National Post (National Edition)
Financial CRISIS: 10 YEARS later
Lessons from the great recession,
Adecade ago, Lehman Bros. filed for bankruptcy protection, effectively ending a 150-year story that saw the company rise from humble beginnings in Montgomery, Ala., to become the fourth largest investment bank in the United States. After that story ended on Sept. 15, 2008, 25,000 employees lost their jobs, and more than US$600 billion in assets was wiped out. Lehman’s was the largest bankruptcy in the history of the world at the time. And it still is.
So the collapse of Lehman Bros. was and remains a big deal. It was neither the first nor the last chapter in the most severe economic crisis since the Great Depression, but it was nevertheless an important demarcation point. Before Lehman, we could hold on to the hope that damage from the U.S. subprime mortgage crisis could be contained. After Lehman, the depth of the rot in the global financial system was frighteningly clear. The fallout was going to hit just about everyone, and it would hurt.
Ten years later, it’s tempting to forget — but hard to overstate — how bad things got.
The U.S. economy was already in a downturn when Lehman fell, but the ensuing crisis of confidence in the global banking system made things much worse, and helped tumble almost every developed economy in the world into recession.
While everyone suffered, Americans were hit particularly hard. Job losses numbered in the millions; unemployment doubled between 2007 and 2009. The equity Americans held in their homes fell by more than half, and real household income dropped by 6.7 per cent. Hundreds of U.S. banks went under; Freddie Mac and Fannie Mae, government-related companies that provided much of the secondary mortgage market, were effectively nationalized. Corporate casualties ranged from GM, which the U.S. and Canadian governments eventually bailed out, to an estimated 200,000 small American businesses.
Policy-makers acted aggressively, at least in the U.S. There were extraordinary fiscal measures, like the Troubled Asset Relief Program, under which the Treasury Department ended up assuming more than US$400 billion in toxic debt. There was extraordinary monetary policy from the Federal Reserve, which lowered the funds rate to near-zero and introduced quantitative easing. And yet the recovery from the depths of the recession in 2009 took years.
For investors, the declines in North American markets began in October 2007, and by the time of Lehman’s fall had already topped 20 per cent. After Sept. 15, 2008, it got worse: the S&P 500 index plummeted by 36 per cent in the month afterward, as bad news piled on bad news. The S&P/TSX composite index fell by more than 20 per cent in the three weeks after Lehman’s collapse, and followed the U.S. markets down to new lows through to March 2009.
Given how painful the Great Recession was, it’s not surprising that even a decade later, we’re still trying to figure out who was to blame. But where to start? With the predatory lenders who originated mortgages for NINJA borrowers (who had no income, no jobs, no assets), or the subprime borrowers themselves? The investment banks who securitized crummy loans into collateralized debt obligations and peddled them like they were gold, or the credit rating agencies who said that they more or less were gold? The Wall Street executives who reaped big bonuses before and in some cases during the crisis, or the boards of directors who let them do it? The politicians whose policies backstopped the housing boom of the early 2000s, or the regulators who failed to address the risk building in the financial system?
Well, take your pick. But the truth is, the path to the Great Recession was overdetermined. You can’t single out just one bad actor, or group of them. Subprime borrowers who were getting a chance at owning their own home, Wall Street alchemists who turned CDOs into a trillion-dollar market, investors who rode the bull as along as they could — they were just embodiments of the animal spirits of the time. Everyone tends to see things bigger from inside a bubble.
And like all crises, this one provided opportunities, too. Investors who got in and bought stocks at the bottom would have reaped the full benefit of a bull run that is now the longest in history. Since March 2009, the S&P 500 has risen by about 275 per cent; with dividends reinvested, the total return is more than 350 per cent. In short, buying the market in March 2009 was one of the savviest plays of all time.
