Lessons learned from the global financial crisis

Key points

• A range of factors lies behind the severity of the global financial crisis and its fallout over the last year. These include: financial deregulation; the search for high, yield-based returns in ignorance of the risk; low interest rates earlier this decade; financial innovation; high debt levels; and, of course, greed on the way up and fear on the way down.
• The key lessons for investors from the last year are: the investment cycle is alive and well; higher returns come with higher risk; the role of sentiment can never be ignored; be wary of financial engineering; be wary of gearing; and government bonds should always be included in a well-diversified portfolio.

Introduction
The past 60 years have not seen anything like the freezing up of lending between global banks, the disruption to credit flows or the need for so many financial institutions in the US and Europe to be rescued as we have seen in 2008. The current crisis is not the worst in Asia (1997/98 was) or Australia (the early 1990s was). But for the world as a whole, it is the worst financial crisis in the post-war period. How did it come to this? What will it mean going forward? What are the lessons for investors?

How did it come to this?
While many are looking for scapegoats to blame, the origins of the current malaise are multifaceted. They include:

• Financial deregulation. Over the last 20 years, this created much greater competition in the global financial system and, hence, a greater availability of debt. It ultimately led to a failure of US regulators to keep up with new financial products and growth in leverage. This is not to say deregulation was wrong, but in some countries, such as the US, it went too far.
• The shift from high inflation to low inflation. This saw interest rates fall, which was great, but also had the effect of encouraging borrowers to borrow more and driving investors to search for higher yields. This led them to greater allocations to investments such as listed property trusts and, of course, the complex securities at the heart of the current problem. This occurred without due regard for the extra risks involved.
• Financial innovation. Among other things, this saw a massive expansion of the securitisation approach to debt financing. This is where a financial organisation (ie a mortgage lender) ‘originates’ a loan to a borrower (ie a home owner). These loans are then sold to other organisations that package them up with lots of other loans into securities which are ‘distributed’ to investors around the world. The theory was that by combining many loans, the risk would be low. Ratings agencies provided high credit ratings for securities whose underlying loans would normally be regarded as sub-investment grade. A problem with the ’originate and distribute’ model was that there was no ‘bank manager’ looking after depositors’ funds.
• The US housing boom. Low interest rates early this decade drove a housing boom in the US which was increasingly underpinned by a deterioration in lending standards. This saw a huge growth in loans to so-called sub-prime (or high risk) home borrowers in the US up until 2007.

The music stopped in 2006 when poor affordability and an oversupply of homes saw US house prices peak and then start to slide. This made it harder for sub-prime borrowers to refinance their loans in order to maintain their initial low ‘teaser’ mortgage rates. As a result, more and more borrowers defaulted causing investors in the fancy products that invested in sub-prime loans to start suffering losses. In 2007, this became the sub-prime mortgage crisis. Rising unemployment and falling house prices have since seen the problem spread to all US mortgages.

But why did the sub-prime crisis drag down the whole world?
First, the extent of bad loans and losses has been far worse than thought. Second, record levels of debt in investment banks and hedge funds have accelerated the losses and the declines in key assets as positions had to be unwound to cut debt or meet redemptions. High household debt has also made the economic fallout far greater. This has seen the crisis spread to countries such as China. Third, the distribution of securities investing in US sub-prime debt all around the world has led to a wider range of exposed investors and, therefore, greater worries about which financial institutions are at risk. Fourth, just as greed played a role on the way up, fear played a huge part on the way down. This was evident in the freezing up of lending between banks following the failure of Lehman Brothers on fears that all banks are at risk, as well as the dislocation in credit flows to good companies. All of these factors came together to produce a downward spiral of falling share markets, falling confidence, reduced lending, reduced economic activity, more losses, followed by more falls in share markets etc. This was transmitted globally via trade flows, confidence effects and capital movements.

Hence, fault lies with a range of players: the US home borrowers who weren’t aware of what they were getting into, the lenders who relaxed their lending standards, the ratings agencies, investors chasing returns without regard to risk, US regulators and financial organisations that took on too much risk. And, as always, greed and fear played a big role in magnifying the boom and then the bust.

