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BirdsEye View

the great crash, 2008: root causes

My last article also received much reaction. One reader wrote:"I disagree with you FAS 157 is not the problem. Other Than Temporary Impairment and the conservative position taken by the public accounting firms is the problem. FAS 157 lets you build your own model of value if the market is nonexistent.The problem comes when you have to decide if the decline in value is temporary or other than temporary. Many investments lost value and public accounting firms took the easy way out and required write downs through P/L because the client could not make a strong case for a speedy return in the value of the investment. It's OTTI that needs to be fixed."

And Jeff Brown,EVP at Webster Bank, adds: "As community bankers we have allowed main street banking to be tarred by the same brush as wall street banking. While we well understand the difference, obviously congress, the administration and increasingly the public do not. It's an old political axiom that if you do not define yourself in the minds of the public your opponent will do it for you. Our opponents are doing their job well and we need to take heed. Main street bankers are lending and still working in their communities to help their customers achieve their financial goals. This storm is not going to blow over and it's time for mainstreet's bankers to take back control of the message".

Also, folks mentioned 14 inches of snow as I was referring to spring buds. I hope spring will be upon you before you know it! On theForums front, we've changed most of our fall venues to modest hotels in Chicago, Dallas or NYC, to reflect the times. We also changed one of our CEO Forums to a straight 1 1/2 day meeting in Chicago. We know our Forums bring much value to the attendees, and want to ensure that the venue does not detract from the business focus and perception of the meetings. I hope you welcome these changes.

Liat and I are getting ready to go to Japan for a week for our 1:1 trip this year.I'm very excited! I'm also spending a week in Los Angeles doing Forums, and Gil is a student in UCLA, which means I get to see him almost every day. Hooray! And last, Arik surprised us with a 3.5 GPA on his progress report. At times like this, one is reminded that, ultimately, family is all we've got, and nothing is more important than the people we love.

Article synopsis: It's not about real estate prices: it's about very low rates and too much liquidity

The Great Crash, 2008: Root Causes

  • Root cause: very low rates and very high liquidity
  • Liquidity sought higher yields, and inevitably focused on higher risk investments (subprime mortgages)
  • Higher liquidity exploded the market and pushed up real estate prices well beyond traditional ranges
  • Home prices crashed and over-supply is huge
  • Americans lost enormous value in home equity, retirement assets and other financial instruments
  • Funds have flowed back into the banks, under the unlimited FDIC insurance for DDAs
  • Downward financial spiral ensued
  • Usual government tools for stimulating recovery are ineffective
  • The problem is broad and global, not domestic
  • Market and regulators' overreaction will further depress the markets

My esteemed and great friend, Prof. Richard Osborn of Case-Western University, shared with me an amazing article by Roger C. Altman. It is indeed a sobering article, but it, for the first time, made sense for me of this great crash we're undergoing. Below are my paraphrases of what Mr. Altman's thesis is. Thanks in advance for your own insights on this painful but critical subject.

We are in the throes of the worst global recession in over 75 years. The crisis' underlying cause, though, was NOT the real estate slump, says Mr. Altman. Rather, it was the inevitable lethal combination of very low interest rates and unprecedented levels of liquidity. Following 9/11, the US enjoyed extremely low interest rates for several years, while the rest of the world, particularly China, Singapore and the oil producers, amassed vast amounts of liquidity, reaping the fruit of years of investments.

"Facing low yields, this mountain of liquidity naturally sought higher ones", says Altman. And, one fundamental tenet of Finance, is that yields and risk are positively related: the higher the yield, the higher the risk. Regardless, funds flowed to higher risk loans (a.k.a. subprime loans), ballooning the market from $100B to $600 between 2005 and 2006 alone.

The flood of mortgage money, in turn, caused both commercial and real estate prices to rise at an unprecedented rate. The average US home appreciated 1.4% on average for 30 years before 2008. Then, appreciation hit 7.6%, and peaked at 11% between mid 2005 and mid 2006. The crash in home prices was inevitable.

