September 15, 2018, marked the tenth anniversary of what many consider the key event of the global financial crisis (“GFC”): the fall of the venerable Wall Street firm, Lehman Brothers. On this tenth anniversary, our quarterly letter will touch on some root causes of the crisis, how certain issues related to it echo through capital markets today and, finally, what this means for Delegate clients. While we will discuss many aspects of the GFC in this letter, we recommend the following sources for a more complete retrospective of the 2008-2009 period, when the world teetered on the precipice of total economic collapse:
- An interview with McKinsey Global Institute’s Susan Lund about the history and effects of the GFC
- Tracing the Origins of the Financial Crisis by Paul Ramskogler, an academic article from the OECD Journal
- A J.P. Morgan report on how the response to the GFC reshaped the global economy
- A Bloomberg article outlining “Nine Lessons from the Global Financial Crisis” by Mohammed El-Erian
- An Economist special report on “The Next Recession,” which touches on the GFC with an eye toward the future
At a high level, two primary causes of the GFC were poor underwriting of mortgages and a long period of deregulation. As home prices began to rise in certain parts of the country (e.g., South Florida, Las Vegas), lenders loosened underwriting standards to almost comically low levels under the false belief that home prices would always remain high. The resulting toxic mortgages were packaged together in often highly leveraged, illiquid structures and held by, in many cases, depository banking institutions and investment banks. When home prices crashed and these structures collapsed, the investment banks’ capital (e.g., Bear Stearns, Lehman) immediately dried up and “mom and pop” began to fear that they would not be able to withdraw from their local bank because it had invested their deposits into these toxic structures. This occurred against a backdrop of an almost 30-year period of capital market expansion and deregulation beginning with the savings and loan crisis of the mid-1980s, a small-scale prototype for the GFC. Lessons that markets and investors learned as a result of that crisis were apparently forgotten.
Since the GFC and until very recently, the regulatory pendulum has swung in the opposite direction, toward more regulation rather than increased deregulation. The Basel Accords III and the Dodd-Frank Act were attempts to rein in many of the practices that caused the GFC and strengthen banks’ capital requirements to prevent future insolvency.
These new regulations caused a boom in the “shadow banking” industry, which sounds nefarious but is really just the business of private lending outside of the banking system. Since the GFC, as illustrated below, global private direct lending assets under management has increased from $39 billion to $181 billion, a 4.6x increase over an eight-year period.
Source: Prequin
This shift is generally thought of as a positive effect of the GFC, because the riskier loans are now knowingly held by sophisticated investors (e.g., pension funds, endowments, ultra-high net worth families), rather than by depository institutions who used “mom and pop” deposits to fund suspect investments.
While the growth of private lending is an encouraging sign, the explosive growth of public high-yield “junk” and bonds rated BBB has created the potential for future distress.
As shown below, the size of the domestic corporate high-yield market has tripled since 2009. Not only has the size of the market grown drastically, lenders have increasingly agreed to relaxed covenants, which limit their ability to monitor borrowers and to take action if necessary to limit the risk of a default.
Source: Bloomberg
While BBB-rated debt is still considered investment grade, it is the lowest-rated class of investment grade bonds. Since 2008, the total value of the investment grade market has grown from $4.8 trillion to $9.3 trillion. In 2000, BBB-rated debt comprised about 20% of the investment grade market ($1.2T). Now, BBB rated debt comprises over half of the investment grade market ($4.8T). The primary reason for the growth in both high-yield and BBB-rated debt is that investors, facing historically low interest rates, are searching for yield in increasingly higher-risk investments. If there is a troubling sign for the current economy, this is it. While “mom and pop” are somewhat more insulated from risk with their cash at the bank than ten years ago, retirement accounts might be invested in riskier investments than they realize. Additionally, many of these risky investments are packaged in increasingly popular ETFs and mutual funds that offer overnight liquidity and so are obligated to sell when they get redemption requests, regardless of whether it is prudent to do so.
Source: SIFMA
In summary, while private debt investments are protected by lock-ups that prevent the need for “forced selling”, public investments in ETFs that hold risky debt would likely become stressed in a credit or liquidity event similar to what occurred during the GFC. To mitigate against this risk, we have generally advised clients to reduce high yield exposure to zero.
So what does all this mean for a Delegate client? We believe the three most important lessons for investors coming out of the GFC are:
- Don’t panic.
Investors who panicked and sold at the worst time (early-2009) have missed out on a historic bull market in US equities. We repeatedly, for good reason, look to Warren Buffett’s simple advice in times of stress to be “fearful when others are greedy and greedy when others are fearful.” - Use long-term planning to avoid getting into a liquidity bind.
At Delegate, we treat each client like their own financial system and project their cash needs far out into the future to determine how much cash and short-term, liquid investments to hold in case the economy’s gears grind to a halt. - Have a plan in the event of a crisis.
Work with a trusted advisor to understand what would cause personal stress in such an event, and establish a plan to mitigate that stress. Create an investment plan designed to be opportunistic in a crisis, capitalizing on fear and market dislocations. The best time to establish a crisis plan is when there’s not a crisis (i.e., now).
The good news is that we do not see signs of an impending crisis in the near term. We see where we believe it might manifest if we had one (e.g., high yield credit or dollar-denominated emerging market debt), but we do not currently see a catalyst to trigger the “next” GFC. If a crisis begins to emerge, it will likely not be as catastrophic as the last one. To safeguard against a shock, however, we have been advising clients to begin to:
- Build cash positions to above policy targets
- Maintain short duration, high-quality fixed income portfolios
- Reduce equity positions to neutral or slightly underweight versus policy targets
While economic activity is expected to remain strong, financial assets may struggle to generate compelling absolute returns due to high current valuations and the fading effects of fiscal and monetary stimulus. With the still-present tailwinds of the corporate tax cut driving earnings ever higher and the continuing expansion of corporate stock buyback programs providing price support for equities, however, this economy has positive momentum that we believe can take it well into 2019.