Yves here. The second part of Das’ series on “What hath Trump wrought?” sets forth how a financial crisis would unfold, including the numerous sources of excessive leverage and therefore risk, as well as how an unwind might propagate. It seems that the very few lessons the officialdom learned after the 2008 crisis about contagion have been forgotten.
One place where I differ with Das’ forecast is he depicts real economy damage as primarily an effect of the catastrophe. A known unknown is that tariff/supply chain damage will accelerate (absent a major Trump reversal) on a track parallel to bank/financial system implosions (although as each crisis intensifies, they will increasingly feed each other). Remember, most small businesses facing a serious contraction won’t try to borrow their way through the slump (among other reasons, small business owners are typically personally liable for their debt). But they may have to make a more drastic downsizing if they have borrowed and have maturing debt they can’t roll over at all or face much higher borrowing costs.
By Satyajit Das, a former banker and author of numerous technical works on derivatives and several general titles: Traders, Guns & Money: Knowns and Unknowns in the Dazzling World of Derivatives (2006 and 2010), Extreme Money: The Masters of the Universe and the Cult of Risk (2011) and A Banquet of Consequence – Reloaded (2021). ). His latest book is on ecotourism – Wild Quests: Journeys into Ecotourism and the Future for Animals (2024).
Part 1 of this two-part series looked at the factors which may make a new financial crisis inevitable. Part 2 looks at the transmission of shocks, resilience and the capacity to respond to contain a new emergency.
All financial crisis have similar pathologies. Once triggered, the initial shock is transmitted along well known pathways until the contagion engulfs the entire economy. If it takes hold, then it is difficult and expensive to contain. Often it cannot be controlled and must burn itself out effectively eliminating excesses such as overvaluation of assets and debt. A series of economic and geopolitical shocks may have set such an event in motion.
Vectors
Like diseases, crises need a vector that propagates the pathogen. In economics and finance, it is the basis of income and value – cash flow.
Contraction of trade and activity reduces household and business incomes. Investment income falls as dividend, rents and interest rates decline. This, in turn, decreases consumption, which makes up around 50 to 70 percent of economic activity. Slowing demand reduces the need for new capacity.
As automatic stabilisers take effect, government transfers increase but cannot make up the income shortfall. In a major downturn, tax revenues fall and spending demands multiply. Tariff revenues cannot not fill the gap. During the first Trump administration, the additional revenue from agricultural tariffs ended up funding subsidies to affected farmers. Fear of wars means that many countries must trade off ‘guns and butter’.
Cash flow drives asset valuations. For profitable or cash positive operating businesses, economic slowdowns reduce earnings dragging down share prices. With corporations now a significant purchaser of shares, the fall in debt-funded share buybacks further drives lower valuations. Real estate and infrastructure project values are reliant on future rental streams. As they adjust, prices fall. For businesses lacking earnings or cash flow, survival depends on cash reserves and the ability to raise new funding from investors or through asset sales.
Values adjust to repricing of risk. In early 2025, equity risk premia (ERP), the additional return investors require for the extra risk of equities over safer government bonds, became negative, that is, investors were willing to accept lower returns on shares than safer bonds. In reality, it was caused by high bond yields and stretched equity valuations. This will eventually reverse as the true risk of equities is re-established. At the same time, credit spreads increase reflecting rising default risk due to a weaker economy, particularly for entities with low investment grade or non-investment grade ratings. The higher ERP and credit spreads offset any falls in absolute interest rates. The higher cost of capital increases discount rates used to present value future cash flows feeding lower valuations.
The shift away from cash flow compounds the problem. New age finance favours growth, market share and capital gains. The model, particularly for unprofitable technology start-ups, is to acquire customers at a loss, undercut competitors and bankrupt them and when in a market dominant position increase prices. The evidence rarely support this hypothesis. In practice, a constant stream of new entrants, funded by cheap capital and belief in their technological prowess, means the nirvana of market dominance and profitability is difficult to attain.
Cheap capital encouraged speculative investments for which enthusiasm is now flagging. AI is one example. Deriving from once similarly lauded neural networks, they are pattern recognition engines that generate probabilistic predictions rather than exhibiting reasoning or intelligence. Cheerleaders miss the point that a system which trawls existing data, even assuming that is accurate, cannot create anything new. There is the costs of computing power, electricity and other resources required. AI has to date generated no compelling profitable products. Microsoft CEO Satya Nadella drew the ire of true believers when he argued that AI had yet to produce a killer application to match the impact of email or Excel.
