Sept. 15, 2018, marks the 10-year anniversary of the bankruptcy of U.S. investment bank Lehman Brothers—the one event most closely associated with the onset of the global financial crisis.
What followed was a game-changing period that saw massive destruction of wealth, economic turmoil, and change. Although there has been considerable healing, major economies and financial markets are still not back to normal.
The day Lehman went down, stocks fell by 4 percent. Fear gripped financial markets as financial institutions stopped trusting each other. Banks’ liquidity positions were under assault as terms like “contagion” and “counterparty credit risk” became part of the vernacular.
Between Sept. 15, 2008, and the eventual bottom of the market on March 9, 2009, the S&P 500 had fallen 46 percent.
Brian G. Belski, now chief investment strategist at BMO, was the chief U.S. sector strategist with Merrill Lynch in 2008.
“I don’t remember any other time in my career … I was never as analytically, emotionally, and physical drained,” Belski, who has been in the business for nearly 30 years, said in an interview.
Merrill Lynch, like Lehman, needed to be rescued. It was acquired by Bank of America a day before Lehman went down.
While the global banking systems got shredded, Canada’s banking system was praised for its resilience. Canadian banks did not need bailouts, as the level of risk-taking and exposure to subprime mortgages was peanuts compared to their American counterparts. However, they did need emergency funding as financial markets seized up globally.
“Canadians by culture are just that much more conservative and, as such, didn’t get over their skis like the Americans did,” Belski said.
But its economy could not escape the carnage. Canada’s export sector cut back on production, laid off workers, and many companies vanished.
The Canadian economy shrunk 2.3 percent in the first quarter of 2009 and inflation turned into deflation. In contrast, the U.S. economy fell more than 8 percent in early 2009.
Central Banks to the Rescue
Major central banks rushed to save the financial system and would become more inseparable than ever in discourse about the economy and financial markets. They dug deep into their toolkits slashing interest rates to historic lows, injecting capital into teetering banks, and providing a buyer for a wide range of assets so that the financial system had the lubrication it needed.
Central bank actions were meant to stimulate risk-taking. However, while their actions were necessary, they were also criticized for exacerbating bubbles in some markets, such as real estate.
Canada’s real estate market didn’t swoon like the U.S. market did—it kept rising. Canadians borrowed money at low rates and bought homes. Policy-makers have since been trying to slowly let air out of the balloon.
It’s been a long recovery of fits and starts. And it isn’t done yet. Central banks still have a lot of stimulus in the system and are fighting an uphill battle to remove it. Major economies are adapting to a new paradigm of slower growth and lower interest rates.
Canada’s economy has grown just 19 percent in the last 10 years; however, it also had to overcome the oil price crash of late 2014, which sent the economy into a mild recession.
Lack of Trust
Signs of stress in the financial system were being seen over a year before Lehman went under. In Canada, trading in $30 billion of asset-backed commercial paper stopped in August of 2007 due to fears about subprime mortgages and panic in credit markets.
But on Wall Street, the risk-taking culture was nearing the end of another cycle of boom and bust.
In the 1990s, investing in U.S. stocks was en vogue. But when the dot-com bubble burst, investors shunned tech and moved into financials.
Then, financials provided growth as the mortgage business started to pick up as rates fell and home prices rose. But in a sense, the craziness that propelled some dot-coms to ridiculous valuations despite not being able to earn a profit took place in mortgage underwriting. Borrowers without proof of a job, income, or assets were able to finance homes they could not afford.
As long as home prices kept rising and the various links of the chain—from borrowers and mortgage brokers to bankers, rating agencies, and investment banks—could take a slice of the pie and pass on their risk, it was business as usual.
Millennial investors could be understandably scarred as the financial crisis hit early in their investing careers.
A study by the Vanguard Group showed that young adults who started investing with them after the financial crisis are more than likely to not hold stocks compared to those who started investing with them pre-crisis. Many younger investors had lost their faith in financial markets and investment banks.
In a Bloomberg column, Barry Ritzhotz, founder of Ritzholtz Wealth Management said these young adults were adopting a more conservative approach than what is appropriate for their age.
“It could add up to a retirement crisis for the generation that came of age during the financial crisis,” he wrote. The column noted that the older Generation X is more likely to have a higher risk tolerance, based on analysis from UBS.
In the recovery, those who were able to hold onto their investments profited handsomely. But it also exacerbated the income divide as those who had little to no investments did not benefit from stocks roughly tripling in price from the March 9, 2009, low.
Despite the S&P 500 surpassing its 2007 peak just six years later and with arguably the longest bull market in history, Belski feels equities have more room to run.
“The wherewithal in terms of equity ownership still isn’t what it was and the believability of equity investing according to our lens remains very low,” Belski said.
Too Far Too Fast
In the aftermath of the financial crisis, some say financial regulation has become too punitive. In the S&P 500, only the financials sector has not surpassed its pre-crisis level.
“What happened in 2008 is your classic rule of a few bad apples,” Belski said. Subprime mortgages, excessive risk-taking, reckless financial innovation, and fraud all contributed to the downfall.
The United States was the leader in heavier regulation, with Dodd-Frank for reforming Wall Street and protecting consumers and the Volcker Rule to limit banks’ proprietary trading.
Belski is firmly in the camp of those who feel financial regulation has gone too far. “Unfortunately they threw the baby out with the bathwater,” he said.
“We had to have something,” said Terry Duffy, CME Group chairman and CEO, regarding Dodd-Frank in an interview with CNBC. “We were always going to take the needle and move it too far.”
He is not an advocate for the Volcker Rule and hopes it will be revised.
The question becomes where the next crisis will come from—because it surely will. What happened in 2008 is an every-other-generation event, according to Belski. He feels the same type of crisis won’t happen again given the changes in management styles and regulation.
The banking system is also much healthier, some attitudes toward risk-taking have changed, off-balance sheet entities have come under greater supervision, and subprime mortgages are mostly a thing of the past.
But public debt in advanced economies has increased by more than 30 percent of GDP, according to the International Monetary Fund, as government spending has had to pick up the slack for central banks. The situation is less worrisome for Canada, which still has the lowest debt-to-GDP ratio among the G7.
Growth in the less regulated shadow-banking sector has also picked up and could create threats to the financial system.
U.S. consumer credit has hit an all-time high and Duffy is concerned about the over $2 trillion in credit card debt and student loan debt and what that means for the future spending power of today’s younger generation. Auto loan debt is over $1.2 trillion.
Belski said it is human nature to expect history to repeat itself, but he expects the next crisis to come from something unanticipated.
A positive development has been the reining in of Wall Street’s risk-taking culture. Pay isn’t as excessive for the highest earners.
“Ethics is not only important for its own sake, but because ethical lapses have clear economic consequences,” said IMF managing director Christine Lagarde in a blog post.
Regulation and financial reform have provided impetus for change, but memories of 2008 play a lasting role.
“The work on Wall Street has changed because people are playing defence,” Belski said. “They’re afraid to be wrong because they don’t want to lose their job or be sued.”
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