Recent credit crisis and their consequences will shape the investment landscape for decades to come. Therefore, investors who wish to be successful need to have a comprehensive understanding of the credit crisis and the changes it has produced in the financial community.
This report analysis the brief history of credit crises, an analysis of the differences between investment and commercial banking, and an overview of the disappearance of the classic 2008 credit crisis. The third and fourth chapters will look more closely at the credit crisis; first by examining its origins and then by analyzing the events that prompted its onset. The tutorial will then provide an overview of the most important events that occurred during the credit crisis before examining governmental efforts to mitigate the crisis and prevent the systemic collapse of the financial system.
We'll also examine the crisis's impact on financial markets and investors, and provide an overview of its impact on the financial markets. You'll also find some timeless investment lessons that the credit crisis has reinforced and that can help you succeed through future market downturns.
While this tutorial is as comprehensive as possible, readers should remember that the credit crisis consisted of an amazing array of previously unimaginable events. In addition, future accounts of the credit crisis may differ somewhat from this tutorial, based upon the perspective that will come from examining events with additional hindsight.
Introduction:
In the 1980s and 1990s, many firms began to merge as the globalization of financial markets and increasing capital requirements prompted the creation of increasingly larger companies. This trend culminated in 1999 with passage of the Gramm Leach Bliley Act,which essentially reversed the Glass-Steagall Act. By allowing commercial and investment banking operations to once again occur within the same firm, the Gramm-Leach-Bliley Act facilitated the creation of the so-called "Universal Bank". Universal banks such as Citigroup JPMorgan ,Barclays, and UBS combined commercial and investment banking and use their massive balance sheet to under price the traditional investment banks. By the onset of the credit crisis, the investment banking "bulge bracket" included not only traditional investment banks such as Goldman Sachs and Morgan Stanley but also universal banks like Citigroup, UBS and JPMorgan.
The Ascent of Risk
In the not-too-distant past, the bulk of investment banks' business consisted of advising corporations on mergers and acquisitions, raising capital for companies and governments, and facilitating stock or bond trades for their customers. Over time, though, the profitability of these activities began to decline as the investment banks faced increasing competition from emerging universal banks.
Seeking higher profits, investment banks such as Goldman Sachs increasingly turned to riskier activities such as principal trading and investing to generate the bulk of their profits. Principal trading and investing occurs when a firm uses its own capital to invest in the markets in hopes of generating profits. During good times, these activities can be phenomenally profitable, and many firms posted record profits in the years leading up to the credit crisis. However, principal trading and investing also exposed Wall Street firms to much higher risk.
While investment banks were increasing the amount of risk that they took in their principal trading, they were also becoming increasingly dependent on complicated derivatives and securitised products. The complicated nature of these products allowed firms with an expertise in them to generate large profits. However, derivatives and securitized products are also difficult to value; these difficulties would eventually result in many firms having much higher levels of risk exposure than they had intended.
Disappearance of Investment Banks
At the start of 2008, Goldman Sachs, Morgan Stanley, Merrill Lynch ,Lehman Brothers and Bear Stearns were the five largest stand-alone investment banks. The companies had existed for a combined total of 549 years, but within the span of six months, they would all be gone.
In March 2008, Bear Stearns teetered on the edge of bankruptcy. J.P. Morgan purchased the bank for $10 a share, a fraction of its all-time high of $172 a share. The purchase was facilitated by the Federal Reserve, which guaranteed a large portion of Bear's liabilities as part of an effort to mitigate the potential impact of a Bear Stearns bankruptcy. Following a tumultuous summer, Lehman Brothers succumbed to the credit crisis on September 15, 2008, when it filed for the largest bankruptcy in U.S. history. The Federal Reserve had attempted to facilitate a purchase of Lehman Brothers, but it had been unwilling to guarantee any of the firm's liabilities. Following its bankruptcy, parts of Lehman Brothers were purchased by Barclays PLC and Nomura Holdings).
At the same time that Lehman Brothers filed for bankruptcy, Merrill Lynch was struggling for survival. Unsure of its ability to continue as a stand-alone entity, Merrill chose to sell itself to Bank of America ending 90 years of independence.
Following the disappearance of Bear Stearns, Lehman Brothers and Merrill Lynch, the only two remaining independent investment banks were Goldman Sachs and Morgan Stanley. These firms were the two largest and most prestigious of the investment banks. As the credit crisis intensified, it became apparent that both of these firms were also in a struggle for survival. With confidence in the investment banking business model evaporating, Goldman Sachs and Morgan Stanley chose to convert to bank holding companies, thus ending their existence as stand-alone investment banks.