Another troubling new age investment is crypto. Given that they do not represent claims on real assets or cash flows, cannot be consumed and have no alternative use, they are only speculative objects worth what people ascribe to them. In addition, crypto assets are tightly held and traded between a small circle of investors creating “mutually supporting fantasies”. While elements of blockchain technology may be useful for recording property claims, crypto is unlikely to replace fiat money and become a reserve asset given its volatility making it an unreliable store of purchasing power. They are, as one commentator termed them, “consensual hallucinations”.
Ultimate spending power and value is determined by cash. Endless recutting and pasting these flows does not change anything. Many current investments are versions of the ‘greater-fool-theory’, financial charlatanism that believes you can always sell at a higher price to someone else. As cash flows decrease or the prospect of an investment producing money diminishes values will adjust.
Deadly Interactions
Declining cash flows and falling values interact with debt, the one thing that there is no shortage of. With nose-bleed levels of borrowings, households and businesses will struggle to meet obligations as incomes fall. Fiat money allows governments to continue the game by debasing the currency and purchasing power. They will issue new debt or create money, effectively paying interest and principal with new obligations that it cannot repay.
Despite the shocks not having flowed through fully, financial distress levels are rising. US business defaults hit a post-financial crisis high of 9.2 percent with rates for highly leveraged private equity loans and junk bonds reaching the highest levels since the pandemic in 2020. The International Monetary Fund has warned of rising levels of distress in commercial property. Delinquency rates on mortgage, auto, credit card and other consumer debt are increasing. Where America leads others will follow. With tariffs and sanctions raising inflationary pressures, the low probability of a return to ultra-low rates adds to the problem.
Falling values have multiple effects. As distributions decrease and losses mount, investor may sell their holdings or redeem fund increasing pressure on prices and straining liquidity.
Trading liquidity of currencies, government bonds and large capitalisation shares has declined markedly. This reflects consolidation of dealers and market makers after the 2008 crisis. It also reflects reluctance to hold inventory because of higher capital charges. Trading is now dominated by specialised quantitative traders, electronic trading and fund managers, who are not providers but users of liquidity. In periods of turbulence, trading will be at disadvantageous prices and incur substantial trading costs.
Illiquid private investments and a mismatch with redemption terms offered to the investor increase the likelihood of gating or suspension of redemptions. Those with longer memories will remember that BNP Paribas’ decision to halt redemptions at some of its funds due to inability to value or trade the underlying securities was a pivotal part of the 2008 crisis.
Liquidity constraints will accentuate price falls. Unable to realise illiquid assets, investors will sell more liquid positions driving values, including those of safe or unaffected securities, lower. Where unable to sell out of positions, they may hedge losses by shorting related assets placing additional pressure on prices.
Price declines affect borrowings secured over financialised assets. Mortgages are collateralised by houses. With leverage mandatory to boost returns, there are significant volumes of debt supported by real estate, shares, bonds, fund investments and even artworks. As values fall, the loan-to-value ratios rises triggering margin calls soaking up available cash or requiring asset sales.
Reliance on collateral is flawed. Deposits or initial margins are probably inadequate because of artificially low volatility and pressure to increase business volumes without concern for excessive leverage. The problem of wrong way correlation, where the underlying risk increases at the same time as the value of the collateral decreases, is underestimated. The ability to realise collateral as needed assumes liquidity which in practice is limited.
High leverage and multiple layers of debt increase sensitivity to asset prices. Investors, asset managers (which often themselves invest in multiple vehicles) and the underlying investment all have borrowings effectively reliant on the cash flows of the ultimate operating investment. The amount of debt is also increased by financial ‘innovation’ such as pay-in-kind securities where the borrower can meet obligations by issuing new IOUs. Falls in asset prices create a cascade of margin calls and forced selling.
Any market disturbance will increase volatility which will flows into risk models forcing further deleveraging as the collateral needed or frequencies of margin reviews rise. This affects loans as well as derivative positions which are largely collateralised. The correction of volatility may be exaggerated because over time volatility has been supressed by significant option selling to earn premium income to boost returns.
The interactions between declining cash flow, falling values, high levels of debt and rising volatility will prove toxic.
Pathways of Contagion
An interconnected financial system acts as the main pathway for spreading the crisis.
Potential losses are sizeable. In 2008, around $1.3 trillion of US sub-prime loans triggered the global financial crisis. Theexposure to riskier borrowers today is significantly higher. Global commercial real estate exposure is around $21 trillion. Non-investment loans and bond outstandings are around $5-6 trillion. Equity margin loans in the US are around $1 trillion and globally probably 3 or 4 times that.
