By Gareth Vaughan
Ten years ago, on September 15, 2008, Lehman Brothers collapsed. A financial world where US sub-prime mortgages were already spooking people, lurched into full blown panic as what became known as the Global Financial Crisis (GFC) took hold.
Down here in New Zealand we reacted, nervously, to the events unfolding in the global financial capitals. Some New Zealanders, however, had front row seats in these capitals. One was Antonia Watson, now managing director of retail and business banking at ANZ New Zealand. Another was Christian Hawkesby, now executive director and head of fixed income at Harbour Asset Management.
Watson, who worked for Morgan Stanley in Hungary, was visiting New York. She recalls watching the news of the Lehman collapse unfolding over the weekend with her husband, followed by the bailout of Merrill Lynch by Bank of America.
"To me - naively - it felt like Monday morning was opening with things largely sorted out," Watson says.
"We happened to eat breakfast on the Monday morning in a diner across the road from Lehman’s state-of-the-art head office building. It had been purpose built for Morgan Stanley but we had never moved in, selling it to Lehman after 9/11 when everyone was reducing concentration risk in Manhattan, and Lehman needed new office space having lost theirs in the attacks. My main memory from sitting in the diner was that the whole area around the Lehman building was strangely quiet."
"As it turned out the action was a couple of blocks away outside the Morgan Stanley headquarters at 1585 Broadway. That’s where all the news trucks were, hoping to see us all walking out of the building with our cardboard boxes, because after Lehman and Merrill, Morgan Stanley was next on the list of not being likely to survive in its current form. My husband went past Lehman again later in the day and did see people leaving with cardboard boxes," says Watson.
She recalls Morgan Stanley's share price was hit hard that day and over following weeks.
"My observation as I watched my colleagues’ reactions in the office was the lack of a 'plan B.' There was a lot of fear and uncertainty. So many people had 20+ year careers and much of their wealth invested in the firm."
"There was no doubt that 'RIFs', reduction in force - our code for job losses, would be on the horizon as well. The interesting thing was that amid the fear and uncertainty there was also the odd colleague who took the opportunity to buy Morgan Stanley shares rather than sell in a panic - they would have done very well," Watson says.
"Morgan Stanley did survive largely intact. But in doing so it became a traditional trading bank, regulated by the Fed, and had a significant capital injection from Mitsubishi UFJ. I exercised my own plan B in early 2009, returning to NZ to work for ANZ."
A view from London
In September 2008 Hawkesby was on the other side of the Atlantic working at the Bank of England (BoE).
"That weekend of the Lehmans collapse I was shifting roles from running the Deputy Governor’s private office, where I had been involved in the Northern Rock rescue and measures to save HBOS, RBS, and Lloyds TSB, to being chief manager, sterling markets where I was part of the crisis teams advising how to buy the assets for the BoE’s QE [quantitative easing] programmes," Hawkesby recalls.
"The big lesson to central banks and regulators is the difficulty for markets or the public sector to predict when exactly a financial crisis will strike," says Hawkesby. "The Bank of England had been writing for years about the risks that ended up crystallising during the GFC."
He points to two articles written in 2001 that "seem prophetic" with the benefit of hindsight. The first, on page 137 here is entitled Risk transfer between banks, insurance companies and capital markets: an overview. The second, on page 117 here, is entitled The credit derivatives market: its development and possible implications for financial stability.
"But when markets, even in the face of large imbalances and vulnerabilities, continue to perform strongly for years on end, then the warnings from places like the BoE, Fed, IMF or BIS [Bank for International Settlements] start falling on deaf ears," says Hawkesby.
Wide ranging impact
Here in New Zealand the local response to the Lehman collapse and onset of the GFC included a dramatic reduction in the Official Cash Rate from 8.25% in July 2008 to 2.50% in April 2009, with the Reserve Bank making 150 basis point cuts in both December 2008 and January 2009. There was also the collapse of dozens of finance companies that began in 2006 and gathered pace through 2008 resulting in significant losses for tens of thousands of depositors.
In reaction to events in Australia, the Labour-led government cobbled together the Crown retail deposit guarantee scheme over a weekend, as then-Finance Minister Michael Cullen details here. It cost taxpayers' the thick end of $1 billion largely due to the demise of South Canterbury Finance. There was also a Crown wholesale funding guarantee scheme covering overseas bank borrowing that was used by ANZ, BNZ, Westpac and Kiwibank. There was also new Prime Minister John Key's Jobs Summit in February 2009 that spawned the idea of a national bike trail and a little used $1 billion job creation fund from ASB.
