What led to the 2008 crash?
|Our Correspondent||Mar 31, 2009|
The following Part II a chapter of the highly-acclaimed 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. Part III will be available tomorrow.
See Also:Part I of Market Panic.
A case can be made for tracing the origins of the 2008 crash back to the development of the Black-Scholes formula in 1973 which, in essence, provided a mathematical equation for pricing risk. It was originally devised as a means of pricing stock options but the authors, and a host of their followers, quickly came to realize that the formula was applicable across a whole range of derivative products, including the securitization of loans, which were then bundled together with what were, in effect, option positions and leveraged on the original asset, that is, the loans. The authors of the formula were not advocates for the development of ever more sophisticated derivative products. But they provided the tools which gave confidence to those in the financial community who devised these products, even if they were often only dimly aware of the origin of the tools they were using. What they grasped was the fundamental idea that once a value could be placed on risks it was possible to package and repackage loans.
Armed with these tools, US financial institutions and their counterparts in Europe (but to a lesser extent) borrowed vast sums of money from 2004 to 2007 and, in particular, made investments in mortgage-backed securities. This period marked the height of this business, although securitization of loans in the US can be traced back to the 1970s – a process greatly assisted by guarantees provided to investors by the government-supported Federal National Mortgage Association (Fannie Mae) and the Federal Home Loan Mortgage Corporation (Freddie Mac).
Underlying this flurry of loan securitization was the assumption that home values would continue to appreciate and that mortgages would be repaid. It looked like a classic no-brainer – borrowing at low interest rates to invest in higher yielding products. In 2004, the US Securities and Exchange Commission (SEC) fueled the borrowing frenzy by granting permission for investment banks to increase their debt levels, which they did with enthusiasm and proceeded to buy larger and larger numbers of mortgage-backed debt securities.
Before the SEC changed the rules, banks were obliged to keep their leveraging ratios within 10 – 15 times of their core holdings. Once these rules were relaxed leveraging ratios more than doubled in a staggeringly short space of time. This relaxation also meant that United States global corporations and financial institutions intensified their search for ways of moving their business either into the US itself or to offshore locations where restrictions were similarly relaxed or even more so. And in Britain, according to the Bank of England, the banks headed into the crisis of 2008 with outstanding loans of some £6 trillion, supported by a capital base of just £200 billion – in other words, a ratio of 1 to 30 in terms of capital base to lending.
The net result of all this in the US, Britain and elsewhere was both to greatly boost loan portfolios and to do so in a way that seemed less risky as the widespread securitization of loans appeared to shift risk from the lenders onto a much wider base of investors.
A World Bank research paper correctly points the finger of blame at US government policy for “supplying an unprecedented expansion of Federal Reserve liquidity facilities and Federal Home Loan Bank advances which helped some of the most blameworthy institutions to avoid asset sales that might otherwise have triggered net-worth writedowns punishing enough to force them out of business”.
But it was not government alone that was responsible because, as the authors proceed to show, at every stage of the process those involved had a vested interest in ensuring that the gravy train stayed on the tracks, regardless of its unstable cargo: “Lenders collected upfront fees for originating and selling poorly underwritten (and sometimes fraudulently documented) loans and passed the risks along to investors and securitizers without accepting responsibility for subsequent defaults. Securitizers sliced and diced the cash flows from questionable loans without demanding appropriate documentation or performing adequate due diligence. Insurers and credit-rating organizations used poorly tested statistical models and issued (along with accountants) aggressive judgments about whether a non-recourse “true sale” of the underlying loans had actually taken place. Finally, servicers accepted responsibility for working out troubled loans without assembling an appropriate information system or training a staff large enough to deal with the delinquencies and defaults they might (and did) eventually face.”
By 2007, US banks had issued $922.1 billion worth of mortgage-backed securities. Because these securities were so profitable there was little incentive for the people making the underlying loans to be particular about the repayment capabilities of their loan customers.
Without the underlying loans there could be no assets to rebundle and without this booming business there would be far less scope for earning the ever-rising bonuses paid out on Wall Street. According to the New York State Comptroller’s Office, these bonuses totaled $23.9 billion in 2006.