Lending by regulated entities to the shadow banking sector are greater than $2 trillion globally ($1.2 trillion by US banks alone). Lending to hedge funds, private equity, private credit, and buy-now-pay-later companies is one of the fastest-growing part of the banking system. Hedge funds currently manage around $4.5 trillion, up from $2.8 trillion in 2008. They have recovered from the significant fall in assets under management after the 2008 crisis and have grown by almost 56 percent since 2015.
Global bank equity is around $6-7 trillion. Banks are leveraged around 8 to 10 times. Large losses would place some banks at risk of insolvency and threaten financial stability.
There are existing losses. Bank which purchased often long-dated bonds with excess liquidity which outstripped loan demand suffered markdowns from rising interest rates when inflation rose sharply in 2022. The failure of Silicon Valley Bankwas related to these problems. US banks currently have around $500 billion in unrealised losses, representing 50 percent of their Common Equity Tier One Capital. Global losses are 3 to 4 times that. Liquidation of these holdings would crystallise these write-offs reducing bank capital.
Following the 2008 financial crisis, regulators introduced stricter bank regulations. Known as Basel 3, they are still not fully implemented with the industry seeking to weaken them. Their effectiveness also remains untested. If hybrid securities and bail-in securities do not work as intended then the capital available to absorb losses will be lower.
In any event, the crucial factor in banks surviving large credit losses is liquidity. Banks operate with a fundamental mismatch using short-term deposits to fund longer duration assets. Rising credit losses may lead depositors, both retail and wholesale, to withdraw funds or limit exposures triggering a familiar bank run specially where the levels of deposit insurance are low. Regulations to improve bank liquidity reserves have not been stressed by a real crisis and their efficacy remain unclear.
The shadow banking system (non-banks including institutional investors, public and private funds, securitisation vehicles, family offices and HNWIs) is now a significant supplier of capital. However, the real equity and liquidity reserves ultimately supporting these investments is not transparent. Fund losses will directly flow through to institutional and retail investors. Some like insurers and pension funds are contractually obliged to pay out on their obligations. Others, if leveraged, may have to sell assets for liquidity to cover losses. Problems in private credit markets will affect banks which have significant exposure through their lending to non-bank financial institutions. The favoured strategy of ‘originating’ not ‘holding’ assets means that a disruption in private credit will leave banks with warehoused loans intended for on-sale. This will affect prices exacerbating markdowns.
The financial system now entails complex chains of risk with legal and financial rights or obligations, enforceability, and claim priorities uncertain. Transactions routinely involve multiple investors and lenders, sometimes managed by the same asset manager. One fund may hold equity interests while a related entity may be the primary creditor. Investors frequently collaborate in large transactions. Complex capital structures and competing claims will create conflicts of interest despite much-touted Chinese walls. Litigation and lower recovery rates may result in higher than expected losses.
Actual losses or mark-downs, because of lower prices, will result in a contraction of credit. This will exacerbate any economic slowdown given the model of debt-funded consumption and investment. The diminished supply of capital will place pressure on cash strapped firms. It will also affect the value of existing start-ups, many of which do not have sufficient liquidity to reach the operational stage and need follow-on funding.
The process is one of downward spiralling feedback loops. Losses lead to lower leverage and lower credit availability which leads to economic retrenchment setting off a new round. As markets become increasingly illiquid, struggling to handle the selling and worsening conditions, the crisis intensifies.
Resilience and Resolve
A system weakened over time lacks the resilience and capacity to respond to a new crisis.
The ability to absorb shocks is limited by low growth, much of its driven by government deficits and debt, and high prices. Businesses have not fully recovered from the pandemic. With disposable income reduced by wages lagging inflation and excess savings from the Covid19 period largely exhausted, individuals are struggling. 59 percent of US consumers would need to borrow or sell assets to cover an unexpected $1,000 emergency expense.
The wealthy have gained from rising asset prices. But these are phantom profits based on volatile market values. It is not cash in hand as the gains are unrealised. Investors are reluctant to sell because of fear of missing out on further appreciation. Many investors have taken out additional borrowings against these assets to fund spending. 50 percent of all US consumer spending now comes from the top 10 percent of income earners. The linkage between share and real estate values and expenditure means that consumption expenditure may be less reliable than in previous downturns.
Any new crisis will be global as the principal drivers affect all economies. The impact of restrictions on trade and capital movements, one of the key factors in the expected downturn, are especially pervasive. The first-order effects of trade wars will be particularly damaging for Europe, China and Canada. Second order effects from a decelerating global economy will be larger and more widespread.