What Is a Financial Crisis?
A financial crisis is often preceded by a bubble. A bubble occurs when many investors are attracted to a market sector, usually due to attractive fundamentals. Speculators then rush to this newest hot market, searching for quick profits and driving prices even higher. At some point, the amount of money flowing to the market increases to the point that valuations are no longer supported by attractive fundamentals, signalling the end of a bull market and the beginning of a bubble. Although many market participants may realize that valuations are stretched, greed drives them to bid prices ever higher.
When enough market participants eventually realize that valuations are not supported by the fundamentals, the market begins to decline. As prices fall, more and more investors rush to sell. This wave of selling quickly escalates, driving prices even lower. As this downward spiral continues, fear replaces greed, and market participants stop making rational decisions and instead rush to sell their holdings at whatever price they can get. Profits made over the course of many years can turn into losses in a frighteningly short time. A sufficiently bad downward spiral is commonly referred to as a crisis.
This increased willingness to accept risk combined with excessive leverage, a housing bull market and widespread securitization would sow the seeds of the 2008 financial crisis.
Risk
As the global savings glut contributed to extremely low interest rates in many traditional asset classes, investors sought higher returns wherever they could find them. Asset classes such as emerging market stocks, private equity, real estate and hedge funds became increasingly popular. In many instances, investors also found above-average returns in staggeringly complex fixed-income securities.
This global search for yield was prompted not only by historically low interest rates, but also by very low levels of volatility in many financial markets. These low levels of volatility made many risky asset classes appear safer than they actually were. Computerized models used to price complicated fixed-income securities assumed a continuing low-volatility environment and moderate price movements. This mispricing of risk contributed to inflated asset values and much greater market exposures than originally intended.
Leverage
The use of leverage can enhance returns and does not appear to carry much additional risk during periods of low volatility. The "great moderation" featured two forms of leverage. Investors used derivatives, structured products and short-term borrowing to control far larger positions than their asset bases would have otherwise allowed. At the same time, consumers made increasing use of leverage in the form of easy credit to make possible a lifestyle that would have otherwise exceeded their means.
The early parts of the decade provided a near-perfect environment for this increasing use of leverage. Low interest rates and minimal volatility allowed investors to employ leverage to magnify otherwise subpar returns without exposure to excessive risk levels (or so it seemed). Consumers also found the environment conducive for increasing their use of leverage. Low interest rates and lax lending standards facilitated the expansion of a consumer credit bubble. In the U.S., the savings ratio (a good approximation of how much use consumers are making of leverage) dropped from nearly 8% in the 1990s to less than 1% in the years leading up to the credit crisis.
As long as interest rates and volatility remained low and credit was easily available, there seemed to be no end in sight to the era of leverage. But the increased use of leverage and increasing indebtedness were placing consumers in a dangerous situation. At the same time, higher leverage ratios and an increasing willingness to accept risk were creating a scenario in which investors had priced financial markets for a near-perfect future. (For more on leveraging, see Put An End To Everyday Debt
Housing
To understand what happened in the housing market, we need to step back in time to the aftermath of the tech bubble and stock market meltdown of 2000-02. The precipitous decline in the stock market, combined with the accompanying recession and the terrorist attacks of September 11, 2001, caused the Federal Reserve (the Fed) to lower the federal funds rate to an unprecedented 1%. The economy and stock market did recover, but the slow pace of economic expansion prompted the Fed to maintain unusually low interest rates for an extended period of time. This sustained period of low interest rates accomplished the Fed's objectives, but they also contributed to a huge boom in the housing market.
As housing prices soared in many areas of the country, mortgage providers offered a variety of creative products designed to help buyers to afford more expensive homes. At the same time, lenders relaxed underwriting standards, allowing more marginal buyers to receive mortgages. The combination of low interest rates and easy access to credit prompted a dramatic increase in the value of homes. Consumers have historically believed that home prices do not decline, and that buying a home is one of the best investments they can make. The soaring housing market reinforced these beliefs and prompted a rush among consumers to buy a house as quickly as possible before prices rose even further. Many people also began speculating in the housing market by purchasing homes in the hope of "flipping" them quickly for a profit.
As home prices continued to soar, the market began to take on all of the characteristics of a classic bubble.
Securitization
Securitization describes the process of pooling financial assets and turning them into tradable securities. The first products to be securitized were home mortgages, and these were followed by commercial mortgages, credit card receivables, auto loans, student loans and many other financial assets.
