The Great Stampede

In future years September 2008 will be seen as a defining moment in economic history similar to the Great Depression of the 1930s, or the Great Inflation of the 1970s. A suitable epitaph for this catastrophic episode might be ‘The Great Stampede’, the day the financial markets realised that the US banking industry had metamorphosed into a casino; a casino that was burning down around them, and there was only one exit. The panic and undignified scramble to get out was beyond the comprehension of most people, and only when the wreckage ceases to smolder and history can be written will the world understand how truly close we were to financial Armageddon.

The cause of the Great Stampede was rooted in financial deregulation that occurred in 1999. This repealed regulations that had been enacted after the Great Depression in order to protect bank depositors by separating commercial banking from investment banking, in essence preventing commercial banks from trading, or gambling, with depositor’s cash. Financial deregulation also occurred at the same time as the expansion and widespread use of IT. The combination of deregulation and IT unleashed huge banking, investment, brokerage, trading behemoths like Citigroup, and caused the investment banking industry to erupt, with everyone riding on the back of an array of complex new IT driven securities and derivatives that were beyond the comprehension of the public, government, regulators, and most people within the financial institutions themselves.

The Federal Reserve regulated the commercial banking sector, but the unregulated shadow banking sector - investment banks, hedge funds, private equity funds and the securitisation market - eventually mushroomed to a size where it was significantly larger than the core commercial banking sector that the Fed was created to protect. Because it was unregulated, the authorities did not pay much attention to shadow banking, nor were they aware of the true size of the sector. As a result, when the markets started contracting, government was taken off-guard and failed to respond appropriately. Wall Street was clearly in big trouble in 2007 and from the moment institutions started failing in early 2008, the authorities were never properly prepared and were always playing catch-up. A characteristic of 2008 was officials believing they were planning for a worst case scenario when in fact they were always insufficiently pessimistic. When the fire alarm went off in the casino, government incorrectly thought the fire could be contained with extinguishers in a few restricted areas, not having a clue that the whole building was alight and in imminent danger of being burned to the ground! This myopia was a major contributing factor to the global meltdown in September 2008.

Bear Stearns was the first big institution to crash in March 2008, leading to a government orchestrated takeover by J.P. Morgan. The bail-out was justified on the basis that Bear was too heavily interconnected within the financial system to be allowed to fail. Even then the bail-out nearly unwound because the authorities insisted on capping taxpayer guarantees to USD 2 per share, making the purchase of the bank equivalent to the amount the LA Galaxy paid for the services of David Beckham! When common sense prevailed and a more equitable discount was agreed, the take-over was consummated.

In the summer the authorities stepped in to save home mortgage companies, Freddie Mac and Fannie May, by effectively nationalising them. When Lehman Brothers and Merrill Lynch declared they were in trouble in September 2008, the Fed and the Treasury were extremely concerned over public opinion of earlier bail-outs. As a result they made a catastrophic error by choosing not to intervene. Merrill were pushed into a shotgun marriage with Bank of America, but in the absence of an unsupported suitor Lehman had no choice but to declare bankruptcy to the tune of USD 650 billion. As their rationale the authorities cited that the markets were already aware of Lehman’s plight after the Bear collapse and had time prepare for their inevitable demise. This decision demonstrates how detached the authorities were from the markets. The reality is that the markets believed the exact opposite; having bailed out Bear, which was significantly smaller than Lehman, the markets thought it unthinkable that the authorities would allow Lehman to fail, and no-one had prepared for this eventuality!

The chaos that followed that week was due to the shock of realising that the US government would not stand behind its financial sector, that every institution was now at risk, and who would be next to go? The Lehman collapse hastened the fall of AIG within 48 hours and in the next days the money markets froze. All around the world, banks no longer trusted one another and stopped extending credit to each another, whilst panicked investors scrambled out of the casino as best they could and sought shelter in government sovereigns. Within a week, Goldman Sachs and Morgan Stanley would make the historic decision to cease as investment banks and seek shelter behind the Fed as commercial regulated entities, to be followed shortly by Amex and GMAC, the financial arm of GM. The costs of cleaning up the mess will likely exceed USD10 trillion, much of which could have been saved if Lehman had been rescued, but the most important lesson from this episode is that within a decade of financial deregulation the financial system of the greatest economy in the world was bankrupt.

Lessons from the Great Stampede

1. Interest rates were kept too low for too long. Rates had been kept low in response to a number of problems like the dot.com bubble, 9/11, and Hurricane Katrina. Throughout this period risk premiums remained artificially narrow, and investors felt optimistic that the new IT driven information economy could help sustain the bull market and hedge the downside. Because interest rates remained so low for so long investors needed to increasingly reach out further for yield in order to maintain growth until they ultimately reached out too far and fell off the cliff.

• The housing bubble was underestimated. The government was concerned about bursting the housing bubble in case it interrupted economic growth, and naively believed that a downturn would not occur nationwide. Housing boom and bust cycles are an inevitable recurring theme for the simple reason that eventually prices always rise to a point where they are no longer affordable and the market crashes. A brief study of the history of housing bubbles in western economies shows an average cycle of 14-18 years; 14 years of rising house prices followed by 4 years of depression when the bubble bursts. Given the last US recession finished in 1990, history would have predicted that the housing market was likely to collapse between 2004 and 2008, and once again it has been proven right. Future housing bubbles may take a different shape though, given the emergence of a large number of exchange traded indices during the past cycle. Homes will continue to be bought and sold in the traditional manner, but the new indices will encourage greater speculation and volatility as a result of investors being able to short the index and place bets against specific movements or events.

