In 2005, the Harbinger of a Great Economic Storm

Years before the subprime mortgage crisis triggered the Great Recession and millions of Americans lost their homes, Larry McDonald, then a vice president at the now-defunct Lehman Brothers, discerned ominous signs in the real estate market. In a 2009 New York Times article, he described the situation as "living on borrowed time," with Lehman Brothers "headed directly for the biggest subprime iceberg ever seen."　　Despite his warnings, McDonald's superiors disregarded his concerns. The 158-year-old institution eventually collapsed in 2008 when the housing bubble burst, leading to a 50% loss in the SP 500's value during the subsequent 17-month bear market.

　　A Warning of Another Market Crash

　　Today, McDonald, founder and editor of the widely read investing newsletter The Bear Traps Report, sounds the alarm again, predicting another stock market crash. He relies on "Lehman systemic risk indicators" he developed after the subprime mortgage crisis. These indicators include corporate default rates, stock market short-interest ratios, and investor sentiment surveys, all of which are currently flashing warning signs.

　　"Our 21 Lehman systemic risk indicators point to the highest probability of a crash or a sharp drawdown in the next 60 days—the highest probability since COVID," McDonald told CNBC, referencing the COVID-induced market drop of March 2020.

　　Ignoring the Signs of a Rolling Credit Crisis

　　McDonald believes investors are overlooking the risk of a "rolling credit crisis" following the failures of Silicon Valley Bank and Signature Bank, as well as the unexpected demise of Credit Suisse. Instead, they are overly focused on emerging technologies like artificial intelligence and robotics.

　　"We saw this before with Lehman. A shock comes in, credit markets start pricing the risk, but equities don't. They focus on things like A.I. or the dotcom revolution in the '90s," he cautioned, drawing parallels to the errors made before the dotcom bubble burst in 2001.

　　The Spread of Instability in the Financial System

　　McDonald highlights the vulnerability of U.S. banks, despite the FDIC's intervention to protect depositors at SVB and Signature Bank. Banks hold hundreds of billions of dollars in unrealized losses due to the decline in value of mortgage-backed securities and U.S. Treasuries, a result of the Federal Reserve's aggressive interest rate hikes. This has led to instability, prompting many banks to tighten lending standards and prepare for potential bank runs.

　　The lending slowdown is now impacting the commercial real estate market, and McDonald worries that this could spread to other sectors of the economy as the Fed continues to raise rates to combat inflation.

　　A Different Kind of Crisis

　　McDonald emphasizes that this is not a "Lehman event" that would cause a devastating recession. Instead, he describes it as a "rolling, slow-moving credit crisis" that the Fed is attempting to manage behind the scenes. However, he warns that stocks are not immune, and a sharp drawdown is imminent.

　　Subscribe to Well Adjusted, our newsletter full of simple strategies to work smarter and live better, from the Fortune Well team. Sign up today.