The Next Financial Calamity Is Coming. Here’s What to Watch.

By Matt Phillips and Karl Russell

A decade ago this week, Wall Street imploded. Read our special coverage.

The global financial crisis is fading into history. But the roots of the next one might already be taking hold.

Financial crises strike rich countries every 28 years on average. Often, the break between busts is much shorter.

Fast-growing pockets of debt, as in the last time around, look like potential sources of problems. They’re nowhere near as big as the mortgage bubble, and no blow-ups appear imminent.

“But what we saw last time around is that things can creep up on you,” said Wesley Phoa, a bond-fund manager at the Capital Group. “You can turn around and in three years’ time you can go from not much of a problem to a pretty big problem.”

Total student loans outstanding

Total student loans outstanding

The amount of American student debt — roughly $1.5 trillion — has more than doubled since the financial crisis. It is now the second-largest category of consumer debt outstanding, after mortgages.

Public colleges and universities, hurt by state budget cuts, increased tuition. The drop in house values also made it harder for families to tap into their home equity to pay for tuition. As a result, the financial burden shifted to students, who took on heavier debt loads to pay for school.

Percentage changes in total loans outstanding since the fourth quarter 2003.

Percentage changes in total loans outstanding since the fourth quarter 2003.

Many borrowers are already falling behind. During the second quarter of 2018, more than 10 percent of student loans were at least 90 days past due. That was down slightly from a couple of years ago, but higher than the peak for mortgage delinquencies during the last crisis.

Serious delinquency rates

% share of aggregate debt

Serious delinquency rates

% share of aggregate debt

Source: Federal Reserve; Equifax

Could this spark a new crisis, with student loans playing the role that mortgages played a decade ago? Probably not.

The student loan market is much smaller than the mortgage market. And the main lender is the federal government, so even a surge of defaults would barely touch the banking system, unlike the mortgage meltdown.

The bigger issue is whether growing amounts of student debt may be a drag on consumers. Some think it could be playing a role in the decline of homeownership over the last decade, an important driver of spending in the consumption-led American economy.

After the crisis, central banks slashed their interest rates. Investors moved their money out of government bonds, which were paying essentially nothing. And they piled into corporate bonds, which typically pay slightly higher rates.

American companies were more than happy to satisfy investors’ ravenous appetites — and they did so by selling gobs of debt.

Corporate debt oustanding

Average from

1952 to 1998

Corporate debt oustanding

Average from

1952 to 1998

Sources: Federal Reserve; Bureau of Economic Analysis

There are signs that the borrowing binge may have gone too far. Debt issued by non-financial companies is near its highest levels, as a share of the United States economy, since World War II. In the past, such indebtedness has been followed by a rise in defaults.

Even in the market for the safest corporate bonds, funds have been flowing to the borrowers that have some of the lowest credit ratings — the category known as BBB. Roughly $1.4 trillion of the debt is currently outstanding, making it the largest single piece of the investment-grade corporate bond market, according to Standard & Poor’s.

More than $500 billion of these BBB-rated bonds are just one downgrade away from being junk, according to Fitch Ratings. A wave of downgrades could cause losses for investors, potentially scaring them from lending more. That would make it more expensive for companies to borrow and invest, weighing on the entire economy.

Share of corporate bonds with a BBB rating:

the lowest investment grade before junk

Share of corporate bonds with a BBB rating:

the lowest investment grade before junk

Source: International Monetary Fund

Developing economies are looking shakier — and, again, a main culprit is corporate debt. The amount outstanding in all emerging markets is now slightly greater than the size of their actual economies.

In China, the ratio of corporate debt to gross domestic product is above 150 percent, according to the Bank for International Settlements. Some Chinese companies are struggling to keep up with their loans as the world’s second-largest economy faces pressure. While China has significant financial heft to deal with problems, any issues could prompt jitters in the broader markets.

A key risk for many countries is that much of the debt is denominated in American dollars, as opposed to the borrowers’ local currencies. The loans are getting more expensive because the dollar has gained value in recent months relative to other currencies.

In Turkey, the lira’s plunge is already expected to unleash a wave of bankruptcies, and the risk of a recession there is rising. In the past, problems in one emerging market have tended to spread elsewhere, creating concerns about the health of the global economy.

Source: Bank for International Settlements

Once again, lending is growing outside the confines of the traditional, heavily regulated banking system, by entities like private equity firms, hedge funds and mortgage companies. The trend is especially pronounced in the market for home loans, where many mainstream banks still haven’t regained their hunger for risky lending.

Non-bank financial companies tend to offer loans to borrowers with lower credit scores and higher debt-to-income levels. But their standards are nowhere near as lax as the subprime mortgages that preceded the 2008 bust.

It’s much harder for regulators, investors and banks to keep track of where the risks lie in this so-called shadow banking sector, potentially allowing big problems to bubble up undetected.

Share of mortgages

originated by nonbanks

Share of mortgages originated by nonbanks

Source: Home Mortgage Disclosure Act data, via the Brookings Institution

Another pocket of concern is the fast-growing market for so-called leveraged loans. Banks make these loans to companies, and then sell off slices that are packaged up and resold to investors, like hedge funds, mutual funds and pensions. The market is much larger than it had ever been, with more than $1 trillion of the loans currently outstanding.

Investors are so eager to get their hands on these loans — because they have adjustable interest rates, they perform well when the Fed is hiking rates — that they’re accepting lower-quality deals. Some 80 percent of today’s institutional leveraged loans are known as “covenant lite” deals, because they offer weaker protections for investors.

So far, defaults in this area have been low, given the strength of the American economy and fat corporate profits. If growth sputters, that is likely to change.

S.& P. Leveraged Loan

Index market value

S.& P. Leveraged Loan

Index market value

Note: Data not available from May to June 2012 | Source: Thomson Reuters

Most financial crises are tied to excessive debt. But they don’t have to be. In 1999, the financial world was on edge because of fears about the Y2K bug. In the end — whether because widespread efforts to prepare computer systems for the new millennium were successful, or the concerns themselves were overblown — the disaster never happened.

But threats to the technological foundation of the world’s financial system have only grown more severe. Devastating cyberattacks are the greatest source of anxiety for big bank executives. In July, when lawmakers asked what risks kept him up at night, the Federal Reserve’s chairman, Jerome H. Powell, cited similar fears.

What financial companies think are

the biggest risks to the broader economy

Impact of

new regulations

Britain’s exit

from the E.U.

U.S. Federal Reserve

monetary policy

Sudden dislocation

in financial markets

Significant business

continuity event

Major compliance /

governance event

What financial companies think are

the biggest risks to the broader economy

Impact of new regulations

Britain’s exit from the E.U.

U.S. Federal Reserve monetary policy

Sudden dislocation in financial markets

Significant business continuity event

Major compliance / governance event

Percentage of respondents in a survey of financial service companies to identify the top five systemic risks to the broader economy, looking ahead into 2018 and beyond | Source: Depository Trust and Clearing Corporation

There’s no question that hackers are trying to penetrate the American financial system. The number of successful data breaches has been rising.

Banks are rushing to fortify their defenses. The crippling of a major financial institution at the hands of hackers could sow fear and instability across the entire banking system — the same sort of chain reaction that brought financial activity to a halt 10 years ago.

U.S. data breach incidents

U.S. data breach incidents

Source: Privacy Rights Clearinghouse