Of course, that’s only clear in hindsight, and it underestimates the real fear that gripped investors during and after the crash. Anyway, it’s not 2009 anymore. We are now almost a decade into a bull market, and buying low in the equity markets is not an option. If today’s investors want to find relevance in the Great Recession, it will come from looking at the lead-up to the financial crisis and the way market participants behaved — and trying to figure out to what extent we are making the same missteps now.
Consider monetary policy. In some ways, the seeds of the subprime meltdown were born in the early 2000s, when the U.S. experienced a brief and mild recession. The Federal Reserve responded dramatically, however, lowering the target rate from 6.5 per cent to just one per cent between late 2000 and mid-2003. The low interest rate environment spurred the housing boom (from January 2001 to June 2006 housing prices rose by 70 per cent) and the excesses of the mortgage industry. When the Fed began to normalize in 2004, it raised rates into the teeth of a crisis. Home ownership peaked that year, and the combination of higher rates and falling demand started a housing price collapse that began in 2006.
Now, of course, it’s a different world; for one thing, banks globally are not nearly as leveraged as they were in the mid-2000s, thanks in part to post-recession regulations. U.S. mortgage debt is a fraction of what it was even as prices have recovered. Yet the similarities between the early 2000s and the current monetary policy environment linger. We are coming off a long period of very low interest rates that have supported higher asset prices, and now policy-makers are returning to “normal.” The chances of another banking crisis or U.S. housing meltdown seem remote, but the experience of the early 2000s suggests that monetary policy manoeuvres can have unintended consequences — and their reversals can be perilous tasks. When the crutches of low interest rates are pulled out from under them, economies can wobble.
Another lesson is that market participants tend to discount warning signs when sentiment is positive. Investors largely ignored the downdrafts in U.S. housing and the early portents of rot in debt markets. Even the near-collapse of Bear Stearns in March 2008 was followed by a two-month minirally on the S&P 500. This is about the time that U.S. Treasury Secretary Hank Paulson was saying that “the worst is likely to be behind us.”
Are there signals flashing yellow now that maybe we are ignoring? The epicentres of concern are in emerging markets, some of which (Turkey, Argentina) loaded up on U.S.dollar debt during the long low-rate era; with rates rising, their currencies and economies are now paying the price. (We are told the risk of contagion is low.) Trade tensions and tariffs are throwing into the gears of global commerce, but hardly enough to throw the world into recession. (Yet.) Corporate debt has skyrocketed, and so has consumer debt in some countries (like Canada). How exposed will they be amid rising rates? (We just don’t know.)
More worrying, perhaps, is the yield curve, which has been flattening amid the Fed’s tightening. Back in 2005, too, the Fed was hiking but long rates were falling, flattening the curve — something thenchair Alan Greenspan famously called a “conundrum.” (He also said that the yield curve was no longer a good predictor of recessions.) Well, the yield curve went on to invert twice in 2006, a phenomenon that had occurred before every one of the previous eight recessions. The 2007 recession made it nine in a row.
Are we on that path again? We are told (for instance, by the Bank of Canada) that tightening spreads are not a cause for concern. But that’s kind of what analysts said back in 2005. And as a recent paper from the Federal Reserve of Cleveland points out, professional analysts have been pretty bad at predicting inversions. Perhaps they’ve become better at it over the past 10 years.
Compared with the prelude to the financial crisis, perhaps it really is different this time. The world has enjoyed nearly a decade of economic expansion and upward-pointing markets. Ten years on from the 2008 meltdown, the global banking system seems more resilient to shocks, corporate profits are generally strong, and the bull market trudges along. But that in itself is a dangerous situation. As economist Hyman Minsky argued, “stability is destabilizing” — and we have had nearly a decade of it.
If the collapse of Lehman Bros. and the financial crisis should have taught us anything, it’s that something always has to give. Another crisis will hit, and we won’t necessarily know where it will come from or how severe it will be. And then we’ll find out just how sturdy the underpinnings of our decade of stability really are.
IT’S NOT 2009 ANYMORE. WE ARE NOW ALMOST A DECADE INTO THE BULL MARKET.