The Bubble Bursts

The following is Part III of a chapter of Market Panic: Wild Gyrations, Risks and Opportunities in Stock Markets 0470824727, by Stephen Vines, who updated it in the wake of the 2008 economic crisis. Reprinted with the gracious permission of John Wiley & Sons (Asia) Pte Ltd. The book is available through all major bookstores, US$19.95.

Although the crisis of 2008 is often described as 'Made in America' it is worth pointing out that the probable ignition point for panic came from France in August 2007 when BNP Paribas revealed that it was deep trouble, a revelation that immediately pushed up the cost of credit.

As rates rose, house prices fell, especially in the United States where the sharp incline in borrowing rates led to a high level of defaults, particularly on sub-prime loans and among clients who, almost certainly, should never have been allowed to borrow the sums they received from eager bankers. By October 2008, some 6 percent of all mortgage loans in the US were in default. This is more than two thirds higher than the level of defaults customarily experienced by the banks.

The problems of individuals struggling to make loan repayments rapidly started affecting the banks themselves. In 2007, America's five largest investment banks reported that their collective debts had risen to $4.1 trillion, equivalent to approximately 30 per cent of the US economy. By 2008, three of these banks were in crisis. Lehman Brothers went bust while Bear Stearns and Merrill Lynch (the bank with the bull as its symbol), resorted to fire-sale mergers to keep afloat. History is likely to record that the fall of Lehman Brothers on 15 September provided the trigger for the development of a fullblown crisis.

The bankruptcy of Lehman was the biggest in US history and came despite speculation that the US authorities would be prepared to launch a rescue as the bank's leaders had confidently expected. At this point, the crisis came forcibly to the attention of the American public and prompted the mood of panic.

And, while Wall Street was busy putting out fires, an even bigger fire fighting operation was underway in Europe where Fortis, one of Europe's largest banking and insurance corporations, had to be rescued by the Netherlands, Belgium and Luxembourg at a cost of €11.2 billion ($16.1 billion) in return for partial nationalization.

All squeamishness about a return to the days of nationalization quickly faded across Europe as the British government injected a total of £37 billion ($55.5 billion) into three retail banks to prevent them from going under and secured partial ownership in return. Germany quickly followed suit by rescuing its banks and, in tiny Iceland, where the banking sector had expanded to a remarkable degree, the entire nation was faced with fiscal collapse as a result of their banks' exposure.

Elsewhere in the world, it soon became clear that the credit crisis on Wall Street was in fact a global crisis, or to be more exact an American and European crisis, although nations in Asia and Africa were rapidly drawn into the vortex even though their financial institutions were not brimming with toxic debts. Their problem was that they were trading with the West, were recipients of investment funds from the West and were themselves investors in the US and Europe.

That delicate instrument, market sentiment, having swung into negative territory was also impacting on the confidence of local investors in Asia. The irony was that, in some cases, like China, their stock markets suffered even bigger falls than the markets in the West because they were already dangerously overvalued but, in others, such as Hong Kong, they suffered simply by being an open and liquid market which enabled investors to get their hands on badly needed cash to settle positions acquired elsewhere.

In mid-November 2008, Jim Rogers, the fund manager who made his name by predicting the commodities boom of 1999, estimated that more than $28 trillion had been wiped off global equity prices, accompanied by $690 billion in credit losses and write-downs. The Bank of England put that figure higher at $2.8 trillion but in reality all these figures are little more than 'guesstimates', albeit useful for conveying some idea of the magnitude of the crisis.

As stock prices declined, average global price-earnings ratios, based on the MSCI All Country World Index, fell from a high of around the mid-30s in the late 1990s to around 10 as the crisis took hold in 2008. It should be noted, however, that this is far from being an all time low – that dubious distinction was achieved in the mid-1970s. Most striking is the fact that volatility in the stock markets returned to levels not seen since the 1929 crash. This increase in volatility is viewed by many analyists as an unprecedented opportunity for trading. However, while markets are in such a state of flux the prudent investor is almost certainly best advised to stand on the sidelines.

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A real panic

In a background paper produced by the IMF's researchers for the November 2008 G20 summit of leaders from the world's 20 leading economic nations, the IMF forecast world economic growth declining by 1.5 percentage points to 2.2 per cent in 2009. However, the most advanced economies, the US, the Eurozone and Japan, were seen as suffering their most significant economic decline since World War II with a collective 0.3 per cent fall in growth. Every single major European economy was either in recession, or headed that way, by the last quarter of 2008. In November, Japan joined the nations in recession. The United States was hesitant about admitting that it was in the same situation but as Japan made their admission, the US administration was already conceding it was in the position but delayed using the 'r' word. It was said, with reason, that this was the worst economic situation since 1929.

