Introduction

Since 15 September was the tenth anniversary of the Lehman bankruptcy, this article sets outs a review of what caused the crash, subsequent policy responses and a review of the current situation.

Reasons for the crash

There are a complex number of reasons, but the list of 16 factors below encompasses most of the contributors to the financial and economic events in 2008.

1. Undercapitalised and over leveraged banks: The average leverage ratio of US and European banks in 2007/08 was close to 30 as compared with a historic average of less than 15. Consequently, the banking system was more vulnerable to a withdrawal of liquidity and a deterioration in asset quality, implying greater scope for market and economic volatility.

2. Investors were over leveraged: Surveys of investor positions showed historically high levels of leverage either through options/derivatives purchases, straight borrowings or the purchases of instruments with embedded leverage. Consequently, investors were vulnerable to asset price declines and/or defaults, again implying a high degree of volatility built into markets.

3. Opaque structured products were widely purchased by banks and investors. In many cases, products such as CDOs, CBOs and CLOs had different levels of risk built into them with investors unable to calculate clearly the degree of risk they were buying and the extent of potential losses in a market downturn.

4. Consumer and mortgage credit was “easy” in the US and in certain other countries. In the US, household debtto- GDP, currently 89%, reached a record 98% in Q1 2008.

5. Misuse of derivatives and mis-pricing of risk: Investors were major purchasers of derivatives either to obtain market access with leverage and/or to get market exposure without buying the underlying assets. Frequently, there was a divergence between the price performance of the derivatives relative to the assets with derivative pricing being opaque.

6. Concentration of derivatives risks: In the OTC markets and notably in the credit derivatives markets, there was a concentration of risk and activity amongst a limited number of participants, which was a key contributor to the bankruptcy and forced rescue of AIG.

7. Reactive behaviour of the credit rating agencies: Although it is contentious, much criticism has been levelled at the CRAs for either being tardy in making downgrades, in incorrectly assigning ratings and in underestimating the risks and speed with which credit >risks could change in multi-tiered structures, such as CDOs.

8. “Blind faith” of investors in the credit agencies: Many investors purchased credit risk without carrying out their own due diligence and therefore were particularly exposed when structured product investment grade tiers were downgraded to high yield status. These credit downgrades triggered forced selling where investor guidelines prevented them from holding assets lower than investment grade.

9. Overvalued, mis-priced bank takeovers, such as the RBS acquisition of ABN Amro: In many cases, it was clear that the acquirer had not correctly stress-tested the value of the assets to be purchased, while valuations were historically high and acquisitions which were debt financed compounded the increase in bank leverage. The level of M&A activity concentrated bank risk, thereby compounding economic/systemic risks in a downturn.

10. Flow of foreign capital into the US mortgage market: Countries with high savings ratios and banking systems with high or excess reserves with insufficient lending opportunities in their home markets were attracted to the higher returns in the US mortgage market. This was particularly the case of the European and notably the German banks. The Japanese banks, having experienced their own major crisis in the 1990s were less exposed although pockets of Asian banks outside Japan had high levels of exposure as did the Middle East banks. Capital flows into the US increased liquidity in the US market and stretched valuations further.

11. Investor positions were concentrated: Risk surveys of investor positions showed a steady increase in risk appetites in 2006-H1 2008 with investors increasingly chasing higher risk assets such as those in the US mortgage market, high yield and emerging markets. There is often a high correlation between market volatility and the concentration of investor positions.

12. High market valuations/tight credit spreads: Although the P/E ratio on the S&P in 2007 was around 17, credit spreads had rallied since 2002. High yield spreads in October 2002 were 10.6% but had narrowed to less than 250 bps by May 2007, clearly implying that in contrast to 1999, when the “bubble” was in equity markets led by the tech sector, in 2007 the bubble was driven by the credit markets, which were more associated with banking risk.

13. Monetary policy was too easy with the Fed Funds Rate being cut from 6.5% in November 2000 to 1.25% in July 2004 and then slowly and progressively being increased to 5.25% in March 2007. Private debt-to-GDP was 212% in 2008 compared with 180% in 2000 (and higher than today’s 202%). Arguably, monetary policy was eased too rapidly and by too great an extent until 2004 and then was only tightened slowly and too late, with real rates being negative. Although borrowing became more expensive in 2007, credit availability was still generous.

14. The housing market in the US became overstretched: The Case Shiller 20 city index rose from 100 in 2000 to approximately 210 in 2006 and after the crash reversed to 140 by 2009. Housing affordability became increasingly difficult in 2006-2007 and encouraged home owners to borrow more either to upgrade their homes or to take equity out (a much-used phrase at the time was to treat your home as an ATM).

15. “Waterfall” selling: As defaults rose on lower rated tiers of structured debt, higher rated tiers were downgraded, forcing investors to sell. Where forced sales were at a loss, investors would have to liquidate profitable positions to cover losses elsewhere, which compounded downward pressure on asset prices leading to a further spiralling of price declines (the waterfall effect). As the banks were de-risking their balance sheets, market maker liquidity declined, thereby forcing investors to sell at frequently distressed prices.

