Reflections on the Global Financial Crisis

This weekend marks the tenth anniversary of the collapse of Lehman Brothers which many observers consider to be the transition point from a downturn in the U.S. subprime mortgage market to the Global Financial Crisis (GFC). We remember well the uncertainty surrounding the future of the financial markets, with stomach-churning 10% daily movements being commonplace.

Unfortunately, we will never know if the massive government bailout truly prevented another Great Depression, as there was no control group for this unprecedented experiment. One thing we did learn is that, with the exception of Lehman, the large banks, brokerages, and insurers would no longer be allowed to fail for better or worse. Although these companies have appreciated handsomely over the last decade (because they started from depressed stock prices), their future returns may be somewhat curtailed by the removal of the risk of failure. By the way, if anyone thinks that Dodd-Frank ended “too big to fail”, we would like to name a star after them, the one that’s not too bright.

We often hear the complaint that nobody went to prison for all the shenanigans that led to the GFC. While 35 bankers from local and regional banks were incarcerated for fraudulent activities as of April, 2016 (according to Christy Goldsmith Romero of the Troubled Assets Relief Program), nobody from the major firms has ever been criminally charged. The unsatisfying explanation repeatedly offered is that incompetence is not a crime.

Perhaps the mother lode of incompetence occurred at the rating agencies that gave A-ratings to complex debt instruments constructed from D-rated loans. Our favorite was the CDO-squared, that was so memorably explained by Richard Thaler and Selena Gomez in The Big Short. At long last, one of the rating agencies (Moody’s) has been called out by the SEC for “internal controls failures and rating symbols deficiencies” related to US residential mortgage-backed securities. Moody’s has agreed to pay $16.25 million in the SEC’s first such enforcement action. Hopefully, more will follow. Ironically, the deficiencies occurred in ratings assigned from 2010 to 2013, after the GFC.

Regarding the GFC, the question perpetually asked is, “Will it happen again?” The answer, of course, is nobody knows. However, we can evaluate today’s conditions in light of what we experienced in 2007. While the infamous “NINJA (no income, no job, no assets)” subprime loans are gone, we do have nonprime loans marketed to folks with “less-than-perfect credit”, but they are supposedly fully underwritten. A worrisome loan market is student debt, now valued at $1.5 trillion and also highly securitized in a similar manner to mortgage debt. According to William Dudley, the President and CEO of the Federal Reserve Bank of New York, student indebtedness has grown by 170% from 2006 to 2016, and 28% of students who left college between 2010 and 2011 defaulted within five years compared to 19% who left between 2005 and 2006, indicating substantial deterioration. Lastly, the size of the junk bond and leveraged loan markets are now double what they were in 2007, according to Jonathan Rochford of MarketWatch.

The history of finance is filled with excesses followed by catastrophes. Wise investors do not allow themselves to be caught up in the frenzy of the moment nor do they capitulate and sell everything at the bottom. If you would like to learn more about weathering a financial storm while keeping costs low with flat fees, please contact our fiduciary wealth advisors at 800-345-4635 or info@clarityca.com.