A former business school professor of mine, Douglas Diamond, is one of the world’s foremost experts on financial crises and bank runs. A common theme in his Financial Markets and Institutions class was that all financial crises are the result of a run on the “bank” of some sort.
While many think of a run on the bank in the classic sense, as famously depicted in It’s A Wonderful Life, modern bank runs are less visible yet have the same incredibly destabilizing impact. For example, as Warren Buffett described this week, the run on the bank during the Great Recession came in the form of the September 2008 run on the commercial paper market.
This situation manifested itself when the Primary Fund money market fund broke the buck as businesses became unable to roll over their commercial paper. Up until that point, investors had treated money market funds as if they were as safe as bank deposits. However, money market funds aren’t insured by the FDIC like bank deposits are, so when people started to question the validity of the assumed safety of money market funds, panic ensued.
In the case of 2008 commercial paper run, as well as with many prior crises, there is always a demand for liquidity that the market infrastructure was not able to support. When this support ceased to exist, the models used to make decisions broke down. And anytime a model breaks down, whether it’s an technology platform for investing or an interbank lending market, uncertainty among investors prevails and all asset classes suffer in a flight to safety.
While the biological dynamics of the coronavirus are still unknown, the signs of the economic risk posed by the virus are fairly well-established. Global supply chains have been disrupted, and many have been revealed to rely on China more than was commonly understood. Demand for travel-related services has at least temporarily declined as businesses and consumers stay home to reduce the risk of infection. Overall lower economic activity due to the virus will therefore likely cause lower growth in the near-term, until the virus has run its course and the disrupted business activities can resume normal operation.
All of these risks, while not ideal, are fairly well-established and understandable. In fact, Goldman Sachs predicts that by the end of the year the S&P 500 will be back at 3,200 as the virus runs its course and the resulting economic impact is absorbed into 1H 2020 earnings and analyst estimates. When businesses can specifically attribute one-time disruptions to a non-recurring event, investors and decision makers are able to discount and look past that event.
As Professor Diamond consistently told us, the sign of a broader financial crisis is a bank run of some sort. I think the sign of a “corona crisis” in which the virus serves as the catalyst leading to a broader financial crisis will be a signal that there’s a run on liquidity. There are early signs that businesses are preparing for a cash crunch by drawing on their revolving lines of credit to ensure they have enough cash to meet payroll. Earlier today, Boeing announced plans to use its full $13+ billion revolver with JP Morgan. Likewise, private equity firms Blackstone and Carlyle have reportedly told their portfolio companies to proactively draw on their revolvers to manage cash flow challenges posed by the COVID-19 virus.
Whether these are simply prudent examples of managers exercising their fiduciary duty or early signs of a broader crisis remains to be seen. However, for investors looking to make sense of the current market conditions and trying to predict what will happen next the time-tested methodology for detecting a financial crisis remains true today: look for the run.