Sydney M. Williams
Thought of the Day
“The Credit Crisis – Ten Years Later”
September 17, 2018
“Capitalism without bankruptcy is like Christianity without Hell.”
Frank Borman (1928-)
“A year ago, it felt like we were on a river raft. The sound of white water was clearly audible,
yet the river under our craft was flowing gently, inducing a care-free sense. Today, we are
in the midst of rapids and the din is all about us. We do not know how far the rapids
will extend or what the descent will be, but at least the anticipation is behind us.”
“Market Note – Year End 2007”
“What we know about the global financial crisis is that we don’t know very much.”
Paul Samuelson (1915-2009)
While it is embarrassing to include one of my own quotes, I wanted to show that the credit crisis did not just appear. There was, during the years preceding it, a culture of fiscal permissiveness, embedded in vague but enticing political promises, the greed of bankers and housing developers, and a willful naivete on the part of individual and institutional investors. Warning signals abounded, including equity and high-yield bond markets that had been in decline for eleven months, and Treasuries that had risen. No one, though, had any idea how perilous the situation would become. September 15 marked the 10thanniversary of the Lehman bankruptcy, the pivotal moment of the crisis. That Monday the DJIA closed down 4.42%. The market then rallied, faltered and continued to decline. By the end of the year 2008, the Averages were 23% lower than they had been on the Friday before the Lehman collapse. They continued to decline through March 9thof 2009. For a sense of perspective, though, it is important to recall that the market was already down 19% on September 12thfrom where it had been a year earlier. The “canary in the coal mine” had been singing for eleven months. Nevertheless, the shock of that day – and what it portended – was palpable.
The financial system came close to unfurling that September day. Looking back, what is remarkable is that it held together. Financial markets and our system of collections and payments rely on confidence – that borrower A will be able to repay lender B, at a specified rate within an allotted time, that a dollar earned will hold its value, at least until it is spent or invested. Confidence is both whimsical and critical. People still debate the rightness in letting Lehman go. After all Bear Stearns had been saved – sold to J.P. Morgan in March for a price just over tangible book value – and funds were subsequently provided other investment banks and financial institutions, including Goldman Sachs, Morgan Stanley and AIG. Fannie Mae and Freddie Mac had been placed into conservatorship. Why Lehman? Would the system have been better off if Lehman had been allowed to continue? The answer to the second question is known only to Mr. Paulson. No one knows the answer to the third
It may have been that officials wanted to test the resilience of markets, and Lehman was served up as the sacrificial lamb? I don’t know. But, that its bankruptcy did not precipitate an unwinding of the credit system was due to quick action on the part of the Bush Administration, especially Treasury Secretary Henry Paulson and Federal Reserve Chairman Ben Bernanke. That it was not prelude to a global depression was due to policy decisions by the outgoing Bush Administration and the incoming Obama Administration. Second-guessing and Monday-morning-quarterbacking cannot replace the urgency of that moment. Might-have-been questions cannot be answered with assurance. As JP Morgan Chase Chairman Jamie Dimon said in 2010, “You would still have had terrible things happen,” if Lehman had been bailed out.
Nevertheless, if the financial system – a U.S. Dollar based one – had been on the verge of total collapse one would have though gold would have rallied, but it did not. Even though New York was ground zero, it was the Dollar that rallied. Investors moved into the safety of U.S. Treasury Bills. The yield on Three-month Treasuries declined from about 1.6% before the Lehman collapse to 0.11% at the end of 2008, with a steepening yield curve. (Interestingly, Three-month Bills remained at that level – and even lower – through the third quarter of 2015, suggesting confidence in risk assets, despite a rising stock market, were slow in re-building. In reality, however, those rates reflected a Federal Reserve that kept rates subdued through active purchases of Treasury Bills, Notes and Bonds. It has only been in the past year and a half that the rate on the Three-month exceeded one percent.) However, in the fall of 2008 one measure of perceived credit risk began to recover: the TED spread – the difference between Three-month U.S. Treasuries and Three-month LIBOR (London Interbank Offered Rate). LIBOR is the benchmark for global interest rates and is used for most short-term commercial loans. It widened from 107 basis points on June 30, 2008 to 314 basis points on September 30, and then declined to 131 basis points by the end of the year. (Normal would be between 25 and 50 basis points.) While stocks continued to fall into early March 2009, High-yield bonds, whose rates exceeded 20% at the end of November 2008, had rallied to offer yields of 17.4% by the end of 2008. The economy was still in recession and stocks had another 20% decline ahead, but it seemed clear that the worst of the crisis had passed.
The allowing of Lehman to go bust and the cause of the collapse remain under debate. There are those who claim that Lehman was disliked, as an outlier on the Street and that Henry Paulson, a Goldman alumnus, had no love for Dick Fuld, then chairman of Lehman. I don’t know, but I suspect they may have wanted to test the system and Lehman was handy. Keep in mind, they were operating in unchartered waters. Fear of the unknown, I suspect, prevented the Fed and the Treasury from earlier letting Bear Stearns go under, a mistake I thought at the time, and still do. As for the other major banks, because of their size and the domino-like interlocking assets and liabilities on their balance sheets, letting them go most assuredly would have condemned financial markets to a meltdown that would have destroyed economies for a generation.
