One Year Ago and What it Means Now

On September 15, 2008, Lehman Brothers filed for bankruptcy. That was the event that precipitated the peak of the financial crisis. Let’s not just look back at what that event meant for the markets, but also forward to what it means today and what the consequences of the financial crisis may be for the markets in the years to come. While GDP growth was below average in the first half of 2008, it was positive and credit markets were functioning. The TED spread began 2008 at about 1% then doubled around the time Bear Stearns was bailed out when JP Morgan absorbed it with the Federal Reserve guaranteeing a lot of the toxic assets. The potential crisis appeared to be averted and the TED Spread narrowed to 1% again. During the summer the rate rose again this time as Fannie and Freddie—the two entities that make possible about half of the home loans in America—were bailed out and effectively nationalized. Again, the rate came back down in August. It was widely assumed in the markets that Lehman was next on the list to get bailed out. The general expectation was that Barclays would absorb Lehman Brothers with the Fed guaranteeing them against some of the losses essentially the same deal that the Fed provided to Bear Stearns. In fact, this was so much a foregone conclusion that the stock market was up in the several days that lead up to the weekend the deal was to take place. 

The TED Spread measures the difference between 3 month LIBOR rate and the yield on 3 month Treasury bills. This is an effective measure of the liquidity available to banks. With bank capital adequacy near the center of the current crisis this is an important gauge of the stress in the banking system. A rise in the TED Spread is a sign of rising stress. 

However, it was not to be. The backlash against bailouts and a desire to contain the toxic debt rather than spread it to more solvent institutions was too great and over the weekend of September 13 -14 Barclays’ was denied the support it wanted and approvals it needed resulting in the bankruptcy of Lehman on Monday, September 15. The shock of a major player in the credit markets that was leveraged more than 30-to-1 resulted in a spike in the TED spread. Banks would not lend to each other for fear that their counterparty may go bankrupt. Without deposits, investment banks were dependent upon borrowing from commercial banks to support their investing. As investment banks became unable to raise funds from other banks they were forced to sell their investments in housing-related securities. There were few buyers to absorb the supply. This accelerated the decline in the value in the securities and the prices entered freefall adding further pressure to the highly leveraged financial system. 

Tight credit spreads prompted the investment banks to use high amounts of leverage in order to increase the profit on investments. To illustrate the problem, consider that a homeowner would be leveraged 5-to-1 with a purchase of a home with 20% down payment and an 80% mortgage. With a 5-to-1 ratio, when the price of the home declines 10%, the value of the homeowners’ equity would be cut by 50%. Some investment banks, like Lehman Brothers were leveraged more than 30-to-1 on their housing related investments. 

In the aftermath, the whole financial system seized up. This tipped the sluggish economy into recession and the markets into a tailspin. Within a few days of Lehman’s bankruptcy, a money market fund broke the buck and money markets stopped buying the commercial paper of financial institutions. General Electric, one of the few companies in the U.S. that had the highest possible credit rating, tried to borrow some money on a short-term basis. Despite very low short-term interest rates, on October 2, GE had to pay 10% plus equity to Warren Buffett’s Berkshire Hathaway to get the $3 billion it needed. If credit was unavailable to a company like GE it was certainly inaccessible to smaller businesses and consumers and the economy seized up. Short-term credit is not the engine of the U.S. economy, it is the oil in that engine - we even refer to it as liquidity. Once the oil is gone, the engine seizes up. 

The Federal Reserve and Treasury responded to the credit crisis with enormous and unprecedented policy actions to liquefy the seized up financial markets and restore funding to financial institutions. These included the TARP which directly injected capital into embattled institutions, the credit facilities available to banks and other financial institutions, the commercial paper program to lend directly to businesses, over a trillion in direct purchases of mortgage-backed securities, and providing explicit guarantees of the liabilities of a few financial institutions including AIG and Citigroup.

Eventually, the credit markets began to heal. With the oil restored to the economic engine it restarted as we entered the second half of 2009. This is true outside the U.S., as well. In the past few months, virtually every country has seen a turnaround in key measures of growth, including: manufacturing output, exports, housing activity, business confidence, and the stock market. 

One of the outcomes of the crisis that may have far reaching consequences is that virtually every company in every country around the world is now in one global business cycle. The effects of the Lehman Brothers bankruptcy plunged nearly every economy in the world into recession and now we are witnessing an unprecedented synchronized global upturn. A unified global business cycle may intensify the cyclicality of demand for raw materials, credit, and labor. In the past, the world’s economies were often at different stages of the business cycle and this helped to smooth the rise and fall of demand for raw materials, credit, and labor. But now, with virtually every company in every country in sync the volatility has been intensified.  

After companies cut production and costs leading to an unprecedented plunge in commodity prices and much larger drop in employment and wages than during the average recession, the return of confidence by business leaders and renewed focus on growth may boost commodity prices, interest rates, and wages more than many expect based on past experience. 

Another outcome of the crisis is the changing landscape of financial market regulation. The mandate for action in Washington was clear in the aftermath of the Lehman Brothers bankruptcy. The November elections that took place near the peak of the crisis reflected a decisive vote for change with much of that sentiment directed to Wall Street institutions and their regulators. Over the next six months, Congress will likely enact major changes in regulation of the financial markets, derivatives and credit default swaps, hedge funds, the mortgage markets, and establish a council of regulators to oversee systemic risk. In addition, a new Consumer Financial Protection Agency is in the works. 

The most unique of these new rules is how to address the issue of “Too Big Too Fail.” Systematically important financial institutions would have to be designated. This may imply a competitive advantage because they would have what amounts to an implied government guarantee. But also could be a negative depending upon the special regulation and costs that may accompany the designation. This may result in major changes in the business mix and scale of the financial conglomerates. Crafting new rules and a framework to oversee them is a major challenge. The oversight of the Government Sponsored Enterprises (GSEs) Fannie Mae and Freddie Mac failed despite the implied government guarantee.