Securitization provides several benefits to market participants and the economy including:
Providing financial institutions with a mechanism to remove assets from their balance sheets and increasing the available pool of capital
Lowering interest rates on loans and mortgages
Increasing liquidity in a variety of previously illiquid financial products by turning them into tradable assets
Spreading the ownership of risk and allowing for greater ability to diversify risk
In addition to its benefits, securitization has two drawbacks. The first is that it results in lenders that do not hold the loans they make on their own balance sheets. This "originate to distribute" business model puts less of an impetus on lenders to ensure that borrowers can eventually repay their debts and therefore lowers credit standards. The second problem lies with securitization's distribution of risk among a wider variety of investors. During normal cycles, this is one of securitization's benefits, but during times of crisis the distribution of risk also results in more widespread losses than otherwise would have occurred.
In the years leading up to the credit crisis, investors searching for yield often focused on securitized products that seemed to offer an attractive combination of high yields and low risk. As long as home prices stayed relatively stable and home owners continued to pay their mortgages, there seemed to be little reason not to purchase 'AAA'-rated securitized products.
Conclusion
Following an extended period of relative calm, a housing market decline led to falling values for mortgage-backed securities. Losses on these and other hard-to-value securities soon spread to encompass all risky assets, prompting fear on the part of investors and an unwillingness to provide liquidity in the marketplace. As this downward spiral accelerated, fear turned to panic and the financial markets descended into crisis.
The credit crisis of 2008 includes some key events. Let's take a look at the series of events that reshaped the global financial community and forever changed the investment landscape.
Conclusion
Following the stock market crash of 1929, policy makers committed a trio of errors. They tightened monetary policy, restricted fiscal spending and failed to enhance confidence in the banking system. It is widely believed that these mistakes exacerbated the effects of the depression that followed.
Policymakers have learned from these mistakes, and those lessons were put to good use during the credit crisis of 2008, during which the Fed provided enormous amounts of liquidity to the financial system. The government also increased its spending, thereby providing fiscal stimulus to the economy. Finally, the government took extraordinary measures to secure confidence in the financial system through a variety of guarantees, insurance programs, loans and direct investments.
The credit crisis has been touted as one of the greatest threats to the global financial system since the 1930s. It is not surprising, then, that the crisis has also produced unprecedented volatility in the financial markets and large losses for many investors. Let's take a look at market movements during the credit crisis and the erosion of confidence investors experienced as a result.
Overview of Market Reactions
T-bills trade with negative yields
Corporate bond risk premiums soar
The S&P 500 and global stocks record their worst weeks on record in October 2008
Worldwide stock markets down more than 30% for 2008 year
A general lack of confidence or liquidity in the market develops
The Bond Market
At its inception, the credit crisis was primarily reflected in the bond market, as investors there began to avoid risky assets in favour of ultra-safe U.S. Treasury securities. The chart below shows the option adjusted spread (OAS) on the Merrill Lynch Corporate Bond Index. The OAS reflects the additional compensation investors require for purchasing corporate bonds as opposed to ultra-safe Treasury securities. After demonstrating virtually no volatility between 2003 and mid-2007, the OAS increased to record highs at the beginning of 2008, and then soared dramatically as the crisis intensified during the latter part of the year. Not only did this sharp increase cause large losses for many banks and investors, but it also reflected much higher borrowing costs for companies wishing to raise capital.
At the same time that bond market investors were selling risky assets, they were rushing to the safety of U.S. Treasury securities. During the credit crisis, the yield on the two-year Treasury bonds fell from more than 5% to less than 1%. Yields on shorter term Treasuries declined even further, and at one point the yield on some securities was actually negative. In other words, investors had so little confidence in the financial system that they were willing to pay the Treasury to hold their money, as opposed to investing it elsewhere and attempting to earn a reasonable rate of return.
The Stock Market
While stock prices have been steadily declining since reaching their highs in November 2007, the selling intensified following the bankruptcy of Lehman Brothers in September 2008. When the U.S. House of Representatives failed to pass the Treasury's bailout plan on September 29, the S&P 500 fell 8.8%, its largest one-day percentage decline since Black Monday in 1987. That same day, total U.S. stock market losses exceeded $1 trillion in a single day for the first time.
The U.S., Europe and Asia saw major stock market declines, but some markets such as Hong Kong and Russia, fell even farther. In other words, investors seeking refuge from falling markets found nowhere to hide. Even Mexico had declined by more than 33% YTD as of November 2008 - and it was the best performer among large stock markets.