The gravy train appeared to be smoothly trundling along the tracks and this flurry of activity set equity markets alight. On 19 July 2007 the Dow Jones Industrial Average (DJIA) closed above the record 14,000 mark for the first time in history. Major markets elsewhere in the world moved in tandem with Wall Street, as they generally do, but this time even Japan’s Nikkei 225 Index joined the trend after operating in a sphere of its own following the Japanese crash two decades previously.
The classic conditions of a pre-crash scenario were clearly in play. And, as always happens when markets are poised to crash, the disparity between stock price movements and price-earnings ratios grows. Previous stock market crises have been the product of excessive valuations of companies but the 2008 crisis can be said to be about earnings. Figure 1.2, produced by Robert Shiller, the Yale University academic who authored the best-selling book Irrational Exuberance, shows this rather clearly and, as ever, provides a good warning of overheating which was generally ignored by those who insisted that ‘this time it will be different’.
Shiller himself was among the minority who, in 1996, looked at his data and concluded ‘it is hard to come away without a feeling that the market is quite likely to decline substantially in value over the succeeding ten years; it appears that long run investors should stay out of the market for the next decade’
This was a very early call for caution and could be ignored by those who saw the markets rising to record levels and were confident that price-earnings ratios were incapable of telling much of the story.
However more attention was paid to Warren Buffett, America’s most famous investor, who, in 2003, expressed considerable alarm about the impact of derivatives on financial markets, describing them as ‘financial weapons of mass destruction’. But even Buffett could be ignored as the stock market continued to soar and the sharp young traders asserted confidently that ‘the old guy has lost his touch’.
There is, however, a very interesting wrinkle in the development of this boom and crash which was identified by Shiller and his colleagues at Yale. They found that in this crisis it was private, as opposed to institutional, investors who were quicker to lose confidence in market valuations. In most crises, the professionals are first to identify reasons for caution and are more nimble in heading for the market exit as conditions deteriorate but, since 2007, it has been private investors who have been the biggest sceptics.
It is also worth noting, in passing, that the poor performance of fund managers cannot be overemphasized. Most surveys show that, on average, they never manage to achieve better results than the overall performance of the markets that are home to their funds – indeed most underperform benchmark indexes. Yet, investors in mutual funds pay a heavy price to these managers for handling their investments when they could achieve better results at lower cost by investing in index-linked funds that simply track the markets. Little wonder then that so few managers invest money in the funds they manage. A 2008 survey of 6,000 US-based funds showed that 46 per cent of their managers had not a single investment in the US stock funds they manage; 65 per cent stayed away from their own taxable bond funds and an even higher 70 per cent did not invest in their own balanced funds. It is not possible to discover whether this is merely a recent phenomenon because the data only became available after a 2005 SEC ruling requiring fund managers to disclose their stock holdings in funds they run. Anyone who is dismayed by these figures is likely to be even more dismayed by the staggering lack of fund managers’ experience in emerging markets. Research by the China-based brokerage, Galaxy Securities, showed that the average length of experience among Chinese mutual fund managers was a mere 1.7 years. Clearly few people in this position had even seen a bear market in China, let alone gained experience of how to handle it.
The consequences of falling confidence, based on solid reasons to be wary, started to become apparent very rapidly. However, even at the beginning of 2008, many investment houses were pushing out predictions for the year that were sounding a cautiously optimistic note. Credit Suisse, for example, issued a research note on 10 January 2008 headed ‘Buy US stocks with expected positive earnings surprise against the S&P 500’. The research report predicted that a recession was unlikely and that equities would reach new lows but that as early as the end of the year’s first quarter the authors saw ‘the equity bull market resuming as the economic and earnings uncertainty fades’.
It is not really fair to single out Credit Suisse for lack of foresight because its views were generally in line with the prevailing opinion which was that although the markets were in a bad way there was no cause for real alarm.
This impression was reinforced by the International Monetary Fund’s (IMF) economists who are conservative and largely stick to consensus estimates. As late as April 2007, they were still confidently saying that ‘overall risks to the outlook seem less threatening than six months ago’ and they remained hopeful that growing signs of a downturn in the US would be unlikely to spill over to the rest of the world.8 In other words the IMF, like the overwhelming majority of institutions and individuals in the forecasting business, did not see the storm ahead and were shocked as it gathered pace in thethird quarter of 2008.
It is always easier to criticise such failures of prediction with hindsight. Yet, even though there were high levels of concern about an economic slowdown at the beginning of 2008 it was hard to appreciate quite how rapidly or severely the recession would develop.