Dear Valued Clients and Friends,
In thirteen months there will be substantial coverage of the ten-year anniversary of the financial crisis, and we will surely join the fray. Despite anything I say below, the historical memorialization of the financial crisis will forever be affiliated with the Lehman bankruptcy of September 2008, and then, of course, the famous events that followed (AIG bailout, Merrill-to-BofA, Goldman/Morgan Stanley bank holding company, Wachovia-to-Wells, and TARP). All of these events took place in September 2008 (not to mention the formal nationalization of Fannie Mae and Freddie Mac), so September 2008 represents a more meaningful and memorable “archive point” in history and media.
However, from a more academic and technical standpoint, it is quite fair to say that this week represents the 10-year anniversary of the financial crisis. It was August of 2007 that saw the subprime market roll over, it was August of 2007 that saw credit markets freeze (for a time), and it was August 2007 that saw the famed French bank, BNP Paribas, freeze billions of dollars of assets in several mortgage-heavy investment funds1. Many of the other events proved to be warning signs that did not technically hit fruition until later (Countrywide’s appalling statement that their financial condition “could be affected” by “unprecedented disruptions), but there was foreshadowing in August of 2007 that ten years later warrants reflection. As fate would have it, the Dow would rebound from August carnage to hit its then all-time high two months later (in October 2007), before beginning a peak-to-trough decline that would reach in excess of 50%2. Bear Stearns would not meet its collapse until March of 2008. And as previously mentioned, the various “climaxes” of the crisis are associated with September of 2008. But it was August 2007 that can really be considered an anniversary of monumental consequence historically.
The feeling of recovery after August 2007 which served to delay the inevitable should not be allowed to belittle the lessons August of 2007 taught students of capital markets and monetary policy. 20% of the payments on non-prime mortgages (subprime, but far more systemically, “Alt A,” the real story of the financial crisis) were at least thirty (30) days late in August of 20073. That number would, of course, get a lot worse in the months and quarters that followed. In hindsight, it seems almost surreal to think that the nation’s largest lender admitted to fully 20% of their largest category of the borrower being late, and we did not take it as a sign of systemic catastrophe to come. Investors left the mortgage market en masse, refusing to buy or securitize anything besides that which Fannie and Freddie were guaranteeing. Financial intermediaries were nowhere to be found. Asset prices could not be marked across the credit spectrum, and a complete and total disappearance of buyers, dealers, and intermediaries took place seemingly overnight. It was the most deafening bout of silence I have ever experienced.
Typical responses then followed – demands for more collateral from financial entities holding a lot of the dubious assets. In the dotcom era when I was younger in my career, we had an expression: “Your first margin call will not be your last.” A parallel quote in the mortgage/credit meltdown of 2007/8 may have been “you’re circling the drain, and the only question is whether you go down in one day or one year.” It was a vicious cycle that followed all economic logic and predictability: Fundamentals deteriorated, which forced lenders to take precautions, which caused the fundamentals to worsen still, which confused the difference between a liquidity and a solvency crisis. Earnest pleas that “our capital position is fine” were ignored, and the lack of confidence and faith in the marketplace changed the truthfulness of the pleas, if they were ever true to begin with (they weren’t).
The story of 2007 was a story of leveraged finance, on steroids, sent to hell, and then allowed to play out after August 2007 all the way until the apex we now call September 2008. In reality, the United States of America possessed a housing market, and a financial system behind it, which was deeply, and substantively over-levered. It was not merely lacking liquidity; the assets were rotten. Financial companies had been trading paper and securing debt with paper that was worth a fraction of what was being assumed. Stocks were doing fine. GDP growth was doing fine. But credit markets were telling us in August 2007: “Things are not fine.” They actually were using profanity to tell us; we just didn’t know what we didn’t know.
And by “we,” I do not merely mean investment professionals, but more consequently, policymakers. Central banks were convinced the world financial system was suffering from a liquidity crisis, and as John Taylor so eloquently laid out in his masterful book on the subject, embarked on a lengthy endeavor to treat a solvency problem as if it were a liquidity problem. This provided just enough excuse to toxic asset holders to not deleverage, and the financial system would collapse a year later behind even worse conditions than August 2007 foreshadowed. Deleveraging and aggressive efforts to raise capital pre-crisis would not have avoided recession, but surely would have softened the pain that eventually came. The bad news did not get better with age in 2007/8, it got worse. Insolvency is a nasty parasite.
We do not face the same financial system conditions today. Balance sheets are dramatically de-levered; capital ratios in banks much higher; and inter-connectedness quite re-defined. An over-levered borrower or hedge fund may blow up, but they are highly unlikely to bring down a bank or investment firm with them. Many intrinsic weaknesses in the financial system still exist (the balance sheets of sovereign nations, for starters), but credit markets are in a different place. But do we know more today about the difference between a liquidity crisis and a solvency one? I doubt it. Central banks succeeded in moving toxic assets off of one balance sheet and on to another, and a host of policy tools adequately distorted markets enough to allow time to heal certain impairments. And of course, much of the bad debt was liquidated, as it simply had to be. Capital holes were blown up, and the carnage was ugly for equity-holders in such financial outfits.
Across our economy today, events are better, but principles are not obsolete. Liquidity crises create negative feedback loops. Solvency crises prevent any possibility of stemming the tide other than the inevitable and unavoidable pain of deleveraging. Mark-to-market accounting has been gratefully put off to pasture after it was allowed to do incalculable damage to an already frayed financial system. What should students of August 2007 believe about the future? That capital structure matters – that debt and equity require management and consideration, not blind faith or apathy. That policymakers are most prone to using short term solutions to long term problems, and exacerbation can be a real (and frightening) reality.
And most of all, that it is better to be early than to be late. Anyone who jumped out of Countrywide and Lehman in August 2007 can attest to that. And you know who else can? Those who didn’t!
David L. Bahnsen, CFP®, CIMA®
Chief Investment Officer, Partner