Once the market crashed, the price of housing declined 30-35%, which is huge on a base value of $13 trillion. The collapse of housing prices destroyed the value of the trillions of dollars of low rate mortgage pools created during 2003-2006. Further, untenable loan structures came home to roost. Both culminated in loan losses that emerged in mid-2007 and accelerated at a staggering rate. We plunged into a self-reinforcing death spiral that caused a global market collapse.

A downward financial spiral ensued, as value of financial assets fell, margin calls were triggered, forcing the sale of these assets, which further depressed their value.

American households lost vast amounts during this brief period:

  • In 18 months, they lost 25% of their largest portion of net worth - their home (total home equity plunged from $13 trillion to $8.8 trillion)
  • The second largest American families' asset, their retirement account, dropped 22%, from $10.3 trillion on 2006 to $8 trillion in mid-2008.
  • Savings and investments outside the retirement accounts lost $1.2 trillion of value during the period
  • Pension assets also lost $1.3 trillion

Together, these losses are a staggering $8.3 trillion. Our entire economy is a $15 trillion economy, the largest in the world...

The resultant fears over safety and accessibility of deposits caused a flood of outflows from uninsured investment vehicles. For example, in a two-day period in September, Americans withdrew $150B from money market funds (average weekly volume is $5B). These funds, which are coming into the safe haven of the banking system under the umbrella of unlimited insurance for demand deposits, is a temporary situation which banks should not celebrate. These are parked funds, not core deposits.

Our economy, in the meantime, is experiencing unprecedented tumult:

  • 4Q08 GDP is forecast to plummet almost 4%
  • The economy is expected to contract for 3 consecutive quarters, which hasn't happened for over 50 years
  • S&P 500 was down 45% from its 2007 high by November 2008
  • September was the biggest monthly drop ever recorded in the Consumer Confidence Index and the sharpest monthly drop in consumer spending since 1980 (October was even worse)

The government has attempted to revive the ailing economy, but the tools available to it are ineffective. We can't ease monetary policy any further, given the already extremely low rates. The $168B fiscal stimulus package of February was a drop in the bucket in our $15 trillion economy, and improved the GDP by only half this amount.

The slowdown in Eurozone is every bit as severe, and some say even worse. That economy is in recession, and their financial system devastated. As I mentioned in a previous article, the IMF estimates global loan losses at $1.5 trillion (others peg the number as high as $5 trillion). Already half this number has been reported in November 2008, lending credence to the larger numbers predicted. These losses have depleted severely the capital in the banking system and caused the credit crunch. Faith in the viability of financial institutions deteriorated, causing the 3 months Treasury to LIBOR spread to quadruple within a month of Lehman Brothers' collapse in September 2008.

Between the Federal Reserve and other central banks around the world a total of $2.5 trillion has been injected into the system. This is by far the largest monetary intervention in world history. They further committed $1.5 trillion to invest directly in their respective local banks.

Classically, both markets and regulators are overreacting, swinging to the conservative extreme. Credit approval, pricing, liquidity management, leverage and risk management systems are all moving to a bunker mentality, and the regulators preside over the shift by sharply tightening regulations. This is understandable, since this crisis might be interpreted as the greatest regulatory failure in modern history.

If the past is a predictor of the future, regulatory reform will further constrict our business. Sarbanes-Oxley is a prime example of such overreaction. Another constraint will be the huge deficit, which approaches $1 trillion or 7.5% of GDP, a level previously seen only during the world wars. Additional regulations, TARP strings (and other nations with similar programs) and other interventions will stop the global shift toward economic deregulation. As President Sarkozy: "Le laisser-faire, c'est fini".

Thanks to Mr. Altman, the recent past is more easily explained. The real question is, what's in the future? Most observers are in the doom-and-gloom mode, which is typical to the over-reaction I mentioned above. My crystal ball is cloudy, but I'm not a pessimist. I believe in the global economy's ability to recover, especially considering the unprecedented collaboration across borders to help make it happen.

One important lesson I hope our legislative branch will learn from this is that more regulations does not necessarily mean better controls. It means less efficiency, higher costs to consumers, and, almost always, a few loopholes that end up causing the demise of the entire system. Abandoning our capitalistic roots that brought us to become the greatest world economic power will cause irreparable damage for generations. I hope we'll keep that in mind as we consider the aftermath of the great crash of 2008.