It has been exactly one year since Lehman Brothers declared bankruptcy and sparked a financial panic that substantially changed the trajectory of the already sluggish U.S. economy. The spillover effects rippled through global markets and global trade came to a virtual halt. The U.S. economy contracted by roughly -6% in the 1st quarter and U.S. imports fell by 34%. (Source: JPMorgan / www.imf.org). The repercussions to our trading partners were substantial. During the first quarter Taiwan’s economic activity (GDP) fell -10.2%, Japan -11.7%, German – 13.4%, Hong Kong -16.1%, Mexico -21%, Russia -33.6%. (Source: JPMorgan)
So what was the series of events that precipitated this shock?
I. The Real Estate Peak, Subprime Collapse & Stock Market Peak
In August of 2006, the real estate market peaked. Falling prices put pressure on lenders and by the summer of 2007 the subprime lending market collapsed. In October 2007, the stock market (S&P 500) peaked.
II. Bear Stearns, Freddie & Fannie
By March 2008, reverberations of falling estate prices led the failure of Bear Stearns, a large Wall Street investment bank. Over the summer of 2008, it became clear that the government would need to support mortgage markets as lending was drying out. The stock market was down over 20% signifying a bear market in equities. By September, Freddie Mac and Fannie Mae, two government sponsored lending giants, were placed into government conservatorship.
III. Merrill, Lehman & AIG
As summer came to a close, several investment banks were desperate for cash. Trust among big institutions was eroding and the spigots of capital were shut off. On September 15th, Merrill Lynch sold itself to Bank of America, the largest bank in the country at that time, and Lehman Brothers, another large investment bank, failed as it could not find a suitor. The next day, to prevent imminent collapse, the government extended a loan of $85 billion to save AIG, the world’s largest insurance company at that time. That same day, a large money market fund ‘broke the buck’ due to its exposure to Lehman. The failure of this money market fund was significant in spreading panic throughout the financial system.
IV. Financial Shock & Capital Injections
What had begun as a housing bust / credit crunch morphed into a full-blown financial shock. Over the next 6 months, the stock market would fall 57% from the peak in October of 2007, representing one of the worst bear markets in history. The government would take extraordinary actions in an attempt to restore confidence in the financial system and inject significant amounts of capital into U.S. banks. The impact of the financial crisis caused economic activity to contract considerably. It now appears that the U.S. economy is on the mend.
V. Aftermath: Impact on Efficient Market Hypothesis
The impact of this event on investors, bankers, regulators, policy makers and academics has been substantial. Alan Greenspan, a former Chairman of the Federal Reserve told congress last October – “Those of us who have looked to the self-interest of lending institutions to protect shareholder's equity (myself especially) are in a state of shocked disbelief.” (Alan Greenspan, Testimony to Congress, October 23rd, 2008).
I was taught in school (I majored in business economics) that financial markets are efficient, rational and inherently stable – a concept commonly known as EMH (Efficient Market Hypothesis). This concept was essentially handed down to me as cutting edge thinking about the way financial markets truly operated. I, among others, thought it was generally correct given the evidence produced by Nobel Prize winning formulas. Some now maintain that the application of these formulas encouraged excessive risk taking (meaning utilizing massive amounts of leverage to purchase mountains of debt instruments) because the data used in these models ignored the possibility of highly catastrophic and unpredictable events, like the collapse of Lehman Brothers which would set-off panic selling of money market funds, a seemingly irrational behavior, or that liquidity might dry up completely in mortgage markets, and not just the market for subprime mortgages.
However, before EMH, a guy named John Maynard Keynes (1883 – 1946), the highly influential economist of his time, believed that speculators dominated markets, were prone to exuberant mood swings and the whole shebang was essentially a giant casino. (Krugman, NYT, 9/6/09)
One of most interesting things about Keynes was he was well known as a speculator as well as a respected academic. I think if anything results from this crisis is that people will dust off some of Keynes’s old books and see if he still has anything to add to the conversation.
Written by Jason McMillen, Chief Investment Strategist, PPWM
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