Investor Confidence
Poor performances in the bond and stock markets were the most visible reflections of the credit crisis. Less visible, but even more important, was what was happening to investor confidence. At its most basic level, the modern financial system depends on trust and confidence among investors. Without this trust, a dollar bill is just another piece of paper, and a stock certificate holds no value. The most dangerous aspect of the credit crisis was that this trust began to erode as investors questioned the solvency of banks and other financial institutions. This erosion of confidence ate away at the very foundation of the modern financial system and is the reason why the credit crisis posed such a grave threat.
Confidence is not as easily measured as stock or bond movements; however, one good indicator of the level of market confidence during the credit crisis was movements in the London Interbank Offered Rate (LIBOR.) LIBOR represents the rate at which large global banks are willing to lend to each other on a short-term basis. In normal times, large banks present little credit risk and therefore LIBOR closely tracks the level and movements of short-term U.S. Treasury securities. This is why LIBOR is rarely discussed outside the confines of the bond market, despite the fact that an estimated $10 trillion in loans are linked to it.
At the height of the credit crisis however, LIBOR became an important topic of mainstream conversation and one of the best indicators of the global credit freeze. After remaining unchanged for more than three months, LIBOR spiked sharply following the bankruptcy of Lehman Brothers in September of 2008. This spike reflected an increasing unwillingness on the part of banks to lend to one another. In a global economy based on credit and trust, this was an extremely troubling sign, and prompted concern among policymakers that the global financial system faced a systemic collapse.
Following its sharp increase, LIBOR fell dramatically in October 2008 as the combined actions of global policymakers helped to ease the fear among financial market participants. In fact, because of central bank's interest rate cuts, LIBOR actually fell to below where it was prior to the Lehman Brothers bankruptcy.
Conclusion
This chapter has examined some of the market reactions to the global credit crisis. Investors who followed the markets during this period do not need to be reminded of the unprecedented volatility markets experienced or the dramatic declines in the values of a wide range of asset classes. However, the most troubling aspect of the crisis was the erosion of investor confidence and trust. This erosion was demonstrated, in part, by the increase in the LIBOR rate. It was this erosion of confidence that caused such grave concern among policymakers and prompted the dramatic actions they chose to take.
Even at the height of a great bull market, successfully navigating the financial markets is a challenge for investors. This challenge is magnified exponentially during market crises. It is at these times that solid investing fundamentals pay the greatest dividends. Indeed, investment lessons reinforced during these difficult periods can enhance an investor's chances of success not only during the crisis, but also throughout future market cycles. With that in mind, this final chapter of the tutorial will examine important investment lessons that can be learned from the credit crisis.
Investing During Times of Turmoil
There's recently been a joke making the rounds among traders. "If you can keep your head when all around you are losing theirs," the jokers say, "you haven't been paying enough attention." This gallows humor generates a few chuckles, but the investing principle that it parodies holds the key to success during times of market turmoil.
It is difficult to avoid buying into a market bubble. No one likes to watch from the sidelines while everyone around them makes money, but history has shown again and again that market bubbles always burst. Some investors may have impeccable timing and may be able to ride the bull to its apex before selling at just the right moment; however, these fortunate souls are rare indeed and their unique talent is probably not a successful recipe for the average investor.
Once a bubble has burst (and they always do) the ensuing decline can be even more emotionally challenging than the bubble itself. While bubbles usually occur over time, crashes can occur with stunning rapidity. During these times, the sense of fear in the market can become so palpable that is easy to understand why some market crashes have been labeled "panics".
All investors experience the emotions of greed and fear during market bubbles and crashes. Recognizing this fact and accepting that markets often behave irrationally can enable an investor to step back and objectively evaluate the financial markets. Successful investors are able to adhere to their investment plans, regardless of the current direction of the herd mentality. In fact, truly great investors often possess the ability to act contrary to the herd. Investors who are willing to sell when others are greedy or buy when others are fearful usually experience great success over the course of their investment careers.
Conclusion
This chapter has examined important lessons that investors can learn from the credit crisis. These lessons are not new; they have always been key principles for long-term investment success. However, during bull markets it is easy to forget the fundamentals. In fact, many investors profit during a bull market regardless of their investment approach. These profits can even wind up providing negative reinforcement for bad habits and can prevent an investor from developing a successful, disciplined, long-term investment strategy. Remember, there is a reason that long-time Wall Street traders like to say "never mistake a bull market for brains".
The key to long-term financial success is not simply to profit during bull markets, but rather to manage a portfolio across market cycles with an aim toward maximizing risk-adjusted returns. Over time, investors who incorporate fundamental investment principles into their strategies will have a much better chance of generating superior risk-adjusted returns. With that in mind, if investors use the unprecedented events of the credit crisis to develop a solid understanding of fundamental investment principles, they may one day look back on this difficult period and recognize that it served as the foundation for their future success.
