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Lehman Brothers: Assessing the fallout 10 years on

lehman brothers

This month marks the 10-year anniversary of the start of the global financial crisis in 2008.

While it began with the sub-prime mortgage market disasters of the previous year, the collapse of investment bank Lehman Brothers was what sparked the full global crash, according to most commentators.

To commemorate the past decade and how it has changed investing, Money Marketing speaks to leading fund managers to see what we have learned, and what we have yet to learn, from the financial crisis that shook the world.

Fabrizio Quirighetti

Co-head of multi-asset at SYZ Asset Management

During the Great Moderation [the period of decreased macroeconomic volatility in the US since the 1980s], economies cultivated the impression of a smooth cycle characterised by high growth without inflation. But behind this veneer, they were loading up on debt, exposed by the eventual financial crisis.

The extra-loose policies, either monetary or fiscal, implemented to avoid an economic meltdown have not cured the root problem.

And more troubling for the global economy is, over the past 10 years, growth has been increasingly dependent on credit, as the key
economic growth drivers – workforce growth and productivity – have softened.

Stimulus is able to smooth the cycle but has little effect on the growth trend, which depends on political will to implement reform.

The reality is you can’t have your cake and eat it. I see only two possible outcomes to start again: massive defaults on debt, perhaps via helicopter money, or severe socio-political tensions due to unfunded liabilities precipitating a social welfare crisis. In the past, a massive debt overhang has always ended in default and/or war. I can only hope history does not repeat.

I can only hope history does not repeat

Mark Appleton

Global head of multi-asset strategy at Ashburton Investments

A new paradigm of fear and uncertainty was unleashed on the world following the demise of Lehman Brothers. Financial markets plummeted as liquidity and credit, the very lifeblood of economies, dried up and panic reigned.

What went wrong? In a nutshell, it was the under-appreciation of risk. Credit was too easy. Extending property loans to unemployed people, who had no hope of ever servicing them, was symptomatic of this.

What lessons of the crisis should be reinforced today? Firstly, there needs to be a healthy appreciation of risk, pricing it accordingly.

Secondly, it is important for investors to truly understand what assets are underpinning their investments.

Finally, there must be more of an appreciation of how interconnected the world has become.

What risks still lurk out there? Ironically, it is the exceptionally low level of interest rates, courtesy of the global financial crisis, which perhaps poses the greatest challenge. Lifting interest rates off this low base, together with still relatively high levels of debt, could cause problems.

It is important for investors to truly understand what assets are underpinning their investments

Mark Nash

Manager of the Old Mutual Strategic Absolute Return Bond fund at Old Mutual Global Investors

In 2008 the banking system was heavily invested in illiquid long-term assets via short-term wholesale funding – in other words there was a clear liquidity mismatch.

When the US housing market collapsed, that funding source was turned off and several large banks, including Lehman Brothers, faced either insolvency or government bailouts.

In the past 10 years we have seen an explosion in a different kind of debt, namely US dollar-denominated emerging market corporate debt, attractive because of quantitative easing and investors’ search for yield.

However, as banks have shrunk their balance sheets, it is mutual funds that have acquired a large chunk of the debt this time around.

Today, as the US Federal Reserve tightens monetary policy, the markets are once again faced with the prospect of liquidity being turned off. The Fed is hiking rates at the same time as economic growth in emerging markets and China is weakening thanks to aggressive US foreign policy and a stronger dollar. That is prompting banks and fund managers to yank dollars from the system.

As US dollar liquidity is removed, financial conditions have tightened, further encouraging more outflows. As a consequence, during market risk events, not only is liquidity tested, the funds that are heavily invested in illiquid assets are too.

So while the debtors and creditors may be different from 10 years ago, the liquidity taps are once again turning off in a weakening, over-levered sector. With another mismatch in markets, the question remains – are we really in a different situation?

The question remains, are we really in a different situation?

Bill McQuaker

Portfolio manager at Fidelity International

Over the past 10 years we have been faced with numerous developments we might have thought close to impossible before the crisis.

