Multi-Manager

Lehman Brothers 10 years on

It’s the ten-year anniversary of the collapse of Lehman Brothers
September 2018
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Risk Disclaimer 

Past performance should not be seen as an indication of future performance. Stock market and currency movements mean the value of, and income from, investments in the strategy are not guaranteed. They can go down as well as up and you may not get back the amount you invest.

 

Views and opinions have been arrived at by BMO Global Asset Management and should not be considered to be a recommendation or solicitation to buy or sell any companies that may be mentioned.

 

The information, opinions, estimates or forecasts contained in this document were obtained from sources reasonably believed to be reliable and are subject to change at any time.

It’s the ten-year anniversary of the collapse of Lehman Brothers, an inflection point in a financial crisis that had been building over the previous twelve months that brought the global financial system to the brink of collapse and has had significant economic, social and political consequences that are still being felt to this day.

Along with Gary and Scott, I recently visited New York to meet with fund managers and analysts. In this note, I will look back on what happened and the causes of the financial crisis, what we have learned from the crisis as well as thoughts on where the next crisis might come from.

What happened?

On September 15th, Lehman Brothers filed for Chapter 11 bankruptcy protection, after a frantic weekend of attempts to arrange a rescue of the bank failed. This event sent shockwaves around the global economy and led to what is now known as the Global Financial Crisis (GFC).
 

A housing market downturn

The backdrop to the financial crisis was a slowdown in US and European housing markets in 2007. The cracks in the system became evident in the summer of 2007 when BNP Paribas froze three investment funds due an inability to price asset-backed securities in US markets. The downturn in the US housing market, upon which billions of dollars of asset-backed securities were secured, would lead to a near-collapse of the global financial system. In the UK, we had already seen Northern Rock come to a grizzly demise in September 2007, and early in 2008 the investment bank Bear Stearns, itself on the brink of collapse, was taken over by J.P. Morgan.

Why a housing slowdown in the US and later on in Europe went on to put the global financial system at risk was likely a result of a change in the business models of many banks where they moved away from traditional funding, i.e. lending to consumers and corporates based on deposits. Banks globally had shifted to wholesale funding, in which large short-term loans from money market funds and other banks were used to fund operations. This allowed banks to borrow far larger amounts of money than they could under the old regime, increasing their leverage, and in turn, risk. The inherent flaws in this model were swiftly exposed when the lenders to the banks lost confidence, concerned over the amount of bad assets held by them. With the extent of losses unknown, liquidity in the wholesale funding market dried up. This credit crunch meant the banks were unable to operate, requiring swift and substantial support from the central banks, acting as lender of last resort.

A lesson needed to be learned

Lehman’s, and other banks, had applied to the Federal Reserve Bank of New York in June 2008 to convert to a bank holding company; this would have allowed the bank to broaden sources of funding. This was denied, seen as sending the wrong message in supporting financial institutions and encouraging further risky behaviour. There was little political will to bail out any bank either, with the consensus view that the government should look after Main Street, not Wall Street. Hence there was almost a desire to allow a bank to fail, to ensure that Wall Street ‘learned a lesson’. Soon after the collapse of Lehman, and with financial markets in turmoil, we witnessed unprecedented
injections of liquidity into the global banking system, along with nationalisations or rescues of banks and insurance companies across the US and Europe. In the immediate aftermath of the Lehman’s collapse, an already slowing global economy hit a brick wall. Data from the Bank of International Settlements shows that global capital flows collapsed by 90% during 2008 whilst global trade fell by 22% in the space of nine months. A global slowdown swiftly turned into a global recession.

 

The start of the QE era

Some of the numbers behind the bailouts were eye watering. The New York Fed offered an initial $3.3 trillion special liquidity program to the major banks across the US and Europe, allowing banks cheap funding to shore up their balance sheets. The Federal Reserve was in effect serving as a global lender of last resort, though this only became clear years later. These emergency measures were followed by more structured central bank intervention in the form of artificially low interest rates and trillions of dollars in quantitative easing. In effect they created money out of thin air and injected it into the financial system and boost growth through lending. QE’s effectiveness remains a topic of debate as the liquidity served to boost financial assets whilst the trickle down to the real economy, against a backdrop of banks reluctant to lend money, was extremely limited.

