banker, who has run two commercial banks, Vague saw trouble brewing in mortgage loans as early as the fourth quarter of 2002, he recalls.
Government debt, contrary to popular thought, is not a forecaster of financial crisis, according to Vague. Another fact likely to surprise: Just $10 trillion of America’s $30 trillion in private debt is held at commercial banks, he says. The rest is with secondary institutions, like hedge funds, which are lightly regulated or unregulated.
Vague, 63, was CEO of First USA Bank (sold to Bank One) and Juniper Bank (sold to Barclays); and he founded and ran Energy Plus, a supplier of electricity and natural gas (sold to NRG Energy).
How to break the cycle of excessive private loans that lead to overcapacity, bank loss, bank failures — and ultimately financial crises? Vague discusses that in the interview. Spoiler alert: He’s not shy of the “R” word.
Notwithstanding, he offers advice to financial advisors on how they can help clients invest with caution by knowing which countries are rife with runaway private debt: A certain rise in the ratio of private debt to GDP over a specific period is an early warning sign of lending misbehavior.
ThinkAdvisor recently interviewed Vague, on the phone from Gabriel’s Philadelphia headquarters. The native of Wichita Falls, Texas, is a notable philanthropist who has been flirting with the idea of running for president in 2020. In our conversation, he comments on what America needs now. Vis a vis avoiding a financial crisis, he stresses: Heed the danger signs of out-of-control lending.
Here are excerpts from our interview:
THINKADVISOR: Periods of excessive runaway private debt — household and business — have occurred prior to numerous financial crises over centuries. Why is this pattern repeated over and over?
RICHARD VAGUE: We’ve had crises in 1792, 1819, 1837, 1873, 1884, 1893, 1907, 1914, 1929 — and the list goes on and on. It’s because the way you get ahead in the banking industry is by making more loans. The way you get a raise and a promotion, a bigger bonus and get your stock price up is by growing the revenue of the bank. So early on, lending serves to increase asset prices — and it looks like you’re doing something very smart.
And then what?
You’re making mortgage or commercial real estate loans, and that means there are more buyers of homes and buildings. Any time there are more buyers than sellers, prices get low.
Financial crises tend to follow the same plotline, in which runaway debt plays a major role, you write. Please describe that plotline?
Banks and other lenders get confident and start making more loans — especially in real estate. Prices rise, which increases the enthusiasm of the lenders. So over a relatively short period, they make increasingly aggressive loans under increasingly looser credit criteria.
What’s the upshot?
Vast excess capacity — houses that won’t be sold, buildings that won’t get tenants. The lenders who make these loans, in many cases, end up with more bad debt than capital. At that point, it all unravels.
Many believe that excess government debt is a forecaster of financial crises. True?
It isn’t growth in government debt that’s predictive of financial calamity in developed countries. Government debt doesn’t correlate to financial crises.
Why are there periods when bankers aren’t aggressive and loans aren’t growing too rapidly?
After a boom, because of the carnage, regulators have a stronger hand; and internal risk managers within lending institutions have more credibility and more sway.
Growth in the ratio of private debt to GDP can be an early warning sign of crisis, you write. What would be excessive?
If you see growth of more than 3% or 4% a couple of years in a row.
Is it hard to spot lending misbehavior?
No because it’s never subtle. It’s big, egregious changes to lending policy: It’s no down payment; it’s making a credit approval based on interest rates that are artificially low.
In which lending sector does the trouble start?
Generally not the mainstream commercial banks but the secondary financial institutions that are less regulated or unregulated. They include private equity and hedge fund lenders — all the sources of debt outside of banks.
How does that compare with bank-sourced debt?
In the U.S., there’s $30 trillion in private debt — but only about $10 trillion of that is held within commercial banks.
The long-term trend is toward ever-higher levels of private-sector debt, you write. In the U.S., what is recent history showing?
Debt has tripled from about 50% of GDP in around 1950 to 150% today. We’ll see a slight bit of deleveraging, but the long-term trend for most countries is toward higher levels.
Right now, where is the level worst?
The part of the world that has a lot of excess private debt growth is Asia, especially China and its economic satellites. China is now well above 200% private debt to GDP. Japan is near that level.
What’s the rate of increase in the U.S. nowadays?
The level of 150% has been reasonably flat over the last several years. There are some small pockets: High-yield lending has been a little excessive, like student debt, certainly. Subprime auto lending has been excessive. So we’re seeing an uptick in certain categories. The chairman of the Federal Reserve [Jerome Powell] made a pronouncement [on May 20] that he’s getting a little concerned about the growth of business debt. But it’s not anywhere near the level it was in 2007 and 2008.
Can runway private debt be prevented?
Yes. If there’s widespread understanding of the phenomenon, regulators can intervene early. As I said, it’s not hard to find. If you were a regulator in 2003 with the authority to intervene, you would have seen loans where [institutions] weren’t checking the employment or income of the borrower. [Regulators] could have had them change those policies.
Are you advocating for more regulation?
At the very least, we ought to have more awareness of the direct link between excessive private-debt growth and problems. There’s a little more sensitivity now, but it’s not as well understood or well articulated as it should be. Also, the regulatory community gets compromised [routinely]: It’s not unusual to see the misbehaving institutions with aggressive lending becoming key campaign contributors and developing links to the legislative community.
