Weekly Commentary September 21, 2018
Lessons From the Financial Crash, 10 Years Later
By Tim Courtney, Chief Investment Officer
The U.S. economy is booming. Unemployment keeps dropping1, earnings continue to rise2 and consumer confidence is high3. The mess the market was in just 10 years ago following the 2008 financial crash4 has been replaced with a near-constant stream of positive news.
However, with the 10-year anniversary of the Lehman Brothers collapse5 in the rear-view mirror, it’s a great time to reflect on how unpredictable the market, and the overall economic and regulatory environment can be.
Back in 2007, there were certain companies and assets that seemed too big – or too safe – to fail. High-rated, AAA bonds6 would be one of these. Real estate was often cited as another (they’re not making any more of it) before the market crash in 2008 and 20097. Names like Freddie Mac and Fannie Mae seemed untouchable, as did the major financials like Merrill Lynch and Bank of America.
But when the financial crisis hit, Freddie Mac and Fannie Mae were faced with a federal takeover8 and their bonds were next to worthless9, even though they had previously been rated higher than Treasury bonds. Merrill Lynch acquired a troubled mortgage company (First Franklin Financial Corp.)10 that ultimately collapsed, and as a result, Bank of America bought the struggling Merrill Lynch11, bringing on challenges of its own.
The stories of subprime loans and collateralized debt7 that led to the meltdown are well known. But one of the many pieces that furthered the banks’ collapse was a then new regulation passed by the Financial Accounting Standards Board (FASB) that enforced mark-to-market accounting12. Banks were forced to list their assets not at what they thought was a fair price, but at the most current price in the market. Sounds like a fair enough rule.
However, in the chaos of the moment, investors couldn’t get a good idea of how many homeowners had actually defaulted on their mortgage payments. They assumed the worst and stopped actively buying and selling mortgage-backed securities, and the market froze13. Banks were then forced to list the assets on their balance sheets at near zero value, effectively sealing their fate of insolvency.
In subsequent months, very few assets were positive14, and even highly-rated corporate bonds were negative. Real estate prices dropped anywhere from 10 to 30 percent15. Mortgage-backed assets froze, and the market broke.
This regulation was meant to bring about positive change – after all, transparency is usually a good thing. While this regulation wasn’t the initial catalyst for the market drop, it intensified it and warped the system in ways that weren’t expected.
Some lessons from 10 years ago? First, regulations and changes that seem safe and well-intentioned can cause huge and negative consequences. This is a continual risk for markets, especially for individual sectors of the market.
Another lesson is the importance of diversification. During the financial crisis, U.S. government bonds and Treasury bills were one of the very few assets supplying positive returns13, and ideally these would be sold when investors needed access to their investments. As other assets eventually bounced back, investors were able to sell those as well without losing value. By owning a wide swath of assets, including treasuries, investors created a safety net for themselves that likely wouldn’t have existed if they only invested in one type of “safe” asset.
Certain individual assets or companies that appear rock solid may not be so 5 or 10 years from now. We never know what regulation or corporate slip-up might impact the market next. As we pass the 10-year anniversary of the 2008 financial crisis, it remains important to keep these lessons in mind.
1 TIME – Job growth cools slightly but unemployment rate still drops below 4% for July
2 The Washington Post – U.S. wages growing at fastest rate in 9 years as unemployment stays at 3.9 percent
3 Bloomberg – U.S. consumer confidence rises to highest in almost 18 years
4 Money Morning – 2008 stock market crash causes and aftermath
5 Investopedia – The collapse of Lehman Brothers: A case study
6 Investopedia – AAA
7 Investopedia – The 2007-08 financial crisis in review
8 NPR – Understanding the Fannie/Freddie Takeover
9 Investopedia – Fannie Mae, Freddie Mac and the Credit Crisis of 2008
10 MarketWatch – National City sells First Franklin to Merrill for $1.3 billion
11 The Motley Fool – How Bank of America Came to own Merrill Lynch
12 Investopedia – Market-to-market accounting
13 Reuters – CMBS era of issuance grinds to halt in January
14 CNNMoney – 5 lessons from the crash
15 CNNMoney – Home prices post record 18% drop
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