As for responsibility, Congress and the media placed the largest portion of the blame (and still do) on greedy and unscrupulous bankers, men and women who had devised new and unregulated financial instruments, leveraged balance sheets to absurd levels, skirted rules and took advantage of innocent, ignorant and naïve wannabes. But the truth is we all got sucked into the belief that home ownership was a right, not a reward for thrift and hard work – that home prices would move ever higher. We all bear some responsibility for what happened. Banks may bear the brunt of the blame, but they were aided by politicians and abetted by millions of willing victims. Thinking back on that date ten years ago, should remind us that there are consequences for actions taken and caution signs ignored, that we must take responsibility for the decisions we make, that if a salesman promises something that sounds too good to be true, it probably is too good to be true, that any investment that offers a return in excess of the Three-month Treasury involves risk. In the aftermath of the failed Bay of Pigs operation, President Kennedy said, “Victory has a thousand fathers; defeat is an orphan.” The crisis that cumulated with the failure of Lehman on September 15, 2008 had millions of fathers, though most shunned responsibility, preferring to place all the blame on Wall Street. But greed infected us all. To ignore the role played by home builders, developers, mortgage companies, GSEs (government sponsored enterprises, like FNM and FRE), politicians, investment funds seeking the highest returns, and the roles we individually played, as well as investment and commercial banks, is to condemn us to play the role of Sisyphus, to endlessly repeat the tragedy.
Politicians have always wanted to improve the lives of their constituents. Following a pattern initially set during the Carter Administration (The Community Reinvestment Act of 1977), George W. Bush, in 2003, set a goal of increasing minority home ownership by 5.5 million by the end of the decade. It was a policy adopted by both political parties. Who would not wish that every American who wanted to own a home be able to have one? Banks were penalized for discriminatory lending practices – “red-lining” – against minorities and the poor. Mortgages with no down payments on inflated home prices became common, including “Ninja” mortgages (no income, no job, no problem), adjustable rate mortgages (ARMs), balloon mortgages. Financial derivatives came into their own during the 1980s. By the late 1990s and early 2000s they were being used in creatively destructive ways. CDOs (collateralized debt obligations) allowed lenders and borrowers to mitigate changes in interest rates. By 2006 the percent of all mortgages that were subprime were 20%, versus 8% two years earlier. According to Wikipedia, by 2008 90% of all subprime mortgages were ARMs. The ratio of household debt to disposable personal income rose from 77% in 1990 to 127% in 2007. And, by 2007, the total value of all CDOs exceeded the value of all underlying bonds.
Looking ahead as to what might cause the next crises, JP Morgan Chase’s chief risk management strategist Ashley Bacon was quoted in a recent article in the Financial Times. It is likely to be “some form of operational failure, from within or without, like a cyber-attack or a conduct issue.” In a 16-page spread in last Sunday’s New York Times, cyber threats were also cited, along with student loan debt and an increase in mortgage originations by nonbanks, like private equity, hedge funds and mortgage companies. The truth is, we don’t know through which door the devil will enter. We only know the system is not immune to bad people, poor decisions and greed. Glenn Hubbard, Dean of Columbia Business School and former chairman of the Council of Economic Advisors under President George W. Bush, noted in a recent op-ed in The Wall Street Journal that the post-Lehman debate centered on crisis prevention, instead of crisis response. The crisis has made banks stronger. They are better capitalized, with more equity. They are less leveraged. Their assets bear less risk and are less dependent on short-term liabilities, like commercial paper and re-purchase agreements. But, Mr. Hubbard is right. We should debate the merits of various responses: limits on leverage, capitalization ratios that vary with size, the Volcker Rule, the composition of assets and liabilities, regulation of non-bank lenders and reinstitution of Glass-Steagall. And we must be alert to all things that might go wrong. But the likelihood is that a future crisis will come from a different direction.
Capitalism is under threat today, from socialists on the left and populists on the right. What they ignore is that capitalism has been a force for good for two hundred years. In conjunction with political freedom, it has raised living standards and reduced poverty for millions of people. Reformers should be careful not to kill the goose that lay the golden egg, which is why we should be worried by the lurch toward Socialism by left-leaning extremists. The protection of an institution, or an individual, against poor decisions precipitates moral hazard and only delays the inevitable. Innate to capitalism is risk and reward. The governor that controls excess speculation is the threat of bankruptcy. It should not be removed. The concept of “banks too big to fail” is oxymoronic. If a bank is too big to fail, it is too big. Yet, since the Lehman collapse, the three largest banks in the U.S. have become bigger, controlling $6.8 trillion in assets today versus $4.2 trillion in 2007. According to an analysis of regulatory data by The Wall Street Journal, those three banks controlled 20% of all checking deposits in 2007. Today, they have 32%.
Nevertheless, as we look back on that September morning, we should be thankful the system held, and especially so to those in charge. While millions suffered, and dozens of perpetrators went unpunished, the worst did not happen. We got a chance to play another day. Financial crises and economic recessions have not gone the way of the Dodo bird. My advice: Ignore promises of wealth without effort and beware of excesses wherever they appear.