16. Poor regulation: Although at the time, regulators resisted any criticism, however, in hindsight, most current and past regulators, at least in private, agree that the regulatory regimes worldwide were far too lax. Banks were not properly stress-tested, frequently regulators were unaware of the poor quality of assets on bank balance sheets, insufficient work had been done on contagion risks and regulators were not fully cognisant of the risks in the OTC/derivatives markets. Two further areas where regulators either lacked information or misunderstood risks were in special purpose vehicles (usually in offshore centres) and the risks of downgrades amongst the tiers in CDOs, while banks were allowed to run relatively low levels of capital.

Many if not all of the above factors are inter-related, but the key themes were over-leverage, risk opacity, easy credit availability and a culture of excessive risk taking. One factor which has also been widely debated has been bonus-driven compensation, and at the time, it was obvious that a compensation structure of lower base salaries in the financial sector with potentially higher bonuses driven by (sometimes) questionable performance criteria encouraged excessive risk taking.

The policy responses

Broadly, there were nine policy responses:

1. Banks were forced to deleverage their balance sheets with average leverage ratios declining to less than 15.

2. Bank capital was increased with straight equity issuance,  but also with new capital instruments being used such as  CoCos.

3. Investment banks were forced in the US to take banking  licences, thereby coming under the regulation of the Federal  Reserve.

4. Bank regulation and regulatory resources were dramatically  increased. Inter alia, banks were subject to stress tests and  were forced to write “living wills”. In Europe, bank bonuses  were restricted. Serious attempts have been made to ring  fence banks’ domestic and retail operations away from the  global operations and/or investment banking.

5. Market regulation was increased with a concerted effort  by regulators to curtail opaque OTC trading and force trading  onto regulated exchanges. Outside the banking sector,  regulation was tightened on asset managers, brokers and  exchanges. The levels of liquidity being provided to markets/  investors by the investment banks was curtailed as were  trading volumes. Likewise, the creation and distribution of  opaque products has been restricted notably in the structured  products markets.

6. Given government support for banking sectors and the  extent of the H2 2008/2009 recessions, fiscal revenues  decreased and fiscal policies were in many countries  tightened (in hindsight a mistake notably in the euro area).

7. Monetary policy was eased in an unprecedented way with  the move to negative interest rates in a number of countries  but notably in the euro area and Japan while central bank  balance sheets were expanded to record levels. The Fed  balance sheet was less than US$900 billion prior to the  Lehman collapse but then peaked at US$4.5 trillion prior to  the slow process of tapering. The ECB and Bank of Japan  balance sheets are still at record levels. The Fed balance sheet  was expanded by major purchases of mortgage debt while the  ECB intervened in the covered and corporate bond markets  while the Bank of Japan has become the largest owner of  Japanese equity ETFs.

8. Selective bank bailouts occurred and/or regulators forced  strong banks to purchase weak or failing banks. In the US,  examples were the JP Morgan acquisitions of Washington  Mutual and Bear Stearns and Bank of America’s purchase  of Merrill Lynch. In the UK, Lloyds Bank purchased HBOS,  while the Spanish and Italian banking systems saw significant  consolidations notably amongst the smaller regional savings  banks. The largest bailouts were AIG, RBS and UBS.

9. Selected asset classes received bailouts, notably in the US  with the TARP programme to support the mortgage markets.

The current situation

The last ten years have seen a trend decline in leverage.  Despite the near ten-year rally in equity markets, investor  leverage is low and surveys clearly show that investors are  defensively positioned and well diversified (with the exception  of exposure to the FAANGs). Bank leverage has, on average,  been reduced to less than 15 times and required loan loss  provisioning by the banks has been reduced to low levels.  Bank stress tests are now generally robust with most banks  passing the tests.

Although US corporate debt has increased, largely to finance  share buy backs, corporate defaults are at a near record  low level and the recent rise in the Fed Funds Rate with an  associated increase in borrowing costs has not led to any  signs of stress amongst corporates. Likewise, except for  selected countries, consumer debt is relatively low and, finally,  the recent improvement in wage growth in the US, UK and  the euro area combined with low unemployment has led to an  upgrade in consumer balance sheets.

However, government debt levels are high with debt to GDP  at 253% in Japan, 132% in Italy, 105% in the US, 98% in  Spain and 97% in France. Central bank balance sheets, as  mentioned above, are at record levels in the euro area and  Japan and the process of tapering in the US from the current  Fed balance sheet total of US$4.2 trillion is slow.

Potential or actual problems are the deleveraging of the  Chinese shadow banking industry and the potential for  further defaults in China, selected emerging market countries  with high current account/fiscal deficits and the corporate  sector where US dollar liabilities have financed devalued local  currency assets.

The overall picture is one of pockets of problems with  systemic/contagion risks reduced.

Robert Parker is Chairman of the ICMA Asset Management and Investors Council (AMIC) and Committee.