With markets in turmoil as the Coronavirus spreads, it’s worth revisiting the Global Financial Crisis that took place between 2007 and 2009. For most investors this was the biggest crisis they had ever faced.
In this post we discuss the causes of bubbles and specifically of the credit crisis. We also look at the underlying reasons for the GFC causing such widespread damage. Finally, we look at the performance of major asset classes and what investors could have done to limit volatility in their portfolios.
- What causes major bear markets and recessions?
- What happened during the Global Financial Crisis?
- What caused the GFC?
- How did different asset classes perform during the Global Financial Crisis?
- How investors could have protected their portfolios during the GFC and other crises
What causes major bear markets and recessions?
Most financial crises take place when financial assets are trading at inflated, and often irrational, levels. This can occur for several reasons. Very often, “easy money” contributes to market bubbles. Low interest rates and easy access to credit don’t create the same levels of consumer price inflation they used to. But, they do lead to inflation in asset prices. Very often, low rates and the availability of credit combined with market narratives create bubbles.
Over the last two decades bubbles have been created in internet stocks, real estate (during the GFC), cryptocurrencies and cannabis stocks. These bubbles all shared one thing – a story about how big these industries would be in the future. With cheap money and a good narrative, it doesn’t take much for a trend to develop. The trend is then regarded as proof that the narrative is correct, which attracts more buyers to the market. Bubbles are often driven by retail investors, with encouragement from the financial media.
In short, historical trends are extrapolated and investors are fearful of missing out. There is little consideration for valuations and economic reality. Eventually, one of two things happens. At some point when everyone who is likely to invest has already done so, there will be no more buyers. At this point, any bad news will result in the trend reversing.
Alternatively, news will eventually illustrate how overpriced assets have become. A recent example is the cannabis industry. Twelve months after recreational cannabis was legalised in Canada, it became apparent that the market was a fraction of the size it had been projected at.
What happened during the Global Financial Crisis?
The following is a very brief summary of what happened before, during, and after the Global Financial Crisis:
Between 2001 and 2006 a bubble developed in the US housing market. This was caused by low interest rates and an increase in subprime lending. As the bubble developed, lending practices became riskier. Banks began to create mortgage backed securities, which allowed institutions to invest in the subprime mortgage market. This ensured that capital could continue to flow into the market. If this hadn’t happened, the bubble would have burst a lot earlier.
Banks also increased the leverage they used in their own trading operations. They also began to create synthetic products linked to the mortgage market to satisfy demand. Some hedge funds and bank traders were happy to sell these products as they realised the size of the bubble that was developing.
Eventually house prices did began to fall in 2006. This caused defaults on mortgages by homeowners who were relying on capital appreciation to fund their mortgages. Lenders foreclosed on homes which they then tried to sell. This put further pressure on the property market. As defaults increased, investors realised how much risk they had taken on with the mortgage backed securities they had bought. They tried to sell the securities, but of course by that time there were no buyers.
In 2007 mortgage related funds began to fail. Notably, two Bear Stearns backed funds failed, leaving the bank with large losses. When banks began to deleverage and limit their exposure to the sub-prime industry, liquidity within the system dried up. In October the damage to the banking and real estate industries spread to the stock market and stock prices began to fall.
The first economic stimulus package was enacted early in 2008, but it was too late for some companies. In March, Bear Stearns failed despite an attempted bailout by the US Treasury Secretary. Later in the year the government was forced to take over Fannie Mae and Freddie Mac to stop the entire mortgage market collapsing. Then Lehman Brothers failed, and Bank of America bought Merrill Lynch, which was in danger of failing.
By this time liquidity issues in US markets began to affect markets throughout the world. The lack of liquidity in the US banking system drained liquidity and credit availability from the entire global financial system. This is why the market meltdown is often referred to as the credit crisis.
Between September 2008 and February 2009 economic stimulus packages were enacted around the world. The last of these, the American Recovery and Reinvestment Act of 2009 was a $787 billion economic stimulus package enacted in February. Markets began to recover soon after this – but it took four years for stocks to recover their losses.
