7 SIGNS OF THE NEXT FINANCIAL CRISIS

Article By: Michael Brush, MSN Money

Five years ago, Lehman’s collapse sent the market and economy into a panic. One of the insiders who saw it coming sees eerie similarities in the U.S. market and Asian banks, and a big drop ahead for stocks.

BIG TROUBLE AHEAD

With the fifth anniversary of the disastrous 2008 Lehman Brothers implosion on Sept. 15, 2008, you’re probably hearing lots of ruminating about the bankruptcy that sparked the worst financial crisis in 80 years.

But as investors, it may be more useful to look at what the lessons from Lehman’s collapse are telling us about the outlook for U.S. stocks now.

The bottom line: There’s big trouble ahead. Many of the risk indicators that foreshadowed the last big meltdown are blinking red. And stocks could fall 10% to 15% before the end of the year.

That’s all according to a guy who should know — he was inside Lehman at the time, he was part of the group that tried to warn the company of the risks of subprime mortgages, and he wrote perhaps the best book on the blow-up.

“The next crisis will be Asia-led, but it will bring down U.S. stocks. You want to be lightening up on U.S. stocks,” says Lawrence McDonald, the author of “A Colossal Failure of Common Sense: The Inside Story of the Collapse of Lehman Brothers.”

McDonald, who now advises hedge funds and investors on how to spot market risk, is seeing signs of distress in Chinese banks that are eerily similar to what U.S. banks faced ahead of the 2008 meltdown. (Read more about him, and check out his investing newsletter and other work, at his website.)

“The systemic indicators are dangerously high in Asia,” says McDonald, who tracks 17 key indicators modeled on the Lehman mess to get a “20,000 foot view of risk in the market” as chief U.S. strategist at Newedge USA, a futures broker. “The indicators are saying something very big is happening in Asia.”

McDonald remains bullish on stocks for the long term, because valuations still look good, mind you. But the near term looks dicey.

Here are six of his Lehman risk indicators and one more sign that suggest something bad is cooking in banking, and that U.S. stocks are vulnerable. We’ll start with some overall readings, then zero in on China.

 WILD LENDING HAS SPIKED 

A favorite Lehman indicator for McDonald is one that gauges the number of business loans being made that contain scant protections for the lenders.

Lender protections, known as covenants, are provisions in loans that typically ease loan repayment when financial warning signs crop up for a borrower. For example, a covenant might push a company into bankruptcy — protecting assets for lenders — if cash flow falls enough..

Excessive amounts of “covenant-light loans,” as they’re called, signal that lenders are handing out money too freely. This can be a sign of trouble in the financial system, which can then spook stock investors.

Recently, this Lehman indicator — the number of covenant-light loans — was at the same level it was in 2007, the year before credit markets blew up.

McDonald attributes the covenant-light loan binge to the Federal Reserve’s policy of maintaining near-zero interest rates to spur the economy. Rock-bottom rates have investors chasing yield. “They don’t give a darn about protection. They just want the income,” says McDonald. “People have really reached into very dark corners for extra yield. This is what happened in 2007.”

This kind of wild lending can cause trouble, because it funnels money to less responsible business managers who invest it frivolously. When their bets go bad, lenders — meaning banks, insurance companies and the rest of the financial system — get hurt. That in turn spooks investors into selling stocks.

JUNK BOND MANAGERS ARE CUTTING RISK

One of McDonald’s favorite canaries in the coal mine is the junk bond fund manager, who invests in high yield, aka “junk,” bonds. (Risky companies have to pay more for loans, so interest rates on their debt are much higher. These loans are also more likely to go bad, which is why they’re called junk.)

What makes junk bond managers good canaries? Their markets are less liquid than the markets for large-cap stocks, which means volume is lower and there are fewer buyers and sellers. So junk bond managers tend to be more sensitive to risks than stock investors are. “They have to be more nimble. They have to reduce positions quickly, any time they see a sign of risk,” says McDonald.

Junk bond managers sell fast when they see risk. So when junk bonds underperform stocks, it can mean trouble.

“In the months before Lehman blew up, high yield investments were down 2%, and stocks were up 3%,” says McDonald. High yield also lagged stocks ahead of sell-offs in stocks in 2010, 2011 and 2012.

Now, troublingly, we see the same thing. This summer, high yield bonds have underperformed stocks. Over the past three months, the SPDR S&P 500 (SPY) exchange traded fund is up 75%. But the SPDR Barclays High Yield Bond (JNK) ETF has fallen 2.10%. “This is a very dark sign for stocks,” says McDonald.

INVESTORS SEEM OVERCONFIDENT

This Lehman indicator focuses on two data points that can tell us if stocks are particularly vulnerable to shocks. These figures suggest investors are too confident, following the 23% market increase since November. That makes investors more vulnerable to bad news.

One great way to measure if investors are overconfident, says McDonald, is to look at the percentage of stocks trading above their 50-day and 150-day moving averages. Lately, these technical signals have been at extremes, suggesting that investors are brimming with confidence. This state of mind makes them more vulnerable to shocks of bad news, such as a potential financial crisis in China.

Similar signals of overconfidence preceded big stock market corrections in June 2011, April 2012, October 2012 and May 2013. In all those cases, the proportion of stocks trading above their 50-day or 150-day moving averages was high — 70% to 80%.

This summer, 85% of stocks in the Standard & Poor’s 500 Index ($INX) were trading above their 50-day moving averages, and 70% were above their 150-day moving averages. Those numbers have declined a bit. But such peaks are still signs of trouble ahead, says McDonald, because the decline in stocks since early August may only be the start of something bigger.