The end result was a year of extremes
This has been demonstrated by:

• One in ten US households with a mortgage are now behind in their payments or in foreclosure
• The de facto demise of the big five US investment banks, via bankruptcy, merger or conversion to banks
• The nationalisation of Fannie Mae and Freddie Mac, which own or guarantee half of US mortgages
• The ‘closure’ of 23 US banks, the rescue of Citigroup and public capital injections into many other banks
• The need for numerous European banks to be supported by governments
• The worst bear market in US shares since 1937 and the worst in Australian shares since 1973-74
• The lowest 10-year bond yield levels since 1951 in the US and 1952 in Australia as investors sought their safety
• A blow-out in US investment grade credit spreads to levels not seen since the 1930s
• A 60% collapse in commodity prices since mid-year
• The most synchronised global downturn since World War Two
• A 90% collapse in the cost of freight space on cargo ships, reflecting a collapse in global trade.

Was it forecastable?
Why didn’t all the experts see it coming? This is a good question as most didn’t and even those who saw problems didn’t see them unfolding so quickly. There are several points to note. First, if most of the experts had seen it coming then the crash and the preceding boom wouldn’t have happened. Second, there is an important distinction between something that is foreseeable (eg eventually high debt levels will cause a problem) and something that is forecastable (eg high debt levels will cause a major problem in 2008). While some sort of financial crisis made worse by high debt levels and global savings imbalances was foreseeable, its timing was not accurately forecastable.

Some did get it right but, as former RBA Governor Ian Macfarlane observed, “everyone who predicted what has happened this year has been predicting it for ten years”. And that is not a great track record. There is no guru or expert who will always get it right.

The post-meltdown world – how different will it look?
It is hard to see the events of the last year or so not having major implications. We see several:

• Increased regulation of the financial sector. The damage caused by the financial crisis will lead to a rise in regulatory oversight of the financial sector globally.
• Bigger government. This is already apparent with various governments taking stakes in financial institutions. A big increase in infrastructure spending is also on the way in China, the US and Australia.
• Back to basics investing. Given the problems sophisticated investment products have had and the rise in investor scepticism, we may see a return to simpler investment products with less reliance on financial engineering, leverage or claims of positive returns in all environments. We may well see a ‘back to basics’ world refocused on shares, government bonds, cash and direct property/infrastructure with less reliance on in-between assets.
• Slower growth in the financial sector. The crisis, greater investor scepticism and more regulation are likely to slow the rate of growth in the financial sector after 25 years of above average growth.
• A faster shift in economic power to Asia. The global financial crisis is likely to accelerate the shift in relative economic power from the G7 countries (which have now suffered a loss of global credibility and are likely to be hampered by excessive debt, especially the US) to Asia. Asia has high savings and has not seen its banking system come under threat. This will likely be reflected in a favourable relative performance of Asian assets going forward.

What are the lessons for investors?
The past year or so highlights several lessons for investors:

• The business cycle is alive and well and, therefore, so too is the investment cycle. This reminds us that periods of great returns are invariably followed by a fall back such that long-term returns are more consistent with underlying economic growth. If returns are too good to be true they probably are.
• High returns always come with high risk. While risk is often dormant for years, it usually returns with a vengeance as is now apparent. The trick for investors is to be aware of the extra risk they are taking on.
• Sentiment plays a huge role in investment markets, the global financial system and the economy. This has been amply demonstrated over the last year. While trading against the crowd has not worked very well over the last year, history demonstrates that the crowd always pushes to extremes and successful long-term investors do the opposite.
• Be sceptical of financial engineering or hard-to-understand products. The biggest losses for investors in all of this have generally been in products that rely heavily on financial engineering. Such constructs often have a poor alignment of interests, poorly understood risks and excessive fees.
• Avoid too much gearing or gearing of the wrong sort. Gearing is fine when all is going well. But it will magnify losses when things reverse. It can also force the closure of positions at a big loss when the lenders lose their confidence and refuse to roll over maturing debt or when a margin call occurs.
• The importance of diversification and government bonds. While listed property and hedge funds have been seen as an alternative to stodgy, low-yielding government bonds, they have run into big trouble over the last year and been shown to be correlated to equities. Conversely, government bonds have been star performers. Accordingly, investors need to be much more sceptical of claims by hedge funds that they will provide positive returns in all environments with risk not much higher than that of bonds.
• Finally, the wild daily and weekly gyrations in markets over the last year highlight the difficultly for most investors in timing short-term moves and remind us that the best approach is to focus on a long-term strategy.

Dr Shane Oliver
Head of Investment Strategy and Chief Economist
AMP Capital Investors

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