It seems momentous things happen in years ending in seven. Well, at least in the last 50 years starting with the “summer of love” in 1967 and the introduction of the Chevrolet Camaro. But after that, it was downhill with Elvis leaving the building in 1977, the 1987 share market crash, the Asian crisis of 1997 and the GFC that started in 2007. While Lehman Brothers didn’t go bankrupt until September 2008, the GFC’s initial tremors occurred in 2007. Financial markets really started to take notice in August of that year, with shares taking a big hit before rebounding to new highs for US and Australian shares in October/November 2007 ahead of a roughly 55% decline into March 2009. This note looks at the main lessons for investors from the GFC and whether it can happen again.
But first some history. The GFC was the worst global financial crisis since the Great Depression. It saw the freezing up of lending between banks, multiple financial institutions needing to be rescued, 50% plus share market falls and the worst post-war global economic contraction. At the core of the GFC was something very basic. In an environment of low interest rates (with often initially low “teaser” rates) too many loans were made to US home buyers that set off a housing boom that went bust when interest rates rose and supply surged. So no big deal – it happens all the time! But it was what went on around it that ultimately saw it turn into a global crisis.
The music stopped in 2006 when poor affordability, an oversupply of homes and 17 interest rates hikes from the Fed over two years saw US house prices peak and then start to slide. This made it harder for sub-prime borrowers to refinance their loans at their initial “teaser” rates. As a result, more and more borrowers defaulted causing investors in the fancy products that invested in sub-prime loans (like CDOs) to start suffering losses. The problem really caught the attention of global investors in August 2007 after BNP froze redemptions from three of its funds because it couldn’t value the CDOs within them, which in turn set in train a credit crunch with sharp rises in the cost of funding for banks and a reduction in its availability triggering sharp falls in share markets. Shares rebounded but only to peak in late October/November 2007 before commencing roughly 55% falls as the credit crunch worsened, the global economy fell into recession, mortgage defaults escalated and multiple banks failed.
The crisis went global as: losses mounted; these were magnified by gearing, which forced investment banks and hedge funds to liquidate sound positions to meet redemptions thereby spreading the crisis to other assets; the distribution of securities investing in US sub-prime debt globally led to a wide range of exposed investors and hence greater worries about who was at risk; this all led to a freezing up of lending between banks. All of which affected confidence and economic activity.
Fault lay with home borrowers, the US Government, lenders, ratings agencies, regulators, and investors and financial organisations for taking on too much risk.
It came to an end in 2009 after significant monetary easing and fiscal stimulus helped restore the normal operation of money markets, confidence and growth. That said, aftershocks continued with sub-par global growth and very low inflation.
The GFC highlighted several lessons for investors:
Of course there will be another boom and bust…but as Mark Twain is thought to have said “history doesn’t repeat, but it rhymes” so the specifics will be different next time. History is replete with bubbles and crashes and tells us it’s inevitable that they will happen again as each generation forgets and must relearn the lessons of the past. Often the seeds for each new bubble are sown in the ashes of the former. Fortunately, in the post-GFC environment seen so far there has been an absence of broad-based bubbles on the scale of the tech boom or US housing/credit boom. E-commerce stocks like Facebook and Amazon are a candidate but they have seen nowhere near the gains or infinite PEs seen in the late 1990s tech boom.
On the global debt front, a concern is that after a post-GFC pull back, it has grown to an all-time high relative to global GDP.
However, just because global debt has grown to a new high doesn’t mean a crisis is upon us. It has been trending up for decades, much of the growth in debt in developed countries post the GFC has been in public debt and debt interest burdens are low thanks to low interest rates in contrast to the pre-GFC period. Furthermore, the other signs of signs of excess that normally set the scene for recessions and associated deep bear markets in shares like that seen in the GFC are not present on a widespread basis just now. Inflation is low, monetary policy globally has barely tightened, there has been no widespread overinvestment in technology (as preceded the tech wreck) or housing (as preceded the GFC in the US) and bank lending standards have not been relaxed to the same degree as seen prior to the GFC. Moreover, financial regulations have tightened significantly with banks required to have higher capital ratios and source a greater proportion of funds from their depositors.
So another boom bust cycle is inevitable at some point, but it will likely be very different to the GFC. And many of the signs of excess that normally precede deep bear markets are still absent.
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