Ten Years since the Crash

A Retrospective

Ten Years After the Crisis: Different Risks and Circumstances, Same Human Nature

Crashes are always unpleasantly memorable events. And from an economic standpoint, it doesn’t even matter whether people are directly involved in trading because many will nevertheless end up being collaterally damaged: Their hopes and dreams dashed and futures imperiled.

Yet crashes clear away the assorted financial and economic rubbish – false and phony hyperbolic assumptions, practices and protocols, both actual and theoretical – that had been propagated and accumulated in the preceding asset price bubble. From this perspective, they are as good and useful as they are inevitable. Clear away the toxins and debris, cleanse the ecosystem, and the path to future economic health and prosperity has been at least opened, if not always subsequently followed.

Crashes always crystallize faster than bubbles because fear of losses spurs urgency for action that is usually in practice initiated by forced fund redemption demands and margin calls. In contrast, bubbles can be ridden for a long time without any need for immediate action, except for the all too common situation in which a portfolio is underweighted in the market’s highest flying segments. That’s when clients and fees are lost as a result of relative underperformance, and fear of missing out (FOMO) takes over. In crashes, it is fear of staying in (FOSI).

Such extreme market events place a premium on asset quantities held or not held, as the case may be. And this conflicts with standard theoretical dogma because, in the extremes, considerations of price take a backseat to considerations of quantity. In both bubbles and crashes there is herding – nothing attracts a crowd like a crowd – with price change correlations between assets rising towards 1.0 and time horizons for investment holdings and actions falling toward zero.

Thus, in crashes, diversification doesn’t save your financial hide, the law-of-one-price doesn’t work because it’s impossible to adequately find and then align the capital and time to properly arbitrage, hedging doesn’t work well because the liquidity on one side of the hedge is always a fast-moving target and different than on the other, and the market goes not toward but away from “equilibrium.”

Yet in the economic analysis of such events, the most basic mistake of all to presume that markets for financial assets operate in the same supply-and-demand framework as do conventional everyday goods and services. In bubbles, rising prices for financial assets generate more demand and in crashes falling prices generate less demand – just the opposite of what happens in markets for soups or soaps. As shown in my new Palgrave Macmillan book, Financial Market Bubbles & Crashes, second edition: Features, Causes, and Effects (2018), the conventional economic approach to modeling bubbles and crashes is fatally flawed and thus analytically misleading and useless.

In the greater scheme of things human, ten years is not an especially long time. And there is no evidence, even over a history of 5,000 years that our nature (or mirror neurons governing behavior) has changed. Memories and experiences and lessons learned tend to be diluted and dissolved and then disappear as new generations take over. One could guess that the half-life of taking the lessons learned to heart is probably around ten years. If so, it means that the younger people running the banks, the Fed, the large companies, and governments might have already forgotten half of the lessons learned by their predecessors of only ten years ago.

Considerable improvement in the ability of banks, particularly those in the U.S. and Canada to withstand the next swirl of crisis, whenever that arrives, is evident. And economic growth, albeit slow by comparison to previous periods, has resumed in many parts of the world. That’s all for the good and the hope is that it can be sustained.

But no one should get too complacent or comfortable with this. A major lesson learned was that banks should not be undercapitalized and should not make loans to “sub-prime” borrowers, i.e., those with little or no financial ability or prospect to repay the obligations incurred. Yet car loan and college student-debt delinquencies are already starting to rise. According to Fitch Ratings data, for instance, as of mid-2018 the delinquency rate for subprime auto loans more than 60 days past due has been the highest (5.8%) since 1996. In the 2008 crisis, the rate was 5%.

College loan defaults are more difficult to predict, but according to a U.S. Department of Education (DOE) study of October 2017, it is likely that in the 2004 cohort of graduates nearly 40% of borrowers may default on their student loans by 2023. It is a big number, ranging into hundreds of billions of dollars, even if this DOE estimate is too high.

In addition, the major central banks have become major players in equities. The Swiss run the world’s largest, $1 trillion hedge fund, with significant positions in the most popular stocks of the day: Apple, Alphabet (Google), Facebook, Amazon, Microsoft. The Bank of Japan appears to have bought up half of the equity market in that country. And other central banks, including the Fed, ECB, BoJ, and PboC,. have discovered that, at least for a while, equity markets can be, if not outright manipulated, “influenced.”

Through post-crisis quantitative easing (QE), the Fed accumulated more than $4 trillion in reserves on which it pays interest (IOER). This is arguably an incentive for banks not to make loans. Yet even as the Fed’s latest quantitative tightening (QT) policy will over time supposedly reduce such reserves and shrink the balance sheet, the yield curve spread between shorter and longer term treasuries nevertheless remains ominously close to inverting, which is often a precursor of an oncoming recession.

So, have any lessons been learned in the last decade? Yes, brokerages and banks will not – as Lehman, Bear Stearns, and Merrill were – be allowed to leverage at ratios of more than 30x as they had done before. Lending to the housing sector will be much more carefully rationed and trading in derivatives is now somewhat more transparent.

Still, the lessons of 10 years ago had not, as of 5 years ago, apparently dissuaded the use of deceptive practices in the opening of fake accounts at too-big-to-fail Wells Fargo. Major international banking and financial scandals haven’t disappeared from the news. And new scams via the introduction of crypto-currencies and the associated financially flimsy initial coin offerings (ICOs) have proliferated. In the late 1990s adding “dot.com” to a company’s name made share prices soar; in 2017 adding “crypto” to a company’s name had the same effect.

All of this will, however, be a side show as compared to what will likely happen when central bank QE policies finally become ineffective stimulants and interest rates turn up as trust in counterparty solvency goes down. That’s when the still unknown adverse consequences of QE and zero interest rate policies will surface and the costs of this experiment will be exposed.

In terms of preventing or cushioning the next crisis, the lessons learned from ten years ago will likely turn out to be largely irrelevant. It’s like the proverbial Army generals learning to fight the last war, and not the one that will, sooner or later, inevitably happen.

Human nature hasn’t changed. And economists still have neither a strong theoretical grip on how such extreme events evolve nor the ability to confidently and consistently predict when they will occur.

Harold (Hal) L. Vogel, author of Financial Market Bubbles and Crashes, was the senior entertainment industry analyst at Merrill Lynch and inducted into Institutional Investor magazine’s All-America Research Team Hall of Fame in 2011. Holder of a PhD in financial economics, he is also a chartered financial analyst (C.F.A.) and served as an adjunct professor at Columbia University’s Graduate School of Business.