Can the Dodd-Frank Act prevent the next financial crisis?
No, because it doesn’t address the central issue of excessive loans. We even had a small crisis in 2014 in the energy lending sector, where energy loan growth was off the charts. But there were no regulatory actions to prevent that. Sure enough — things unraveled.
How else doesn’t Dodd-Frank help?
There’s nothing in Dodd-Frank, for example, that [provides for] intervening in [the problem of] excessive student debt. There are a lot of things that are good in Dodd-Frank and a lot of things that are beside the point.
Is there anything financial advisors can do regarding runaway debt that could help their clients?
Be aware of macroeconomic trends. Private debt-to-GDP trends in any country are the single most predictive factor of macroeconomic outcomes. So once a year, advisors could take a quick look at the private-debt trends in various countries. On our — not-for-profit — website, www.debt-economics.org, you can pull down spread sheets on at least 40 countries. This can make advisors aware of where and when problems are brewing in overseas markets so they can recommend that clients be cautious about them.
Right now, as you point out, China has a high level of private debt. What warning signs have there been?
China and its satellites, such as South Korea, Australia, Vietnam and Malaysia have high levels. You’ve seen the first drop in real estate prices in Australia in the last few months. You saw a dip in GDP in South Korea. So I’d be very cautious about those countries.
Didn’t most economists see private debt rising to a high level in the years leading up to the 2008 crisis? I mean, how could they have missed that?
Orthodox economists and Federal Reserve models don’t even consider private debt a factor. During the period when we had that massive buildup in mortgage debt, Ben Bernanke [former Federal Reserve chair] was saying it was The Great Moderation and that things were fine. Even after the point of no return had long passed, he was saying that [private debt] is going to be a small problem. The Fed didn’t consider private runaway debt, and therefore mainstream economists didn’t properly consider what would seem obvious from the standpoint of a business person: Too much debt creates a problem.
But there were some economists who saw what was happening. Didn’t they discuss it publicly?
The folks that saw it were, kind of, the outcasts of the mainstream economics profession, politely called heterodox economists.
I found in late 2007 that typically optimistic FAs were subdued or even worried.
A lot of smart, helpful financial advisors out there weren’t getting the right kind of guidance from the Fed and orthodox economists. It was amazing that the rhetoric was about how things were good, that we were in this Great Moderation and that we defeated the business cycles of the past.
Yet you write that the 2008 crisis “was inevitable well before Lehman [Brothers] filed for bankruptcy.”
Most of the crazy mortgage loans that had zero down payments and compromised credit standards had been made by the end of ‘05. A crisis of sorts was inevitable at that point. Yet, in the summer of ‘07, all the conventional things that people looked at showed consumer confidence at a near all-time high; the stock market about to set an all-time record; consumer net worth looking like it was at an all-time high.
A few months later — because of all the bad loans that had been made in 2003-2005 — it all started to come unraveled in dramatic fashion.
But there was a group of people who’d scoped out what was going on and tried to make money from it.
Yes. The savviest analysts, the most willing to be contrarian, saw it in late ‘05 and early ’06, and began placing bets against the mortgages. Michael Lewis made some of these folks famous with his book, “The Big Short.” They saw this massive problem and figured out a way to profit from it. Their big bets were underwritten naively by companies like AIG, and that just amplified the problem and made it more widespread.
At what point did you forecast the 2008 crisis?
I was in the industry making unsecured consumer loans; I wasn’t in mortgage lending. However, in late ’02 I saw that mortgage loans were about $5 trillion of the U.S. economy and that by ‘07, there was $10 trillion in household mortgages and $3 trillion or $4 trillion in commercial real estate.
What did that imply?
It was unprecedented growth. If ever there was a hockey stick [graph], this was the hockey stick! Yet it wasn’t being commented on. If something goes wrong in real estate, it reverberates across pretty much all other sectors.
Looking back now: “The prelude to the 1987 stock market crash had begun with the decade’s runaway private lending,” you write. Please elaborate.
The 1980s was one of the most crisis-laden periods in U.S. history. There were 1,000 bank failures and several hundred S&L failures. We had the junk bond crisis, the commercial real estate crisis and the largest single one-day drop in the stock market on a percentage basis [“Black Monday”]. All that culminated in the recession of the early 1990s.
The Black Monday stock market crash was at first a symptom, not the cause of that crisis, and therein similar to most financial crises, you write.
There’s a lot of confusion around that. It was also a popular explanation for the Great Depression. But [the 1929 crash] was a symptom caused by excessive debt. The stock market is a harbinger.
By the way, you’re a Democrat said to be contemplating running for president in 2020. You’ve conducted many focus groups with Americans. Where do you stand at the moment?
At this point, there are 23 candidates [laughs]. So something radical would have to happen for me to consider it. But I’m spending a lot of time trying to bring the case of the average American to the attention of politicians because folks need and deserve help. The average middle class American has been taken for granted over time, and they could use some attention.
But isn’t the U.S. economy booming?
The top-line statistics of unemployment are more misleading now than they’ve ever been. People in the U.S. have jobs, but they’re dead-end jobs. They don’t give them the chance to advance their financial compensation over time.
Where does that leave them?
Most folks are in this vise of stagnant income and skyrocketing health care costs. The average American is not in the middle of a boom economy. The average American is feeling a lot of stress.
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