MARGIN DEBT IS AT OR NEAR RECORD LEVELS

When investors borrow lots of money to get into stocks, that’s a sure warning sign of trouble in the market ahead. That’s exactly what’s happening in the U.S. stock market right now.

In April and May, margin debt eclipsed $400 billion, well surpassing the 2007 peak of $381 billion, a top that was followed by the credit crisis and the stock market meltdown. Indeed, major market corrections and crashes are almost invariably foreshadowed by peaks in the use of margin to buy stocks.

If you’re guilty here and you have borrowed heavily from your broker to buy stocks, now might be the time to part with some of your positions to bring down your borrowing.

Otherwise, you run the risk that if your stocks fall enough — which is likely in any 10%-15% overall correction — the amount of equity in your account won’t be enough to back up your margin borrowing. You will be forced to either sell stocks after they have declined or send a check to your broker.

Trust me, this will hurt at a time when you’re already bothered by how much your account is down. At such times, the last thing you want is for your broker to call and ask, “Is Marge in?”

GOLDMAN, B OF A EXITING CHINA

If you want to know what’s going to happen in the markets, it pays to follow the smart money. And love ‘em or hate ‘em, the guys and gals at Goldman Sachs Group (GS) definitely qualify. That’s why it’s interesting to note that a few months ago, Goldman Sachs dumped the last of its stake in China’s biggest bank, Industrial & Commercial Bank of China (IDCBY).

Goldman is not alone. Two weeks ago, Bank of America (BAC), which learned a thing or two about bank risk in the credit meltdown, said it sold its remaining stake in China Construction Bank (CICHY) for $1.47 billion.

Many skeptics are increasingly questioning the quality of Chinese bank assets following the huge credit boom that has fueled that economy there in recent years — and with good reason. There may be big problems with those banks. China Construction Bank recently said it wrote off $879 million in bad loans in the first half of this year, or four times as much compared with the year before. China Banking Regulatory Commission Chairman Shang Fulin recently warned about rising risks in the banking sector.

The Goldman and Bank of America sales aren’t strictly speaking, a Lehman indicator. But next are two from McDonald that paint the same picture for China.

TRUST AMONG ASIAN BANKS IS SLIPPING, TOO

Remember “Libor”? This measure of interbank trust told us trouble was on the way for U.S. banks before crunch time in the fall of 2008. Now, a Chinese cousin is saying the same about Chinese banks and about Asian banks that do a lot of business in China.

A quick primer: Libor, the London Interbank offer rate, is the interest that banks charge each other for short-term loans. When it shoots up, it’s a sign of mistrust — and problems — among banks. Libor spikes also signaled the European meltdowns in 2010 and 2011.

Now, Shibor, the Shanghai interbank offered rate used by Chinese banks, is flashing red. It shot up to 12% on June 20, its highest level since the summer of 2011. Sure, it has calmed down since, but it’s still elevated, and the decline is not necessarily an “all-clear” signal, says McDonald. After all, Libor signaled trouble for nine months before the Lehman meltdown.

McDonald likens the June Shibor spike to a warning tremor ahead of an earthquake. He expects another one around Sept. 30, at the end of a quarter, when banks have to roll over lots of debt. This is a natural time for the quality of bank loan collateral (assets) to go under the microscope. “There is very high probably that Sept. 30 will be a rocky time for the markets,” predicts McDonald. “If one quarterly refunding is rocky, the next one is normally rocky, too.”

He sees a similar red flag in recent spikes in the Chinese “repo rate,” an interest rate used in a different kind of interbank lending. McDonald calls both types of short-term lending among banks the “plumbing” of the financial system. “When it starts to freeze up, it affects all types of lending,” says McDonald. “This is what happened in the U.S. in 2008. And this is what is happening in Asia now.”

The good news is that Asian banks are less interconnected with the world outside than U.S. banks are, says McDonald. The bad news: Everyone is counting on continued rapid growth in developing countries such as China to lift the global economy. Clear signs of financial sector rot this will hurt U.S. stocks.

INVESTOR INSURANCE ON KEY BANKS WITH ASIAN EXPOSURE IS GETTING PRICIER

Another key Lehman indicator of trouble is the rate big investors have to pay for insurance on bank debt. When this price jumps, as it did ahead of the 2008 bank and credit sector meltdown, it’s a warning sign. One popular form of insurance here: derivatives known as credit default swaps, which repay investors if the bank debt goes bad because a bank goes belly up.

You don’t even have to own a bank’s debt; you can just buy the insurance, in effect betting the bank will collapse.

Recently, CDS prices have risen sharply for two banks with lots of exposure to China, the British banks HSBC (HBC) and Standard Chartered (SCBFF). This signals increased worry about the strength of these banks, due to fears that they are exposed to potentially bad debt in China. “This is the sniffer that tells you something god-awful is going on,” says McDonald. “Now, it tells me that something horrifying is happening in Asia.”

Since May, the price of CDS protection for HSBC has risen to trade in line with swaps for Bank of America (BAC) and Citigroup (C) debt. The price had been much lower for years. And the CDS prices for Standard Charter rose to match those for Morgan Stanley (MS), a similar kind of bank, when they, too, had traded much lower for years.

Here’s another bad sign: Since April, the number of investors betting against HSBC and Standard Chartered by shorting their stocks has seen a big  jump. In shorting, investors borrow shares and sell them, hoping the stock will fall so they can pay back the stock loans with cheaper shares later.

Standard Charter and HSBC declined comment. But HSBC has been dumping holdings of Chinese banks and insurance companies. Another red flag for China? I’d say so.

National Debt

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