1. The sub-prime debacle. The authorities failed to prohibit or restrict abusive mortgage practices. The widespread use of NINJA (no income, no job or assets) mortgages or HELOC (home equity lines of credit) were well publicised and common knowledge, but the authorities rarely clamped down on unethical practice. Institutions encouraged originators to print as many loans as they could, toxic or otherwise, as the risk would be packaged and sold on to third party investors or mitigated through insurance policies. The fact that rating agencies rated securities containing sub-prime mortgages as AAA demonstrates gross irresponsibility on behalf of lenders and rating agencies, and gross negligence on behalf of the authorities. Government then fooled itself into believing that the sub-prime burst in 2007 could be contained. Common sense and history dictates that in a downturn the most risky sectors are the first to fail. Sub-prime defaults were therefore in reality the first obvious sign of the overall housing market crashing.

1. Greater faith in markets participants than regulators. The regulatory authorities were under-resourced to cover all the markets and were therefore happy to believe that officers of financial institutions would self-regulate as they understood the risks better than external regulators. This turned out to be the most spectacular failure of trust and common sense! Worryingly, the regulators under their current framework are still not in a position to plug the gaps in the markets either. In the words of the chairman of the Fed in March 2009: “AIG exploited a huge gap in the regulatory system. There was no oversight of the financial products division. This was a hedge fund attached to large stable insurance company that made huge numbers of irresponsible bets and took huge losses. There was no regulatory oversight because there was a gap in the system.”

1. Trust in financial institution’s risk management. The authorities believed that institution’s internal risk management systems were sufficient to maintain responsible lending, investment and trading practices. In practice they were hopelessly inadequate. Most CEOs and risk managers were ignorant of their true trading risks. Within Lehman ‘diversity’ was given a higher budget than ‘risk management!’ Leverage ratios of 44:1 and 50:1 for Lehman and Bear respectively when they crashed, pointed to an obvious disaster in waiting. Top of the risk-list were derivatives and structured finance products where very few people within the institutions truly understood the downside. As an example, most risk managers would claim that derivatives add stability to the markets. In fact the opposite view may be more accurate: that they stimulate and encourage speculation, and are widely adopted only because they boost trading revenues. For some firms derivatives comprise over 50% of their trading revenues. Take the practice of taking a short position on a security, ie betting it will go down. As a market approaches its peak investors increasingly hedge their downside by shorting it. By the time the peak is reached, the volume of shorting becomes overwhelming, the scales tip to the downside, and the short becomes a self-fulfilling prophecy. This only benefits traders and speculative investors whilst for the underlying sponsor it can be unnecessarily harmful and increases volatility. Another example is credit default swaps - the ability to take out an insurance policy or bet against the odds of a credit deteriorating or defaulting. Millions of dollars of fees are earned in this way without any need to make outlay or buy anything; the only risk is pay out in the ‘unlikely’ event of default. In 2008 a typical case was banks betting on the likelihood of a USD 100 million office building loan in Manhattan failing. By the time the building defaulted more than USD 800 million of bets had been made, which is absurd. The only thing this has to do with banking is the fees gained from making the bets that happen to contribute to bank profits, and it might be simpler just to install a roulette wheel on the trading floor for investors and traders to punt on!

1. Investment bank structure. Such has been the increase in derivative trading that institutional management structure has been heavily staffed in recent years by an army of pure mathematicians in preference to the tried and trusted market player with downturn experience. There is an old saying that you cannot model human behaviour with mathematics, which is a major reason why the investment banks and rating agencies went so spectacularly wrong.

1. The great decoupling theory. The past decade has witnessed the entire planet mutually aligned in economic development for the first time in history. Global business was fired up when excess western capital was exported to Asia after 1997. Once eastern economies started investing their western export profits back in western government bonds and subsidising western governments and consumers to import more, the global market was truly intertwined and mutually dependent. The US has a history of misreading foreign nations and cultures, and this may be understandable given it is the largest economy on the globe, and therefore has the least need to negotiate with other markets. The financial institutions, particularly the investment banks, embarked upon a huge global expansion after 2004 when momentum in the US markets slowed. They chose to ignore global market interdependency believing that any future market crash would be isolated and not worldwide; therefore a worldwide presence would spread risk and limit the downside. This exodus also lulled institutions into a false sense of security in so far as it mitigated the need to clean up their act at home as much as they should have. The reality in 2008 was the banks were 100% wrong. Rather than limit the downside their collapse was exported globally, and the effect of the crash actually ended up increasing the overall negative impact both on themselves and everyone else in the world.

• Better understanding of IT. Everyone, both institutions and consumers, needs to understand better the threats capable of being unleashed through IT as well as the benefits. It could be argued that many trading or derivative products are now a form of legal gambling. Online gambling is illegal in the US but not if it’s a credit default swap! From the consumers’ angle it also needs to be appreciated that people are less embarrassed to gamble online as they avoid human contact and will likely take much greater risks as a result.

Join John Sheehan in the January - February edition of Director to read the second part of ‘After the Great Stampede’ where he gives his unique perspective on what is likely to happen next.

John Sheehan worked for US investment bank Lehman Brothers for ten years up to August 2008, specialising in real estate investment and lending, structured finance, corporate restructuring, distressed debt and NPL servicing.

During 2009 he has developed a new career lecturing on the global financial crisis and its effect on local markets. John's presentations draw upon his wide global experience and an insider’s view of the demise of Lehman and the resultant credit meltdown. He is resident in Bangkok.