The stock market has made gains at rates that are several multiples more than the growth of the real economy for three years running. Investor euphoria is always a sign of danger ahead, but this time there are other special factors signaling a pending crash. And of course, they all interact. Once investors head for the exits, others start bailing.
I. Deregulation of Increasing Risk. Trump’s bank regulators are systematically dismantling the safeguards that were put in place after the financial collapse of 2008. That crash was caused by opaque financial instruments such as credit derivatives that allowed almost infinite amounts of leverage. When they turned out to be worthless, the collapse was also nearly infinite.
In the aftermath, Congress and the regulators limited the risks that banks could take. In classic Wall Street form, the wise guys responded by creating non-banks that could do most of what banks do.
One “innovation” was private credit, a cool-kid word for shadow banking. Another was fintech, a cool-kid word for shadow banking with an app. These newly invented lenders are banks in everything but name, and thus evade nearly all transparency, supervision, or regulation. Absent regulation, these non-bank banks can engage in sky-high leverage, meaning that the ratio of lending to their own real capital can be unlimited and unexamined.
In 2013, as part of the post-2008 reforms, the Federal Deposit Insurance Corporation, the Office of the Comptroller of the Currency, and the Federal Reserve put in place leverage limits for banks. Loans worth more than six times a company’s annual earnings were seen as too risky. That ruled out a lot of bank loans to fund private equity takeover targets, or loans to tech fantasies that had no earnings.
Private credit stepped in to fund those projects that banks couldn’t take. Capital raised for lending to private equity–backed companies jumped more than a hundredfold to nearly $700 billion between 2006 and 2024, according to The Wall Street Journal.
One thing that isn’t well understood is that private credit is propped up by traditional banks; Moody’s reported in October that banks have lent $300 billion to private credit firms. So if those firms go kablooey, it won’t stop short of the broader financial system, but cascade through the heart of Wall Street. Nevertheless, the banks complained to the regulators that they were losing business (to the very companies they were funding).
Given what we know about the crashes of 2008 and 1929, the right policy would be to bring the upstarts under the regulatory umbrella. But instead, last Friday the agencies agreed to the bankers’ demands to help competition by deregulating the banks and getting rid of the 2013 leverage limits. Now, dealmakers can play banks off against private credit entities for the best (most risky) terms. And banks can go beyond funding non-banks and set up their own non-bank affiliates. When the inevitable crash comes, government will bail out the insiders, leaving regular people to suffer the aftermath.
II. Crypto. The value of Bitcoins and other cryptocurrencies have been on a wild ride. Crypto plays no useful function in the economy except for pursuing illegal transactions and speculation in crypto itself.
When crypto was the next new thing, and investors keep bidding up the market value of crypto coins, everyone looked like a financial genius. The whole market has been banking on self-enrichment by the Trump family and his key allies—like Commerce Secretary Howard Lutnick, who handed his crypto-friendly bank Cantor Fitzgerald to his son and has seen it enjoy its best year ever—leading to regulatory leniency and therefore freedom to make a fortune.
Congress, on the take from the crypto industry, added to the hype last July by enacting the GENIUS Act, which stands for “Guiding and Establishing National Innovation for U.S. Stablecoins.” The act, written by the industry, pretends to provide prudent regulation, giving crypto a kind of federal blessing, but with no real protection for investors.
But as the old Wall Street saying goes, genius is a rising market. And here again, leverage that works brilliantly on the upside becomes catastrophic when prices start falling. In recent weeks, Bitcoin, the marquee crypto product, has fallen from a peak value of just below $126,000 on October 7 to about $90,000 today. In just one week in November, the asset class lost $400 billion in value.
This collapse has multiple knock-on effects on residual crypto plays. As Bloomberg recently reported, “An array of public companies thought they had found a sort of perpetual motion machine: Use your corporate cash to buy up Bitcoin or other digital tokens and presto, your share price shot up even more than the value of the tokens you bought.” But once prices started falling, “The median stock price of US and Canadian-listed digital asset treasuries has fallen 43% this year, with some companies’ stocks falling over 99%.”
When the crypto craze began, traditional financial companies were insulated from it. But Wall Street has tried to get in on the action by sponsoring crypto-backed funds, exposing blue-chip firms like BlackRock to risk.
I recently got a pitch from a crypto company promoting the story of how an entrepreneur in Argentina shielded himself from exchange rate risk and inflation risk by loading up on Bitcoin. In fact, the entrepreneur could have gotten exactly the same benefits by buying dollars. Buying Bitcoins rather than dollars added the risk that the Bitcoins would lose value—which they have.
What’s really happening, as it does in every Ponzi scheme, is that the wise guys, who profited handsomely by getting in early, need more rubes to keep buying the stuff in the hope that it will hold its value. As crypto becomes more interconnected with the rest of an unregulated financial system, the risk is that they will take each other down.
III. Artificial Intelligence and Tech. Is the AI boom a bubble? Apologists for the massively inflated value of Nvidia and other digital stocks reliant on the growth of AI keep pointing out that unlike pure stock market bubbles, where inflated stock prices are based mainly on the hope of further price rises, AI is adding real value and Nvidia is earning real and massive profits. Maybe.
On the other hand, a dangerously concentrated share of the stock market’s run-up, more than half, is in just seven companies, the so-called Magnificent Seven: Alphabet, Amazon, Apple, Meta, Microsoft, Nvidia, and Tesla. Of these, Tesla is already faltering. Another tech giant, OpenAI, had a disappointing rollout of the latest version of its marquee product, ChatGPT.
The massive bet on AI may pay off in many respects. But any economy that is this highly concentrated is at risk. With inflation rising and the cost of capital increasing with it, the $3 trillion widely projected to be invested in AI in the coming years becomes more costly and risky. Meanwhile, China, which just rang up its first trillion-dollar annual trade surplus as of the end of November, is challenging the U.S. lead in AI.
Plus, as the Prospect has reported in detail, the way the build-out of AI is being funded bears numerous resemblances to the housing bubble, with dicey loans, loads of hype, and circular financing. A loss of demand or simply someone calling in their loans could lead to a crash.
I am not licensed to provide investment advice. It could be that the highly leveraged loans by private credit will pay off; that the value of crypto will rebound; and that AI will live up to its hype. The Red Sox could also win next year’s World Series.