The only reason that the world as a whole was not forecast to go into recession was that the two powerhouses of China and India were maintaining impressive growth levels in 2008, and were forecast to maintain growth in 2009, albeit at a slower pace than in the previous year. China's economic growth was forecast to decline from 9.7 per cent in 2008 to 8.5 per cent in 2009, while India was forecast to see its economy expand by 6.3 per cent in 2009, compared to 7.8 per cent the previous year. Possibly for the first time in history, we saw global economic growth being sustained by the so-called developing world while the advanced economies were busy dragging down the overall growth picture.

At the November 2008 G20 meeting, called to find ways of tackling the crisis, the leaders struggled to explain what had happened. It is worth quoting in full their explanation of the root causes of the crisis. Their statement said:

"During a period of strong global growth, growing capital flows, and prolonged stability earlier this decade, market participants sought higher yields without an adequate appreciation of the risks and failed to exercise proper due diligence. At the same time, weak underwriting standards, unsound risk management practices, increasingly complex and opaque financial products, and consequent excessive leverage combined to create vulnerabilities in the system. Policymakers, regulators and supervisors, in some advanced countries, did not adequately appreciate and address the risks building up in financial markets, keep pace with financial innovation, or take into account the systemic ramifications of domestic regulatory actions.

Major underlying factors to the current situation were, among others, inconsistent and insufficiently coordinated macroeconomic policies, and inadequate structural reforms, which led to unsustainable global macroeconomic outcomes. These developments, together, contributed to excesses and ultimately resulted in severe market disruption."

Unusually for a statement of this kind, and albeit couched in the type of diplomatic language to be expected from such gatherings, this provides a reasonable summary of how the crisis arose. The solutions offered by the national leaders were less specific but there was a strong commitment to continued funding for economic bailout packages and declarations of intent to reform the IMF. Also, there was to be focus on the urgency of global trade talks, essentially stalled since the 2001 launch of the Doha round of discussions on trade liberalization. Lastly, the leaders talked of plans for greater coordination between central bankers and others responsible for fiscal policy.

By the end of November, the financial newswire, Bloomberg, calculated that the total sum of guarantees, loans and other support measures, given by the US government alone, exceeded $7.76 trillion. A significant amount of this sum includes credit and bank deposit guarantees but much of this is real cash coming out of national treasuries. At the time of writing it is hard to forecast what the total international bill will come to once the debris has been cleared, optimists even see the figures falling sharply as the recovery comes around and money given to institutions in the form of payment for equity is returned at a profit.

The left-wing American academic, Noreena Hertz, describes the panic of 2008 as 'the first full crisis of globalization, a recognition that in a tightly interconnected world, one country's troubles become reach and every one's. It is the first collective "lose, lose" This may appear to be the case but it cannot be overemphasized that the kind of contagion seen in 2008 was only really more global in the sense that there are now financial markets in every corner of the world.

Back in 1929, when markets of this kind were mainly, but not exclusively, confined to Europe and North America, the contagion spread only marginally slower than in 2008 but the Wall Street crash was replicated on every single other financial market existing in the world at that time. And what is most remarkable is the way in which the panic of 2008 spread to markets like the Chinese stock markets, which has relatively few international investors, with every bit as much force as in markets where international trading was a far more significant factor.

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Stages of the 2008 panic

The panic of 2008 showed that little has changed or, to put it another way, this crash follows the pattern of its predecessors in a remarkably consistent fashion. The cycle shows how markets start with a period of euphoria, usually prompted by a significant development. In this instance the origins of the 2008 crash can be traced to the beginning of the new millennium when there was an enormous supply of cheap and plentiful credit to business and individuals.

In all cycles, developments of this kind are followed by an expansion of money supply, which in turns stimulates heavy speculation and borrowing. Then, novices start pouring into the market and are easily persuaded to get involved in speculations that they barely understand.

And, as they do so, news of market matters moves from the business pages to the main pages of newspapers – this is a major warning signal at all times, and at all times largely ignored. Then, as we have seen above, more concrete warning signals emerge as price-earnings ratios reach quite unrealistic levels and yields on stocks become derisory. But these warning signals are also ignored because there is much talk about new paradigms and rejection of so called 'old fashioned thinking' which focuses on indicators which are dismissed as being no longer relevant. Another stage is reached when companies realize that there is near insatiable demand for new equity issues and new forms of debt instruments to cater for this investment appetite.

Generally, at this point in the crisis cycle, another rash of warning signals start flashing as dubious practices come to light and a number of scams are exposed. In the 2008 crisis, there was a flurry of excitement in June when the US Federal Bureau of Investigation arrested 406 people from Lehman Brothers over allegations of mortgage fraud. At around the same time, two former officials from the investment bank, Bear Stearns, were charged with criminal offenses related to the collapse of two hedge funds linked to sub-prime mortgages. But, back in June 2008, it was still thought that maybe these problems were little more than aberrations.

It is around this time that the more savvy investors started heading for the market exit. As they did so, lending institutions became more insistent about repayment of loans and made conditions of repayment more onerous, thus forcing sales of assets, which led to greater downward pressure on prices. The next stage of the panic cycle emerged as the plunge in prices turned to full flight and the price of good assets tumbled alongside the weak.

