For financial market participants, the ten-year anniversary of the financial crisis will bring back a lot of bad memories, chiefly among them is the failure of Lehman Brothers (Sept. 15, 2008). In the weeks ahead, we’ll see retrospectives on the events that led to the crisis, the failure to predict how bad things would get, and how we should prevent a similar setback.
Prior to the crisis, the U.S. economy had experienced just two minor recessions in 25 years. The belief was that the business cycle had been tamed. Former Fed Chairman Alan Greenspan called it the Great Moderation. Monetary policy would be able to counter economic downturns, limiting the scope of the damage. Technology had improved the flow of information. Bar codes and scanners, for example, streamlined the inventory process. As a consequence, firms could respond more rapidly to changing conditions.
We tend to think of the financial crisis as the bursting of the housing bubble, but it was much more than that. The U.S. had experienced a number of regional housing bubbles over the years (defined as home prices rising faster than median household income). As one of these regional housing bubbles burst, home prices tended to fall somewhat, but then stabilized, flattening over time as incomes caught up. We had never seen a housing bubble on a national scale. Alan Greenspan, the chair of the Federal Reserve likened the housing market to a glass of beer – a lot of small bubbles – and downplayed the risks.
During the housing boom, a lot of homeowners used their homes as ATMs. In major metropolitan areas, companies ran TV commercials offering to free up extra cash to pay bills, take a vacation, or buy that new boat or motorcycle. At its peak, the extraction of home equity was huge, totaling more than 10% of the level of personal income. That extraction funded a wide range of consumer spending, especially motor vehicle sales, but the support to spending evaporated as home prices declined.
As a rule, debt doesn’t matter until it does. High debt levels are never a catalyst for a recession, but can make an economic downturn worse. Household debt had risen sharply ahead of the financial crisis, but so had home prices, leaving household balance sheets in generally good shape – that is, until home prices began falling. Some had feared that a resetting of adjustable-rate mortgages would trigger a downturn in spending, but this doesn’t seem to have been a major issue.
Nonfinancial businesses debt did not appear to be much of a problem ahead of the crisis. Firms were generally positioned to be able to service their debt if the economy were to experience a moderate downturn. In contrast, financial sector debt was enormous. Bear Stearns was leveraged more than 30-to-1, which is still hard to believe. The ensuing deleveraging generated uncertainty and boosted counterparty risks. Mortgage-backed securities stopped trading. The global financial system seized up, as the big global banks were unwilling to trade with each other. The global financial system was saved by the Federal Reserve, which set up swap lines with other major central banks and offered to exchange illiquid securities with U.S. Treasuries.
The most controversial part of the crisis was the bank bailout. Originally, the intent was to set up a market for problem assets (it was, after all, called the Troubled Asset Relief Program). Approved in the Senate, TARP failed to pass in its first attempt in the House of Representative, and the stock market tumbled in response, but TARP succeeded it the second attempt. Still, setting up a market for the troubled assets proved difficult and time was of the essence. Within two weeks, the government decided on a much simpler solution – and that was to simply give the banks the money. Taxpayers were furious – and still are. Bankers did not exactly bathe themselves in glory soon after, receiving large bonuses and shrugging their shoulders when asked about where the money went. Still, the economic downturn would have been much more severe if not for the bank bailout.
Small business relies on bank credit to regularly meet payrolls, fund inventories, and so on. As the financial crisis quickly developed, banks sharply curtailed credit to small businesses. Small and medium-sized business accounts for a disproportional share of job creation during an economic expansion. The tightening of bank credit made the downturn worse and limited the economy’s ability to recover. Through the recovery, larger firms had easy access to credit and the concentration of larger firms grew (which appears to partly explain the moderate wage growth in recent months even as the job market has tightened).
It’s said that this was not your father’s recession. It was your grandfather’s depression. Recessions following a financial crisis are different. In the Great Depression, policymakers made all the wrong moves – raising interest rates to defend a gold standard, letting thousands of banks fail (taking individuals’ life savings with them), putting up trade barriers (contributing to a collapse of global trade), and raising taxes to reduce the federal budget deficit. This time, there was global cooperation, taxes were cut, the Fed lowered interest rates (and didn’t stop there), and deposit insurance helped to protect household savings.
Looking ahead, we know that the economy will eventually experience another financial crisis. The Fed now has some room to lower rates in a crisis, but should be reluctant to embark on another round of quantitative easing. The surging federal budget deficit will limit the ability to use fiscal policy to counter a decrease in aggregate private-sector demand.
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All expressions of opinion reflect the judgment of the Research Department of Raymond James & Associates (RJA) at this date and are subject to change. Information has been obtained from sources considered reliable, but we do not guarantee that the foregoing report is accurate or complete. Other departments of RJA may have information which is not available to the Research Department about companies mentioned in this report. RJA or its affiliates may execute transactions in the securities mentioned in this report which may not be consistent with the report's conclusions. RJA may perform investment banking or other services for, or solicit investment banking business from, any company mentioned in this report. For institutional clients of the European Economic Area (EEA): This document (and any attachments or exhibits hereto) is intended only for EEA Institutional Clients or others to whom it may lawfully be submitted. There is no assurance that any of the trends mentioned will continue in the future. Past performance is not indicative of future results.
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