What caused the GFC?
A large number of factors coincided to cause the Global Financial Crisis. Broadly, the causes of the GFC can be grouped into the following three categories:
- Housing bubble
- Complex financial products and leverage
- Fraud, conflicts of interest and regulatory failure
The roots of the Global Financial Crisis can be traced to an explosion of sub-prime lending along with very low rates. Sub-prime loans are those made to people with low credit scores, with limited assets and possibly without a steady income. US interest rates peaked at around 7% after the dotcom bubble. After that, they fell to historically low levels by 2004. This low interest rate environment made mortgages more affordable to low income earners.
The mortgage business became very lucrative and competitive. Lenders began cutting corners and even committing fraud to ensure they could win as much business as possible. The result is that a lot of people with no income and resources found themselves with mortgages they couldn’t afford and didn’t understand.
The number and quality of mortgages was amplified by the situation government backed mortgage markets found themselves in. Fannie Mae (Federal National Mortgage Association) and Freddie Mac (Federal Home Loan Mortgage Corporation) are companies that securitize mortgages to sell to the secondary market. The mortgages these companies sell are guaranteed by the government – but they still need to compete in the market like any other institution. To maintain market share, they had to take on the increasingly risky mortgages being sold by banks.
Although interest rates started rising in 2004, they remained low by historical standards. Low rates and greater access to mortgages resulted in more buyers in the real estate market. This resulted in rising property prices. People started buying houses based entirely on the assumption that capital appreciation would cover the mortgage costs. If you can refinance or “flip” a property at a higher price every few months you can effectively cover the mortgage with the capital gain.
As the subprime industry became more competitive, lenders began issuing new types of mortgages to attract a wider group of home buyers. These mortgages all had one thing in common – they made mortgages more affordable for the first few months. The catch was that in many cases the repayments would increase after an initial period. Lenders were not concerned about defaults because in that case the lender would become the owner of the property – and house prices were rising. The result of these loans was that millions of people effectively became speculators with highly leveraged investments.
While this strategy was succeeding, people began buying second and third houses. Many were purchased using mortgages that required no deposit. In addition, many of the mortgages were “interest only” loans and required no repayments for the first few months.
Complex financial products and leverage
The magnitude of the Global Financial Crisis has a lot to do with the new financial products that played a part in creating the bubble. Typically, bubbles burst when interest rates rise and there isn’t enough capital to keep supporting higher prices. However, in the case of the Global Financial Crisis, banks found a way to keep capital flowing into the housing market – including the subprime end of that market.
Mortgage backed securities (MBS) are pools of mortgages that can be traded in secondary markets. Collateralized debt obligations (CDOs) are more complex versions of MBSs. CDOs are split into tranches according to the level of risk. The safest tranches pay lower rates, while the riskier tranches have higher yields. The safest tranches were rates AAA, while the riskiest tranches were rates BB-.
Over time, CDOs were repackaged to form new CDOs. As the products became more complex, the process of rating them became more opaque. Eventually, CDOs that contained only high-risk mortgages were rated AAA. This allowed pension funds around the world to invest in the riskiest home loans – many without knowing what they were buying.
As if risky derivatives with AAA ratings were not enough, new products were introduced. Banks began selling credit default swaps to allow investors to insure their CDOs against default. These swaps were linked to the same mortgage markets as the CDOs. So, when the mortgage market began to slow, investors began betting on mortgage market with swaps. Credit default swaps were then packaged into new instruments called synthetic CDOs. Investors were no longer investing in mortgages but betting on the mortgage market.
Fraud, conflicts of interest and regulatory failure
Unethical behaviour throughout the banking system facilitated the creation of the Global Financial Crisis. This included fraud, conflicts of interest and lack of regulatory oversight. Mortgage originators frequently used aggressive sales tactic and fraud to increase sales. Home buyers were encouraged to exaggerate their financial situation and documents were often falsified.