Emerging markets, which have been under persistent stress, face problems. Those directly reliant on US trade, like Mexico, face major slowdowns. Asian, Latin American and African economies, integrated into Chinese supply chains, will be affected by the cage fight between the two great powers for supremacy. Lower commodity prices, as a result of slower demand, will affect raw materials producers. Remittances, the lifeblood of many emerging nations, will decline. Poorer countries, lower on the value chain and with limited ability to adjust, will be badly affected. Familiar vulnerabilities such as reliance on foreign investment, high debt, spendthrift policies, crony capitalism, corruption, dysfunctional rule and poor governance will be exposed.
Crises result in large loss of wealth. The US economy alone lost over $20 trillion in the 2008 financial crisis, although the number is disputed. There is the additional cost of support. In 2008, the US government committed around $2 trillion in interventions, bailouts and economic stimulus packages. The US Federal Reserve committed around $7.8 trillion in lending and asset purchases. Eurozone governments expended €1.5 trillion in capital support and €3.7 trillion in liquidity support for the financial system. While some of the money was later recovered from sales of acquired assets and institutions, authorities still need to be in a position to make the required initial commitment.
Governments and central bank’s ability to provide support is lower than in previous crisis. Chronic budget deficits, high public debt levels and the rising interest cost limit any new intercession.
Monetary policy is constrained by low interest rates which makes large cuts difficult. Central bank balance sheets remain overextended due to legacy quantitative easing programs. Between 2007 and 2022 (when they peaked), the assets of central banks of the US, Europe, UK and Japan increased from under $5 trillion to over $25 trillion. While now lower, they remain elevated at around $20 trillion. Central banks also have large unrealised losses on their holdings of bonds purchased at low yield due from rises in interest rates.
Another concern is availability of US dollars, in which a significant portion of capital flows are denominated. In past crises, there has been significant reliance on currency swap lines provided by the US Federal Reserve to other central banks. The amount extended reached around $600 billion in 2008 and $450 billion in 2008 and 2020 respectively helping stabilise money markets. There is no assurance that this will occur this time due to the punitive American approach to its allies. Some European central banks have raised this possibility.
If America does not honour its commitments, it will destabilise foreign exchange and funding markets that total tens of trillions of dollars. Even if large holders, like East Asian and Middle-Eastern central banks and sovereign wealth funds, make dollars available to ease shortages, it will push up interest rates and push down asset prices as holders liquidate to free up currency. This assumes that they are willing to do so. The Kindleberger Trap after the eponymous economist, identifies the danger that a fading power lacks the ability but the ascendant one lacks the will to supply a reserve currency. This was a factor in the Great Depression with the Bank of England unable to act as international lender of last resort and the US Federal Reserve unwilling to do so. It helped the crisis escalate into a full blown economic collapse. Any change to the Federal Reserve’s willingness to supply dollars would signal the end of its dominance as foreign ownership of US assets would diminish.
An internationally co-ordinated policy response is unlikely in today’s fissiparous environment. In 2008, Asian and the petrostate investors invested in troubled financial institutions, purchased government bonds and reflated their economies to support global demand. This is not possible as many like China and the petrostates have budget deficits or reduced surpluses. There are domestic challenges. China is managing the aftermath of a property boom. Saudi Arabia and other oil producers are restructuring to reduce dependence on oil and gas revenues. An additional concern is that a large part of their surpluses are invested in advanced economies, particularly the US, and are at risk.
Assuming large scale support from and bailouts by governments and central banks is optimistic.
The End of Illusions
The severity of the crisis is unknown. A real economy slowdown comparable to the 1930s is not inconceivable with a deep and long global recession possible. Large financial excesses, particularly, the disjunction between cash flow and prices, make severe asset value adjustments likely.
The process has commenced with large falls in the value of financial assets. The real economy effects will take longer to emerge. As economist Rudiger Dornbusch noted: “the crisis takes a much longer time coming than you think, and then it happens much faster than you would have thought”.
In a 1974 essay The Year It Came Apart, Arthur Miller observed that “an era can be said to end when its basic illusions are exhausted”. It is characterised by strangeness of the familiar and a deep seated fear and uncertainty which nobody admits to. We have arrived at such a moment. To paraphrase Nassim Taleb, this crisis will follow a path that maximises damage.
© 2025 Satyajit Das All Rights Reserved
This piece draws on material first published at the Nikkei Asian Review and New Indian Express. These pieces are co-published by the New Indian Express Online and NakedCapitalism.com.
