Oil Prices: The Next Test For Central Bankers

Most of the benefits of falling oil prices are obvious.  Consumers, whose median incomes have been falling too, are fist bumping over lower gas prices.  Businesses are seeing some energy costs fall, burnishing the bottom line.  Members of Congress, who aren't doing jack about stimulating the economy anyway, can breath a sigh of relief over the economic stimulus from the gas pump.

Falling prices, however, have downsides.  Today, the stock market tumbled because energy stocks are under stress.  The more vulnerable oil producing nations might default on their sovereign debt (think Venezuela, and maybe others).  Many oil frackers are heavily leveraged, and they could start defaulting as their cash flow sputters.  Some financial market players are surely taking losses on falling currencies of many oil producing nations (the ruble being Exhibit A).  More opaquely, but perhaps of great concern, big banks, hedge funds and other financial market players might well be taking losses on derivatives contracts bets linked to the price of oil or the currencies of oil producing nations.  With oil price losses approaching the 50% level in the past few months, it looks like we have a bursting bubble on our hands--and the potential for another financial crisis.

Recall that it wasn't falling real estate prices alone that triggered the 2007-08 financial crisis.  It stemmed from a poisonous synergy of massive quantities of poorly underwritten mortgage loans, falling real estate prices, defaulting mortgage borrowers (many of whom didn't have the ability to repay the loans, measured by any reasonable standard), a compounding of the losses because falling prices precluded the availability of refinancing, the massive impact of these losses on the financial system through diverse and obscure derivatives contracts not well understood by market players and regulators, and, ultimately, a surprising concentration of losses onto a single entity (AIG-Financial) to which numerous key players in the financial system had unmanageable exposures.  Only an unprecedented bailout by the federal government prevented the collapse of the world financial system.

A sharp fall in oil prices doesn't necessarily mean the financial system is at risk.  There was a proportionately larger oil price fall in the middle of the 1980s which didn't result in a financial collapse (although this occurred before the evolution of complex derivatives markets that allow risk to metastasize with blinding speed).  Another big drop in oil prices in 2008-09 also didn't tip the big banks into bankruptcy (although they were already in major bailout mode by this time because of the mortgage crisis, so this instance may not prove much). 

But the proliferation of risks created by today's highly imaginative financial engineering can mean that any major drop in the price of a key asset like oil could surprise us in unpleasant ways.  One lesson from the 2008 financial crisis is that regulators didn't know where the hot tamale would land, until it hit the fan.  Regulators worldwide should be sending their examination SWAT teams into the major money center banks and other key financial institutions to scope out the direct, secondary and tertiary impacts of falling oil prices.  And that should be now--as in right now--not weeks or months from today when it may be too late to take protective action.