Risk Disclaimer 

Past performance should not be seen as an indication of future performance. Stock market and currency movements mean the value of, and income from, investments in the strategy are not guaranteed. They can go down as well as up and you may not get back the amount you invest.

 

Views and opinions have been arrived at by BMO Global Asset Management and should not be considered to be a recommendation or solicitation to buy or sell any companies that may be mentioned.

 

The information, opinions, estimates or forecasts contained in this document were obtained from sources reasonably believed to be reliable and are subject to change at any time.

“The Federal Reserve was in effect serving as a global lender of last resort, though this only became clear years later.”

Who were the winners/losers?

In the immediate aftermath of the Lehman collapse, there were very few hiding places for investors. Even cash didn’t feel completely safe and the mindset was all about the return of your money rather than the return on your money. Given our Multi-Manager portfolios were holding upwards of 30% in cash at the time, we were very conscious of our counterparties given that trust between financial institutions had completely evaporated. In terms of returns, September 2008 heralded an incredibly difficult time in markets, with investors facing significant falls across equity markets and dashing for government bonds as a safe haven. From September 15th 2008 until the market bottom in March 2009, the MSCI World Index fell by 26%, the S&P index in the US fell by 42% and in the UK the FTSE100 was down 32%. Europe, Japan and Asia were all down around 40% with Emerging Markets down by 22%. Gold worked as a hiding place, and was up 19%, with Gilts climbing 11% and US Treasuries up 4%.

Using the 15th of September as an entry point would, for long term investors, have been a rewarding experience, albeit a nervous one in the first few months. With the exception of a few Middle Eastern Indices, and Greece, investors would be sat on double, or triple digit returns if they had stayed invested until now. Leading the way, the S&P500 is up 198% whilst the NASDAQ index is up 385%. The FTSE100 is up 104% and the MSCI World Index up 198%. Anyone who called the market bottom in March 2009 and held on to invest to this day would be looking at substantially higher returns. From 9th March 2009, the S&P500 index is up 419%, and the Nasdaq index up 691%. The MSCI World Index is up 304% and the FTSE100 up 194%. Some sectors and indices are yet to recover. An index of European banks remains 35% lower than in September 2008 and Greek equities are an incredible 94% lower (as measured by the MSCI Greece index).

(Note that for ease of comparison, all returns quoted are in local currency). Data from LIM to 10 September 2018.

What have been the consequences?

Looking at the financial crisis only from the angle of market returns fails to capture the consequences from an economic, social and political perspective.
 

Social and political impacts

The social and political consequences of the GFC are wide ranging. The banks were bailed out and the financial system recovered, with stock markets soaring. However, the bailout of Wall Street failed to help the people on Main Street, with many workers in the US and across the western world enduring a decade of falling living standards, as their wages failed to keep up with inflation. Insolvent households were abandoned – nine million Americans lost their homes; eight million lost their jobs in the US alone while there were significant spikes in unemployment across Europe.

In solving the GFC, policymakers have added yet more debt to an already indebted financial system with unprecedented policy tools used by the central banks, many of which remain in place to this day. Whilst the financial system may have been ‘saved’, central banks have found it very difficult to normalise monetary policy and indeed a decade of ultra-low interest rates appears to have created new problems in terms of consumer and corporate behaviour. According to data from Deutsche Bank, after a very brief dip in the aftermath of the Lehman collapse, global debt is up 43% since September 2008 with total debt now $247 trillion. As a percentage of global GDP, this is 316%, around 30 percentage points higher than in 2008. Whilst the pace of household debt growth has slowed, the fastest pace of growth in debt has been in government and non-financial corporates. Whilst governments have increased debt through the costs of fiscal stimulus and bailouts, companies have binged on record low interest rates, and in many cases, have chosen to increase pay-outs to shareholders or buy back their shares rather than invest in future growth.
 