Overseas the Occupy Wall Street movement sprang up after the US Government bailed out banks rather than homeowners and failed to jail bankers. We learnt all about collateralised debt obligations, or CDOs, and credit default swaps. There has been billions of dollars of QE, or money printing, from central banks, and a European sovereign debt crisis resulting in unprecedented attention focused on Greek and Italian government bond yields.
We also got an entertaining explanation of the US housing market crash courtesy of The Big Short, a movie based on Michael Lewis' book of the same name.
What has changed?
Ten years on is the financial system less risky?
Here in NZ Watson says banking's in good shape.
"We have enough capital and liquidity to buffer us against external impact, and most importantly we make money by lending to people who we believe have the capacity to pay us back, through a series of simple products. And we are acutely conscious of the trust our depositors have in us to do the right thing with their money. Things seem to go wrong when complex, niche products are introduced where no one really understands the full set of risks. I hope banks learned their lesson on that front," Watson says.
Following the Lehman Brothers collapse and subsequent drying up of international credit markets, the Reserve Bank introduced the core funding ratio (CFR) in 2010 to reduce NZ banks' reliance on short-term offshore borrowing/funding. The CFR requires banks to meet a minimum share of their funding from retail deposits, long-term wholesale funding and/or capital. The minimum CFR for each bank is 75%.
The idea underlying the CFR is a comparison between an estimate of a bank's funding that's stable and can be assumed will stay in place for at least one year, and the core lending business of the bank that needs to be funded on a continuing basis.
The CFR means our banks are less reliant on short term, offshore funding than they were as demonstrated by the Reserve Bank chart below. This shows key banks' core funding ratios as at June 30.
Shift in focus
Hawkesby points out there has been a big shift in focus from central banks and regulators, with them moving away from trying to predict crises and provide warnings to market participants, to a new focus on ensuring the financial system is resilient for when the next big shock eventually happens.
"This is what has motivated all the additional requirements for banks to hold bigger buffers of capital, more sticky and reliable sources of funding, and larger holdings of high-quality-liquid assets. In a local context, while many commentators see the RBNZ’s loan-to-value [ratio] restrictions (LVRs) as a way to control or manage house prices, in fact their main purpose is to ensure that borrowers have enough equity in their homes that they, and the bank that lent the mortgage, can withstand a house price crash if it ever occurred," says Hawkesby.
"Measured on the basis of capital, funding and liquidity, both global and local banks are undoubtedly in a much stronger position than before the GFC."
"However, there are still plenty of risks and imbalances that loom over financial markets as vulnerabilities. One is high debt levels, which was at the root of the GFC originally. Normally after a crisis there is a period of austerity where consumers and government tighten their belts and get their balance sheet back in better shape. That hasn’t happened to the same extent this time around," Hawkesby adds.
"When you look across the Western world, the United States is one of the few places where household debt-to-income has fallen after the GFC, whereas in places like New Zealand and Australia it is still very elevated. And even in the case of the United States, while households have been more prudent, it has been offset by growing fiscal deficits and government debt."
New risks emerge
Meanwhile, Hawkesby notes new risks and new unknowns have also emerged.
"One of these is that, as part of trying to reduce their exposure to market risks, banks hold much smaller trading books. As a result, the amount of market liquidity, ie. secondary market trading, has reduced in many pockets of the financial markets. This means some markets may be more vulnerable and volatile in the face of shocks, as market trading is likely to be thinner with fewer market liquidity providers."
Another new risk Hawkesby points to is the rapid growth of Exchange Traded Funds, or ETFs.
"These funds are designed to replicate the returns of different equity and fixed interest indices and sub-sectors of markets. However, given they are now making up a large portion of many global markets, there are concerns that they may exacerbate sharp moves in markets, particularly if these ETFs are tracking asset classes with already thin market liquidity," says Hawkesby.
Donald Trump & the next crisis
As you'd expect, the world's financial press has been writing ad nauseam in recent days on the Lehman collapse to mark the tenth anniversary.