Banks that created CDOs paid ratings agencies like Standard and Poor’s and Moody’s to rate the products. This presented a major conflict of interest as the agencies would only be paid if the rating suited the issuers. This allowed banks to sell very risky products with investment grade ratings. It also gave investors a false sense of security about the products they were buying.
Deregulation that took place in the 1980s and 1990s further magnified the crisis. Trading operations at banks grew and became a major source of revenue. In addition, banks used increasing amounts of leverage to increase trading profits. At the same time, many banks and financial institutions new they were too big to fail. They knew that if things went wrong, they would be bailed out by the government.
Another conflict of interest arose when banks began betting against their clients. They created products to satisfy client demand, whilst also recognising the products they were selling were very risky. Ultimately they started selling synthetic CDOs to clients, thus betting directly against their clients.
Regulators also played a part in the crisis by allowing risks to develop throughout the system. Subprime lending was always known to be risky, yet there was little oversight in the industry. There was no regulation of the rating agencies which allowed them to profit from flawed ratings. And, banks were allowed to trade with increasing amounts of leverage with little intervention from regulators or central banks.
How did different asset classes perform during the Global Financial Crisis?
Because the GFC was so severe for risk assets, it’s worth knowing how other asset classes performed. The following table illustrates how some of the major assets performed from the end of October 2007, when the S&P500 peaked, until the end of February 2009, before stocks began to recover. The table also includes the number of months each asset class took to recover their October 2007 levels after February 2009.
Several observations from the table are worth pointing out:
- Equity markets were all highly correlated. While emerging market equities performed worst, large cap US stocks did not manage much better.
- Most of the alternative asset classes, namely, hedge funds, gold, and commodities, outperformed most of the traditional assets like stocks and bonds.
- While some hedge funds performed very well, those with negative reruns lost less than 5% of their value.
- Eleven years on, junk bonds, international equities and emerging market equities have yet to reach their pre-crisis levels. In the case of equities this is partially related to USD outperformance.
While the performance of each asset class varies from one crisis to the next, there is some consistency. An article on the Visual Capitalist website looked at the returns of 16 asset classes during the 5 major market crises, including the GFC. While the average losses across all five periods were lower, a similar pattern was observed.
The best performing assets were hedge funds, US treasuries and gold. The worst performing assets were stocks, junk bonds and listed property investments. These returns do also need to be viewed in the context of long-term returns. Riskier asset classes do generate better long-term returns. Alternative assets generate more modest long-term returns but outperform during periods of market volatility.
It’s also worth pointing out that the performance of individual hedge funds can vary greatly – an index is an approximation of the returns of different types of funds. During the GFC, some hedge funds that focussed on subprime related securities blew up, while others returned in excess of 500%. Many that performed well, failed to perform well after 2010. This highlights the fact that hedge funds that focus on narrow markets may not be effective long-term hedges.
How investors could have protected their portfolios during the GFC and other crises
The returns listed above, prove that while risky assets like stocks do perform well over the long term, they can lose value quickly during an event like the Global Financial Crisis.
The only way to hedge a portfolio against these types of events is by including alternative assets and bonds in the portfolio. Bonds, gold, and hedge funds are the most reliable portfolio hedges. Private equity, venture capital funds and real estate can also reduce volatility as these types of assets are not marked to market each day.
Conclusion: Learnings from the Global Financial Crisis
The Global Financial Crisis between 2007 and 2009 showed us how complex the financial system is. The contagion spread throughout the world’s equity markets to the extent that even well-diversified equity portfolios lost a lot of value. Effective asset allocation means a portfolio can benefit from the long-term growth of stocks, but also survive periodic bear markets. Rebalancing the various asset classes also allows cash to be reinvested in risk assets at low levels and taken off the table when valuations are inflated.
Sometimes there are warning signs before an event like the GFC, and sometimes there aren’t – as has been the case with black swan events like the Coronavirus crisis. The only solution to this is to be diversified at all times.