Central banks stepped up intervention

Central banks have always played a significant role in the global economy, though the last decade has seen unprecedented intervention. Central bank balance sheets have nearly tripled in size in the past ten years, to more than $15 trillion. The Bank of England balance sheet, for example, climbed from 7% of UK GDP in 2007 to 27% today. The previous high was in the aftermath of World War II at 17% of GDP. It would appear that the central banks will continue to play an increased role, not least given that many policy measures, such as quantitative easing, have yet to come to an end in some places. Equally, interest rates have been held at artificially low levels to encourage cash to flow back into the economy. This financial repression has of course been excellent news for borrowers, less so for savers. Yields remain extremely low across financial markets, and the low returns on offer from traditional investments have forced investors up the risk spectrum into higher yielding, but more risky assets. The flow of liquidity that trickled down from the banks into the financial system through money printing has indeed caused inflation, not as measured by CPI but in financial and real assets, from stock markets to property to classic cars and fine wines.

Whilst the US government pursued stimulus and Europe pursued austerity, the consequences in terms of populism have been the same. Arguably one of the main causes of populism –  rising inequality –  has been an issue for some time, but it is clear the GFC accelerated this trend. This theme is yet to fully play out around the world – but recent elections and referendums confirm that the momentum for populist figures and themes continues to build. Governments focused in the short term on stabilising the financial system and putting measures in place to restore economic growth through allowing fiscal deficits to balloon. This may have prevented economic collapse but of course had consequences of its own, as witnessed in the European sovereign debt crisis from 2010 onwards. Fiscal largesse swiftly turned to austerity in many countries, serving to dampen economic growth and increase inequality. The sense of bitterness towards the bankers and politicians in the aftermath of the financial crisis and subsequent years of slow growth has impacted the political environment with significant consequences. A study by Amir Sifu of Princeton University analysed the response to financial crises in 60 countries, finding that they tend to radicalise electorates, and the share of moderates in a country declines in favour of left or right-wing radicals. In recent years, real world examples of this are clearly evident, from the Brexit vote in the UK to Donald Trump’s election win, and more recently the populist parties winning the election in Italy. Populism still has a way to go – the great depression of the 1930s showed how international relationships tend to deteriorate over time, and policies such as protectionism are examples of the reversal of globalisation seen in the aftermath of the GFC.

“We have learned that unchecked financial innovation is a dangerous thing as it becomes clear that few individuals fully understand the products they are investing in.”
The public, not the bankers, paid the price

The financial crisis failed to see significant repercussions for the financial services industry despite the public and political backlash against the ‘bankers’. Few individuals saw criminal convictions and while the public lost their homes or jobs, or were impacted by ‘austerity’ the perception has been that the bankers returned to their pre-crisis existence very swiftly. Financial regulations have been tightened significantly, and banks are fundamentally safer now in the sense that they have to hold significantly more capital on their balance sheets and are subject to regular ‘stress tests’. But there is still a sense that the surviving banks escaped relatively lightly despite paying out $243 billion in fines. Financial rating agencies also escaped the crisis unscathed. Despite failing to foresee the issues across the banks and the instruments they were issuing tied to subprime loans, they are still used today as a guide for trillions of dollars of investments. The US securities and exchange commission’s data from 2017 shows that S&P, Moody’s and Fitch are still responsible for just over 96% of all ratings.

 

Have we learned anything?

Hubris is a dangerous condition, and in hindsight it was evident in spades ahead of the 2008 crisis. Fed Chair Ben Bernanke declared that problems in the US subprime housing market were “so limited they would not create significant spillovers”. Governments and central banks were convinced that the syndication of loans was reducing overall risks by diversifying them, and there was talk from the Bank of England of the era of NICE (non-inflationary continuous expansion). We have learned that unchecked financial innovation is a dangerous thing as it becomes clear that few individuals fully understand the products they are investing in nor the underlying investments they are tied to. In 2008, no one knew where the risks were, and who held them. Hence a complete collapse in trust. Has anything really changed? Many of the markets that failed in 2008 have resumed, albeit with tighter regulation to ensure the issuers interests are more aligned with the investor. A decade of ultra-low interest rates has also encouraged risk taking with borrowing so cheap and so little yield on offer from conventional investments. The borrowing frenzy may not be in US housing but is evident in other economies, particularly in emerging markets where borrowing in dollars has suddenly become very expensive as emerging market currencies have weakened over the summer. With the US continuing to raise rates and the dollar likely to rise further, there are likely to be consequences. Another country binging on debt is the US, where the budget deficit is pushing higher under the Trump administration. Again, the seeds of future problems are being sown with fiscal stimulus at a time where the economy is already growing strongly.

