It was the best of times, it was the worst of times, it was the age of wisdom, it was the age of foolishness, it was the epoch of belief, it was the epoch of incredulity, it was the season of Light, it was the season of Darkness, it was the spring of hope, it was the winter of despair, we had everything before us, we had nothing before us, we were all going direct to Heaven, we were all going direct the other way.
Opening paragraph to “A Tale of Two Cities”, by Charles Dickens
Seven years have passed since the global financial crisis got under way. Five years have passed since the crisis peaked and global stock markets were driven into the floor by a wave of panic selling. Stock markets bounced strongly in the following two years, led by emerging markets. By the end of 2012 the US stock market had caught up. Since the start of 2013 the US has powered ahead while emerging market stocks have fallen. Today I take a look at what happened going into the crisis. In part II I’ll cover what happened next and what it means for investors today.
Back in 2006 I’d already been working for a huge global investment bank and wealth manager for 13 years. I’d moved back to London in 2005 after an exciting few years working in the high growth countries of Asia. London was a drag by comparison.
It was pretty clear that confidence was running high in the financial industry, and its twin brother complacency was also in plain sight.
Money was pouring in, and expansion was the name of the game.
There were real estate bubbles in many countries (and, by the way, there still are in certain European countries such as France and the UK). There was a private equity bubble. There was a hedge fund bubble. And there were bubbles in many parts of the bond and stock markets.
I made the decision to quit banking in early 2007, as I was getting bored with the bureaucracy and internal politics. That said it took me another year to work out exactly what to do next (it was a big decision, after all).
In the end I emigrated to South America in 2008, with no fixed career plans, just as the market crisis reached its peak. But the initial decision was taken before the sub-prime lending crisis got started in the US. The crisis just made it far easier to eliminate any lingering doubts about whether I was doing the right thing.
Banks were leveraged up to the hilt, often with assets 50 or 60 times as large as their equity capital, my own employer included. At 50 times leverage, balance sheet assets only need to lose 2% of their value and the bank is bust. Many banks achieved that. Some achieved it twice or more times over, until they were bailed out.
Something that is often forgotten is that the crisis started way back in February 2007. HSBC got the ball rolling in the US “sub-prime” mortgage crisis, announcing multi-billion dollar losses.
Sub-prime mortgages, put in plain language, were low quality. They were housing loans made to poor people with little chance of ever paying them back.
Sub-prime mortgages, put in plain language, were low quality. They were housing loans made to poor people with little chance of ever paying them back. No surprise then that substantial pain was likely to follow, for both borrower and lenders.
(Note: The financial industry often uses euphemisms like “sub-prime” in their industry jargon. The idea is to make something sound less dodgy or more sophisticated. Here’s one of my favourites: In the 1980s the riskiest corporate bonds were called “junk bonds”, because they were junk, garbage, rubbish, of low quality. But some time during the 1990s they morphed into “high yield bonds”. Much better sounding, don’t you think? But exactly the same thing.)
The banking industry had been busy making low quality loans and clipping fat arrangement fees. They would then sell collections of these loans – called mortgage backed securities (MBS) – to yield hungry investors, often pension funds.
So the banks kept the fees but sold the risk. But at any given time they had plenty of risk, as new loans were made but before they were packaged up and sold on.
Put simply, both banks and professional investors had gone collectively insane, egged on by governments. Arguably borrowers had lost the plot too, although they had the excuse of not being trained financial experts.
I may have taken a decision to check myself out of the lunatic asylum. But the implications for financial markets and the global economy turned out to be massive.
I was expecting some kind of major hit to the industry after a period of complacency. But I’ll freely admit I had no idea how hugely damaging or widespread the effect would be…
I was expecting some kind of major hit to the industry after a period of complacency. But I’ll freely admit I had no idea how hugely damaging or widespread the effect would be, or how long it would take to recover. Many investors took huge losses. And economic depressions continue to hang over southern European countries such as Greece and Spain, where unemployment rates still hang around 27% (and double that for people aged 18 to 25).
After initial denials by bankers and politicians that there was a big problem, things just got worse and worse. It wasn’t until 15 September 2008 that Lehman Brothers, a large US investment bank, was allowed to fail.
Lehman’s management must have really upset people in high places. Almost everyone else who got in trouble was bailed out. But that bankruptcy was a full 17 months after HSBC had been the first to admit big losses in its US mortgage business.
Many other banks failed in the US and Europe. Or they would have done, were it not for massive government bailouts, huge central bank interventions into markets to prop up asset prices, rushed mergers of the weak with the strong (often converting the strong into the weak), and emergency capital raises in the markets.
As for global stock markets those had peaked in October 2007, eight months after HSBC owned up to the first wave of US mortgage losses. They didn’t reach bottom until early March 2009, which was 17 months after the top.
That was five years ago. In part two I’ll explain what happened next to stock markets, and what it means for our investments today.
Stay tuned OfWealthers,