If you wanted a front seat to the financial crisis, you couldn’t have done better than the floor of the New York Stock Exchange, which is where I was in the summer of 2007 and into 2008.
The government’s refusal to bail out Lehman Brothers forced it to file for bankruptcy on Sept. 15, 2008, and precipitated a crisis that not only changed the U.S. economy, it blew apart much of the Street’s trading wisdom.
I started my Trader Talk blog in the summer of 2007, and I recently sat down and read my posts from those two critical years. What struck me was how the crisis started with what seemed like a minor issue — the failure of the subprime mortgage industry. But it proved to be a domino falling in a long row of dominoes.
At the time, it was difficult to grasp how interconnected seemingly unrelated assets and markets would prove to be.
Here are five personal takeaways from the crisis and how it changed conventional wisdom:
1. Investors do not act rationally in a crisis. We all buried Adam Smith economics in 2008, the idea that rational actors make rational decisions, buying low and selling high. We saw that people don’t do that.They panic and sell at any price. They buy high and sell low. They did this with real estate, and they did it with the stock market.
In the week of March 6, 2009, which was nearly two years after the crisis began, the S&P 500 hit 666, an ominous number and a drop of more than 50 percent off the most recent historic high hit in late 2007. No one knew if that was the bottom (it was), but the one thing everyone I spoke with agreed on was that the U.S. economy was not going to zero. If you had not sold by then, it certainly made no rational sense to do so.
Unfortunately, a lot of people did not share that line of thinking. Outflows from mutual funds (which had already seen more than a year of outflows) accelerated in the first quarter of 2009. Investor money did not start flowing back in until later that year.
I remember being filled with despair when I saw that investors were still selling with the market down 50 percent. It was like watching the baby boomers flush their savings down the toilet.
This suddenly made behavioral economics fashionable. It purported to show how humans really behaved, not how they were supposed to behave. In 2017, Richard Thaler won the Nobel Prize in economics for exploring how “cognitive bias” can sabotage investor decision-making.
2. The crisis debunked the idea that buyers and sellers can always agree on a right price. While many factors contributed to the financial crisis, it was at heart a credit crisis fueled in part by predatory and in some cases fraudulent lending.
CNBC spent the summer of 2007 explaining how mortgage backed securities had been repackaged into collateralized debt obligations that had been split into different risk levels called tranches. Those deemed “safest” got very high ratings and the lowest yields, those deemed “least safe,” got higher yields and lower ratings.
The problem came when defaults in the subprime housing loan market wiped out the riskiest tranches, and the “safer” and “safest” tranches seized up as well, partly because there was not much liquidity in any of these CDOs but primarily because no one could figure out just how risky any of the tranches were in the first place.
With no agreement on prices, the mortgage market seized up, and that affected other credit markets.
The lesson: The markets are often mispriced, particularly in a crisis, but it’s devilishly hard to figure out just how mispriced they are.
3. Increasing complexity does not decrease risk, it increases risk. The belief that a financial crisis could be “managed” using the right tools took hold in the 1970s and ’80s. Reducing risks in financial assets by slicing them into easily manageable tranches would spread the risk out, for example. This proved to be terribly wrong.
It’s amazing how long everyone was in denial. On July 27, 2007, I was quoting bulls who were arguing that “housing and credit issues do not represent systemic risk to the global markets.” They were wrong.
4. Markets are not as efficient as everyone assumed. It’s an old Wall Street saw that the markets are efficient at pricing in all available data. Maybe that’s true some of the time, but there was ample evidence of market risks developing in credit and being ignored by the market. And when the data came in way off expectations, markets reacted swiftly.
The week of Aug. 1, 2008, General Motors reported a loss of $11.21 per share. The analyst estimates were for a loss of $2.62. Merrill Lynch reported a loss of $4.97 a share. The analyst estimate was for a loss of $1.91. A week later, Freddie Mac — then considered the key to the housing recovery — reported a loss of $1.63 per share (its fourth straight quarterly loss); a loss of 41 cents was expected. AIG reported an operating loss of 51 cents a share, a gain of 63 cents was expected.
These losses were magnitudes of order off what every analyst and strategist were expecting.
Wall Street was stunned. “What’s the value of analyst estimates?” I wrote in my blog that week.
Markets may (or may not) be efficient at pricing in all available data, but when the reported data is magnitudes of levels off the expected data, look out below. We learned that Wall Street had very poor visibility for what was going on. Corporations were seeing business deteriorate on almost a daily basis, and poor communication and data sharing from the companies themselves exacerbated the problem. Many companies provided little if any guidance and shared as little information as possible.
5. Bold, swift action works better than slow, indecisive action, or no action at all. The Federal Reserve stepped in to make sure banks would not fail, and that finally stopped the free fall, though the economic fallout continued for many years.
In a sense, John Maynard Keynes won out. Keynes had argued decades before that in a true crisis (like the Great Depression), just regulating the money supply — the Federal Reserve’s main tool — is not enough. Government needs to step in, prop up critical institutions and spend a lot of money. That is precisely what Congress, the president and the Federal Reserve under Ben Bernanke (himself a notable scholar of financial market collapses) did.
Keynes’ interventionist ideas won out. Global central banks in Europe and Japan began buying up assets, and governments ran big deficits. Dire warnings that all this stimulus would ignite massive inflation were ignored.
Just how long to continue that kind of extraordinary stimulus is not clear. It is still being debated. This remains one of the risks for financial markets in the future.
There are several key questions. Is the financial sector too big to fail? (The answer so far is yes.) How much regulation should banks be subject to? What limitations should be placed on financial innovations that may pose a systemic risk to the markets? How active should the Fed be in deflating asset bubbles? How much scrutiny and regulation should “nonbanks” or “shadow banks” that have become important players in the financial markets receive?
Stick around a few more years, and we will have better answers to these questions. And, most likely, we will kill a few other Wall Street chestnuts along the way.