“A decade of ultra-low interest rates has also encouraged risk taking with borrowing
so cheap and so little yield on offer from conventional investments.”

It seems like we will likely continue to see higher levels of market intervention than before the crisis. It is important though to remember that economic cycles are necessary for the economy to function efficiently in the long term – recessions may be unpleasant but they are needed to clear out inefficient and poorly run enterprises of which there are many thanks to low interest rates, and fuel the innovation to drive the next economic cycle.

Massive policy stimulus failed to produce anything more than a decade of sluggish economic growth; the recent upswing in global growth is only a result of yet another round of huge stimulus from China in 2015/16. This is being further fuelled by stimulus in the US but both countries are piling on the debt to generate growth. The total debt overhang globally continues to climb and leaves the global economy vulnerable to shocks. These huge debt levels are easy to service when interest rates are so low but will they remain so forever? There are reasons to believe central banks will face political pressure to keep interest rates low in order to maintain the status quo.

 

Can it happen again?

In a word, yes. As always, history does not repeat itself exactly but there are plenty of reasons to believe that we will see a financial crisis again at some stage. A financial system with record levels of debt, artificially low interest rates and political instability driven by populism is not a stable system. Yet this is where we find ourselves ten years on from the GFC.

Back in 2008, US politicians ultimately allowed the US Federal Reserve to do “whatever it takes” to save the financial system. Next time round, with the world a very different place politically, they are unlikely to be given the same flexibility. The US was happy to bail out and support allies in Europe; would they do the same for China? The dollar remains the dominant currency for global finance, and much of the debt build-up in the aftermath of the GFC has been in the emerging markets, not least in China, with Chinese businesses borrowing over $1.5 trillion in foreign currency, the majority of which is in dollars.

 

Policymakers need to be ready to take action

We would hope that the next time it comes, governments and central banks have the willingness and firepower to intervene as we saw in 2008. In hindsight, policy mistakes were made but this is almost inevitable at a time of crisis and financial market paralysis. The next time, with government debt and central bank balance sheets so bloated, this may not be the case. Interest rates are unlikely to return to pre-crisis levels any time soon, and this leaves less scope for central banks to use conventional monetary policy tools to ease financial conditions before they have to resort to policies such as quantitative easing. The global political backdrop, with the US more inward-looking leaves Europe and China more likely to have to face any future crisis on their own.

 

Risks slowly creep back in

We believe that we are closer to the end of this economic cycle than the beginning, and while the global economy is likely to enjoy another year of stimulus fuelled growth into 2019, the impact is likely to fade into 2020. At the same time, central banks are set to continue gently removing their accommodative polices, with interest rates rising in the US as the Fed also reduces the size of their balance sheet. Meanwhile, the European Central Bank will soon call time on QE with a rate rise likely in the second half of 2019. Risks to economic growth from politics are also evident, with protectionism and populist policies set to increase uncertainty and weigh on global trade.

Any market correction will test the structure of the financial system – investment banks no longer act as a shock absorber holding large inventories of bonds or equities on their balance sheets. We have had brief moments of market volatility in recent years, and each time we have seen liquidity disappear very swiftly from some markets. Investors should also consider that we go into any downturn with equity and bond markets at elevated levels and without many risks to the outlook priced in. Given the forward-looking nature of markets, any downtown in the economic outlook in 2020 should become a feature of risk asset valuations in the coming months. We may already be seeing this as emerging market bonds, equities and currencies suffer the consequences of a stronger dollar

 

The consequences linger on

Looking back on the events of the GFC, it is clear that financial markets have recovered and moved on a lot quicker than many governments, companies and individuals. The consequences of the crisis are yet to fully unfold in the world of politics as populism drives the policy agenda towards a more insular world. The economic backdrop post 2008 was saved from an even worse fate thanks to unprecedented intervention from governments and central banks but it has left an unbalanced system and significant inequalities in income across society giving rise to populism and a backlash against the globalisation trends of the past forty years. The financial crisis may have reached its peak a decade ago, but the consequences are likely to linger and weigh upon the global economy, politics and wider society for many years to come.