Sketches of Janus, Roman god of beginnings and endings. Source: Wikimedia
Ten years ago the world experienced a series of financial cataclysms that resulted in the longest and deepest recession since the Great Depression. It started in August 2007, when BNP Paribas announced that they were suspending redemptions on three of their most aggressive real-estate-linked mutual funds. Real estate prices had been falling for over a year, and the market for many mortgage-backed securities was drying up. BNP couldn’t raise enough cash in these funds, so they closed them – locking investors in.
The market’s response was clear. If there wasn’t enough liquidity in the mortgage market to buy and sell mortgages – even esoteric ones – then financial risk was significantly higher than previously thought. Bank borrowing costs bumped up, and didn’t fall back to their pre-BNP levels until after the Fed announced the results of their bank stress-test in May 2009, over a year and a half later.
Bank borrowing costs during the Financial Crisis. Source: VoxEU
This initiated a series of failures, losses, bailouts, and interventions that peaked with the bankruptcy of Lehman Brothers and the subsequent necessity of the Reserve Primary money market fund to “break the buck.” An institutional bank-run ensued, and over a million workers per month were laid off around the world when their corporate parents’ essential credit lines were threatened. People thought we were entering a second Great Depression.
But that didn’t happen. Central Banks around the world took unprecedented action, injecting liquidity and making sure the financial plumbing remained clear of obstructions. Legislators approved massive economic stimulus, spending money on infrastructure and public sector jobs. And banks received capital from both private and public investors, shoring up confidence. By mid-2009, the global economy was on the road to recovery.
There’s a broad consensus now that the financial system was under-capitalized and overly complex. This meant that when a key sector, like housing, started to decline, it was impossible to determine who was exposed and what investments were at risk. Facing this uncertainty, investors pulled their money out and put it into the safest instruments. They weren’t worried about returns on their money, but return of their money.
CDO and RMBS diagram. Source: Wikipedia.
Could it happen again? Sure, but probably not in the same manner. The financial system is a lot more transparent, and money market funds have been reformed to properly reflect the risk that they’re taking. The banking system now has more capital, as a percentage of assets, than it has in over 30 years – over 50% higher than it was before the crisis. For all the complaints about inadequate fiscal responses and fat-cat bailouts, a lot of the folks most responsible for the crisis lost a great deal of their wealth, and we didn’t experience an economic depression.
What have we learned? Little things add up to big things. BNP’s fund closure on August 9, 2007 didn’t seem like much at the time, but it was a harbinger of coming bank failures and nationalizations around the world, primarily because banks use real-estate as collateral for much of their lending. When real estate prices fall, and the loans go upside-down against their collateral, banks get the keys in the mail: “jingle mail.” Bank earnings, and then capital, becomes at-risk. The solution is strict underwriting and enough capital.
The next crisis will come from somewhere new: a domestic crisis in China; an aggressive computer virus that disrupts commerce; a political movement that takes a dark turn. It’s the nature of black swans that they only appear obvious in hindsight. As always, the best way for investors to manage the risk of an unexpected crisis is diversification. And, systemically, appropriate regulation.
To borrow a phrase from biographer Thomas Charlton, the price of financial stability is eternal vigilance.
Douglas R. Tengdin, CFA