By Charles Lewis Sizemore, CFA
Men are notoriously bad about remembering their wedding anniversaries, but some other anniversaries are probably best forgotten. As we write this article, we have just passed the date when, one year ago, Lehman Brothers collapsed, turning a run-of-the-mill bear market and recession into a bona fide crisis—by most measures, the worst since the Great Depression. On September 15, 2008, Lehman Brothers formally filed for bankruptcy protection, setting off an unprecedented wave of volatility as the world’s financial markets ceased to function.
This date also marked the point where the federal government massively increased its bailout efforts, first proposing the now infamous Troubled Asset Relief Program (“TARP”), which eventually led to the controversial quasi-nationalisation of the banking sector.
Lehman wasn’t the only impetus for the crisis, of course. On September 7, 2008 the federal government took control of Fannie Mae and Freddie Mac—the two large U.S.-government-sponsored entities indirectly responsible for much of the liquidity in the mortgage market. An outright failure of Fannie or Freddie would have meant that mortgage lenders would have seen one of the biggest buyers of their mortgages disappear—and the result would have been a complete seizing up of the mortgage market and potentially massive declines in home prices (that is, even more massive than had already been experienced).
On September 16, 2008, just one day after Lehman’s bankruptcy, the Federal Reserve felt compelled to extend emergency funding to the failing AIG—which ended up being one of the biggest casualties of the crisis.
So, while Lehman clearly wasn’t the “cause” of the panic—nor was it the only major financial institution to blow up in a single month—the bank’s untimely demise marked the climax of a crisis that had been building for some time.
The Lehman Brothers bankruptcy: sorting through the rubble
In some ways, not much has changed in the subsequent year. Many of the familiar faces on Wall Street are gone, and the two surviving investment banks — Goldman Sachs and Morgan Stanley — are now reorganised as commercial banks, thus coming under the Federal Reserve’s regulatory watch. Though the financial sector is still shrinking its balance sheet, most of the banks continue to retain too little of their earnings—leaving them with relatively little capital and exposed to the risk of a future crisis. The securitization model, though sharply reduced in volume, is still intact. And, much to the chagrin of French President Nicolas Sarkozy, high compensation and bonuses are slowly starting to reappear.
The Dow Jones Industrial Average was just 10% below its pre-Lehman level at time of writing, and the S&P 500 just under 11%. If an investor were stranded on a remote desert island for the past year, he could be forgiven for thinking that not much had happened in his absence. And he might wonder why the rest of us in the financial industry have considerably more grey hair than when he left.
On a more ridiculous level, someone who had been marooned on the same desert island since September 10, 2001 might have drawn the same conclusion about their eight-year absence. On September 11 of this year, the Dow Jones Industrial Average closed at 9,605 — the same level as on September 11, 2001, the date of the terrorist attacks eight long years ago. Investors who have held their stocks through this rather volatile period have nothing to show for their patience other than a modest stream of dividends and quite a lot of heartburn.
It’s comforting to see the world financial markets returning to good health.
Some world stock market indices have actually returned to new post-Lehman highs, even if they remain below their all-time highs of 2007. The credit markets too have returned to something resembling normalcy. The “TED” spread between Libor and the U.S. T-Bill reached unprecedented levels during the hysteria of the fourth quarter of last year as the banks stopped trusting one another (after all who knew who the next Lehman might be). After the Federal Reserve and Treasury more or less stepped in as a guarantor for the entire banking system, confidence slowly began to return. Today, we appear to have returned to business as usual.
What Can We Expect Going Forward?
While it appears that the financial system has returned to stability, it might be a bit too early to uncork that bottle of champagne. This week, the Federal Reserve announced that it would review banks’ exposure to commercial property. The commercial property market has not been hit as hard as the residential market, which in some bubble areas has fallen by more than 50%. Many fear that this may be simply because commercial property changes hands less frequently, thus making prices “stale.” The regulators fear that, just as the banks were slow to admit their real losses on residential mortgage securities, they may also be withholding bad news on their commercial mortgage portfolios. At this point, it is too early to say what the outcome of this inquiry will be. Judging by the strong recent performance of the commercial REIT sector, investors seem to believe that the risk is overstated. We shall certainly see.
Even if another major crisis is averted, it is not likely that we will return to the “go-go” pre-crisis boom years any time soon. The collapse of the system had a profound impact on bankers—who are now much more reluctant to lend—and on consumers—who are now much more reluctant to borrow. Outside of the government sector (where the debts continue to be amassed at a startling level) the process of deleveraging continues, even if it is at a more subdued pace. The household savings rate has more than doubled in the past year, rising from just over 2% of disposable income to more than 5% today. Consumers are choosing to pay with cash or with debit cards more regularly while they slowly pay down their credit card balances. In short, the party is over, and now it’s time to take some aspirin for the hangover and clean up the mess.
The regulators have gotten a bit more sober as well. On September 15, Federal District Judge Jed Raskoff nullified the $33 million dollar settlement between the SEC and Bank of America over the bank’s inaccurate statements to shareholders concerning salary and bonuses paid to Merrill Lynch employees. It appears that the judge shares the belief of many Americans that financial sector executives acted irresponsibly and perhaps even immorally both before and during the crisis and that they should be punished.
All around the world, and particularly in continental Europe, this appears to be the dominant sentiment.
The Financial Times reports that UK regulators have begun drawing up plans to require large British banks to prepare “living wills” that would, among other things, force the banks to explain in detail how they would raise funds in the event of an emergency—including how they would close their trading books within 60 days of a collapse and which business units they would sell to raise capital. There are potential problems with this scheme; complying banks might legitimately worry that they would be divulging information that could be used by their competitors or by speculators in the banks’ traded stock.
At any rate, it is obvious that banks and hedge funds will be operating in a less permissive environment going forward, and this will likely be translated into a slower rate of economic growth. This is not necessarily a bad thing, of course. A lower but sustainable rate of growth is probably preferable to a higher but riskier rate.
If history is any guide, investors will likely enjoy positive returns in most asset classes in the next decade. They should set reasonable expectations, however. And more than anything, they should remember to take risk into account. If there is one lesson to be learned from last year’s crisis, it would be to respect the awesome destructive power of leverage when it turns against you.