Usually, there is a specific incident that greatly exacerbates this flight. History may well record

that the tipping point for the 2008 crisis was, as pointed out above, the collapse of the US investment bank, Lehman Brothers, on 15 September, having posted a loss of $3.9 billion for the three months to August and then slowly revealing its large basket of toxic debts.

What happened after the Lehman failure was what happens in all market panics at this stage of the cycle. Markets appear to be in free fall and widespread revulsion develops towards the very assets which once basked in the sunlight.

Hence, in 2008, phrases such as 'subprime lending' and 'hedge funds' became terms of investor abuse, much as odium attached itself to the word 'dotcom' at the end of the 1990s Internet boom. And, in the same way that it proved wrong to consider all dotcom companies as being beyond the pale, as memoryof the bust fades, it will surely be the case that aversion to hedge funds will dissipate because there will always be a place for hedging in the investment world, there will always be derivative products and, of course, there will always be leveraging of investments.

This is also a time for reviewing heroes and anti-heroes. When the markets were booming at the beginning of the new millennium those who made the most money were adoringly featured in numerous newspaper stories and invited to pontificate on TV and radio shows. But, as the

markets plunged, sentiment towards these people turned with equal venom. The Wall Street Journal, the house publication of free marketers, ran an interesting story on 21 November, 2008 describing how, just ahead of the crash, the heads of 120 major US corporations, including those hit hardest by the bust, had swiftly pocketed over $100 million in cash compensation and stock sale. Stories like this provoked a wave of anger against the failed heroes who were once able to command wide public respect.

What happens next is the most problematic stage of the panic cycle as markets remain intensely depressed yet some minds turn to thoughts of recovery as seemingly irresistible bargains start to emerge. This stage of the panic cycle contains a number of false dawns when, because of the extreme volatility of markets, it appears that the carnage is over. On 13 October 2008, for example, the DJIA rose by 11 per cent, the fifth-biggest percentage rise in the history of the index – all-time records were set in 1929, 1931 and 1932 (see Figure 2.1). In London meanwhile, on the same day, share prices rose by 8.3 per cent, the second-biggest gain since 1987.

Note these dates because, as ever, the most spectacular share price gains came during the depths of past crises – in America it was during the panic that started in 1929 and in London the price rise followed the Black Monday collapse of 1987.

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The 2008 panic in perspective

The 1987 panic was remarkably severe but, equally, remarkably short lived and, unlike the panic of 2008, it was not accompanied by a full blown recession. In this sense, it contained many elements of a phony panic of the kind discussed in Chapter 3. The biggest worldwide panic before the events of 1987 came in the mid-1970s, triggered by an enormous hike in oil prices engineered by the oil cartel of the Organization of Petroleum Exporting Countries (OPEC) and was greatly exacerbated by the collapse of the Bretton Woods agreement, forged in the aftermath of World War II, to stimulate economic recovery and bring stability and liquidity to the international financial system.

The 1973–4 crisis delivered a nasty shock to the system and forced stock markets into trading on even lower price-earnings ratios than have been seen in the crisis of 2008, yet it was less severe than its predecessor, the crash of 1929, which is now viewed as the closest counterpart to the crash of 2008.

Such is the severity of this crash that some people seem to think that crashes are a more pronounced feature of financial markets today than they were in the past. This is not so, there were more crashes during the nineteenth century but there was one every decade in the twentieth century which was also a millennium that witnessed 30 bear markets on Wall Street and 25 in London. The generally recognized definition of a bear market is a 30 per cent decline in prices over a 50-day period.

But, in the last century, and in the current millennium, the most notable aspect of market panics is that they are either localized or sector specific. The biggest of the sector specific crashes was

the dotcom bust of 2000 which was mainly seen on New York's Nasdaq , cutting share prices in half and then pummeling them again to produce a further decline of the same order in the space of a month. The Nasdaq Composite Index has, at the time of writing, never recovered, indeed it languishes at around 30 per cent of its peak of 5,048 points, reached on 10 March, 2000.

The dotcom crash was essentially centered on hi-tech stocks but, as the Nasdaq crashed, other sectors were affected and the wave of destruction swept around the world; it was probably the biggest sectoral crash since the great railway-related crashes of the mid-nineteenth century.

Meanwhile, the most distinctive crashes of the last century have been regional; the Asian markets crash of 1997–98 was the most significant and spread to both Brazil and Russia but this was less severe than the Japanese crash of 1990 which has led to problems that have lingered for two decades. Mexico had its very own crash between 1994–5 and a number of smaller nations have also suffered nasty slumps which remained confined to their borders.

Although it may appear that globalization and the enormous power of international capital residing in an ever shrinking number of hands has made markets more unstable and, thus, more prone to panics, the evidence is thin on the ground. What happened in 2008 has happened before and, as we shall see, there is a remarkably well-defined pattern to market panics which is the subject of the rest of this book.