In The New York Times Andrew Ross Sorkin nicely summarises the broader impacts of what came to be known as the GFC or Great Recession. He points out the impacts are still being felt in the economy, culture and politics, suggesting President Donald Trump’s election was a direct result of the financial crisis.
Here's more from Sorkin;
The crisis was a moment that cleaved our country. It broke a social contract between the plutocrats and everyone else. But it also broke a sense of trust, not just in financial institutions and the government that oversaw them, but in the very idea of experts and expertise. The past 10 years have seen an open revolt against the intelligentsia.
Mistrust led to new political movements: the Tea Party for those who didn’t trust the government and Occupy Wall Street for those who didn’t trust big business. These moved Democrats and Republicans away from each other in fundamental ways, and populist attitudes on both ends of the spectrum found champions in the 2016 presidential race in Senator Bernie Sanders and Donald J. Trump.
The depth of financial despair during the Great Recession and the invariably slow recovery have unleashed a sense of bitterness that dominates the political landscape, culminating in Mr. Trump’s electoral victory.
John Cassidy in The New Yorker reviews a book on the crisis by economic historian Adam Tooze.
In “Crashed: How a Decade of Financial Crises Changed the World,” the Columbia economic historian Adam Tooze points out that we are still living with the consequences of 2008, including the political ones. Using taxpayers’ money to bail out greedy and incompetent bankers was intrinsically political. So was quantitative easing, a tactic that other central banks also adopted, following the Fed’s lead. It worked primarily by boosting the price of financial assets that were mostly owned by rich people.
As wages and incomes continued to languish, the rescue effort generated a populist backlash on both sides of the Atlantic. Austerity policies, especially in Europe, added another dark twist to the process of political polarization. As a result, Tooze writes, the “financial and economic crisis of 2007-2012 morphed between 2013 and 2017 into a comprehensive political and geopolitical crisis of the post–cold war order” - one that helped put Donald Trump in the White House and brought right-wing nationalist parties to positions of power in many parts of Europe.
“Things could be worse, of course,” Tooze notes. “A ten-year anniversary of 1929 would have been published in 1939. We are not there, at least not yet. But this is undoubtedly a moment more uncomfortable and disconcerting than could have been imagined before the crisis began.”
And as part of a Financial Times series marking the tenth anniversary of the GFC, Nouriel Roubini, the economist who warned of a US housing market collapse before the sub-prime crisis exploded, has written an article entitled Is the next financial crisis already brewing?
Roubini, who has expended a fair bit of energy railing against and warning about cryptocurrencies and blockchain over recent months (see his tweets below), argues that given changes in the structure of financial markets since the GFC, once a market correction occurs the risk of illiquidity and fire sales is now more severe. He says there's less market making and warehousing activities by broker dealers, and the growth of high frequency trading has heightened the risk of flash crashes.
Here's more from Roubini;
Now factor in US domestic politics. Donald Trump is already attacking the Fed when economic growth is above 4%. What will he do in 2020, an election year, when growth stalls below 1% and job losses start? The temptation will be to create a foreign policy crisis, especially if he is boxed in on domestic policies by a Democratic House.
Since he has already started a trade war with China and cannot attack a nuclear North Korea, the only feasible target would be to provoke a military confrontation with Iran. That would trigger a stagflationary geopolitical shock as was the case in 1973, 1979 and 1990, leading to a spike in oil prices. Finally, once this perfect storm occurs in 2020, the tools available to policymakers will be constrained. Fiscal policy is hampered by higher public debts, but returning to unconventional monetary policies may be thwarted by the bloated balance sheets of central banks. Bailouts will be run up against the populist mood and less solvent sovereigns.
Unlike a decade ago, once the next economic and financial downturn occurs the policy tools available to reverse it will probably be less effective.
Below are a couple of tweets Roubini sent out this week.
And since last December the average crypto-currency has lost over 95% of its value while the Top 10 have lost only 90% of their value. Crypto-Apocalype in Crypto-Zombie Land. That entire asset class is essentially dead! https://t.co/afN6KoOBYK— Nouriel Roubini (@Nouriel) September 12, 2018
As I said repeatedly: Blockchain is the most over-hyped technology ever! Crypto-currencies area total scam but blockchain is biggest baloney BS ever... https://t.co/9ATQP9P1qV— Nouriel Roubini (@Nouriel) September 12, 2018
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