A walk through financial contagion

How did we even get here? A couple of months ago, we thought the worst was here. People lost their life savings with UST losing its peg, DeFi protocols lost a further 80 percent of all their value, and to top it off, three arrows capital liquidated their fund because they did not take a basic risk management course. The crypto space thought this was the bottom and couldn't get any worse. But we missed one critical point about contagion: it takes time. When a trader liquidates his account, he loses his money in seconds. But when a company has to liquidate its holdings, it takes time. Contagion takes 9 to 12 months to see the result. Before we dive deep into the history of contagion, we must understand what contagion is and where it started.

Contagions are known as financial crises with the potential to spread quickly and unexpectedly. It can virtually occur in a global or a domestic market. It happens in a domestic market when a large bank sells its assets; this affects the confidence investors have in other banks. While in the global market, as clear in the 1997 crisis, because of the devaluation of Thailand's baht, a large portion of East Asian currencies fell by as much as 38 percent, which spread across East Asia and Southeast Asia. This also affected markets in Latin America and Eastern Europe. Contagions are aggravated mainly by asymmetric information; this results in unsustainable investments and reactionary market downturns in response to the weakening of these markets.

Contagion is a structural feature of the financial system that is endogenous to the economics of maturity transformation. In my judgment, it is not likely to be resolved through better risk management or improved prudential oversight.

Without affirmative steps to contain it, the contagion problem will continue to haunt the financial system.

Contagion has played in the development of the US Federal Reserve System, which was created in reaction to the Panic of 1907. The Fed was the belief that private efforts of the clearinghouses to provide liquidity to their members were not sufficient to forestall panics. Worsening economic conditions can cause depositors to withdraw their money from weak banks in favor of stronger ones, showing that most bank failures result from homogeneous balance sheet impairments caused by the collapse in asset prices.

Looking at the 2008 financial crisis, finance professionals minimized the contagion role. Lehman was a dangerous transmitter of contagion. An increase in the price of a Lehman CDS caused subsequent increases in the CDS prices of other financial institutions. Lehman’s effect on other firms was the largest among global financial institutions. Undefined JPMorgan was a prime beneficiary of this kind of funding transfer during the financial crisis, as retail customer deposits defined and prime brokerage assets defined flowed out of weakened commercial and investment banking institutions and into JPMorgan’s insured deposit and prime brokerage accounts.

Several significant US financial firms that arguably possessed considerably stronger business models than Lehman, such as Morgan Stanley and Goldman Sachs, appear to have been affected by some degree of run behavior after the Lehman failure. Although significant bank runs were not a feature of the financial crisis, some large banks fell prey to runs. Wachovia faced a bank run on its deposits before its acquisition by Wells Fargo. Washington Mutual met a similar fate before its eventual sale to JPMorgan. Nonbank financial institutions also underwent severe runs, beginning with Bear Stearns and later spreading to critical segments of the short-term capital markets and the money market funds. Although no significant financial institution sharing Lehman’s essential business attributes collapsed because of Lehman’s failure, this was likely a reflection of the bailout signals transmitted by the Federal Reserve’s rescue and the multifaceted public support programs instituted by the US Treasury and the Federal Reserve.

Where did it all go wrong? Some of us think it started at the Luna collapse, but what if I told you it started a whole two years earlier. The history of contagion is quite similar; it always begins with cheap liquidity.

The 1997 Asian financial crisis was excessive borrowing by national banks. National banks continuously borrowed from countries abroad and continuously lent within their own country. It did not seem excessive at the time, but it appeared so in the aftermath. Bad loans were made, risks were taken due to misunderstandings, and the level of debt continued to grow.

The 2008 financial crisis was traced back to the bursting of the housing bubble in the United States and the increase in mortgage defaults. This came about as a result of the mandate by the U.S. Congress for the Federal National Mortgage to increase access to low-income housing. As a result of the high default rates, many financial institutions across the U.S. were affected.

Our contagion story started two years ago when Covid-19 hit. When the pandemic erupted, Bitcoin could be purchased for about 3900 dollars. November 2021, the same token costs more than $69000 – a staggering 1600 percent rise. Other cryptocurrencies, such as Ethereum, Solana, and Doge, increased significantly. A considerable amount of leverage has been built up in this system, and when some of this leverage gets taken out, we can see many other projects take a hit. When we look at the Luna collapse, it was a massive Ponzi scheme that spread throughout our industry. Bitcoin was forced lower, and projects lost their treasury because they believed in UST.

You must be wondering - when BOTTOM? Before we can even think about the bottom, bad actors and leverage must be flushed out of the system for us to find a bottom. If we look at the financial contagion history, it takes a year post-event to bottom. The bottom of the 1997 Asian crisis bled out till a bottom was found in 1998. The 2008 housing bubble burst in 2008, but only in 2009 did the stock market bottom. This is because it takes months, maybe even years, for the liquidations of companies to happen. This isn't a futures account where you can get liquidated in seconds. It takes a while for multibillion-dollar corporations to get liquidated. Based on past results, we might bottom in a year. From the Luna collapse, this means May 2023 - from the FTX bankruptcy, November 2023. I have no clue which month it happens; all I know is that it takes time. So load up on ammo because you will need more than one shot to buy the bottom.

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