We have learned that government bond yields and even corporate bond yields can go negative. We have discovered unemployment rates can drop to multi-decade lows, even when growth is anaemic and without a concomitant rise in wages.

Perhaps as a corollary, we have found that record-high US profits as a percentage of GDP can persist for an awfully long time. We have also been newly reminded of the important role played by politics in effecting markets, and that central banks can profoundly influence asset prices.

It remains to be seen what will happen when it becomes apparent to all that the utility of monetary policy, both conventional and unconventional, is exhausted.
We do not yet know for certain whether the post-crisis reforms have actually made the financial and economic system secure. Is the US in structural decline? Can China avoid financial crisis?

These are big questions that have not yet been answered, despite the lessons learned over the past 10 years.

While I am not ready to predict a crash similar in magnitude to that of 2008, there are certainly indicators suggesting the cycle is mature.

Accelerating US GDP growth and the surge in global profits over the past year can hardly persist indefinitely, and we may look back at peaks in 2018. We are starting to see weakness in the interest rate-sensitive consumer discretionary sector, namely big-ticket items like automobiles and housing.

With the Fed continuing to hike rates, will the housing market as a lead indicator of recession rear its head again?

Or will the yield curve approaching inversion precede another slowdown as it did in 1990, 2000 and 2006? These are all signals suggesting that we are late in the cycle.

We do not yet know whether the post-crisis reforms have made the financial system secure

Andrew Lyddon

UK equities fund manager at Schroders

The banking sector was at the heart of the chaos during the financial crisis. This is the sector that has probably seen the most radical change.

In the decade since the crash, the banks have been through a significant episode of corporate restructuring. RBS for instance, once “the world’s biggest bank”, has shrunk from a global behemoth to being predominately a UK-only corporate and retail bank. For many institutions, loss-making divisions have been sold off, lending criteria tightened and debt levels reduced.

While they still have much work to do, management now places a greater emphasis on financial stability over growth, with hawkish regulators playing a far more active role in the industry, which is healthier for the wider economy.

Investors had plenty of instances to learn from previous market crises before 2008, but that didn’t stop the same mistakes being made.

Markets are driven by humans and unfortunately we show time and time again that we have short memories.

While certain industries have seen significant reform, the biases that drive market behaviour will likely continue. We will get carried away when times are good and fearful when they aren’t.

Right now, we feel it is the former that is considerably more pervasive, with investors happy to pay higher and higher multiples of earnings for businesses that are priced for perfection.

While we shy away from making any forecasts about the future, we can make observations on what we see in markets today. We are nine years into an equity bull market and there are signs that the confidence this has instilled in investors is beginning to breed complacency in some areas.

Investors had plenty of chances to learn from previous market crises

David Coombs

Head of multi-asset at Rathbone Brothers

Quantitative easing has been the most successful instrument in managing the financial crisis. The coordinated response across the G7 potentially averted a depression.

Short of using a time machine, there is no way of proving that, but the response, in terms of coordinated and massive levels of liquidity into the market, was unprecedented. Some may argue that the asset price inflation and subsequent wealth chasm meant that QE failed; I’d argue the impact of the crisis would have been hugely exaggerated without it.

The reconstruction of the US finance sector, and the speed of that reconstruction, was also pivotal. Indeed, US financials remain the poster child for the sector.

We’re not predicting another crash. Equity valuations – while acknowledging that they aren’t always a good predictor of market conditions – don’t look particularly stretched. However, the bond markets look rich, which may spill into equities in the short term. Yes, there’s a currency crisis in Turkey but markets are more sophisticated about how they consider idiosyncratic versus systemic risk. Selling is not indiscriminate at this stage, which is a positive.

We wouldn’t have considered liquidity risk as the biggest risk factor pre-Lehman – that event was a big reminder that it can be the most significant contributor to a permanent loss of capital and, ironically, elevated volatility.

The impact of the crisis would have been hugely exaggerated without QE

Stuart Steven

Co-manager of the sustainable investment fixed income team at Liontrust

When central bankers said that they would “do what it takes”, it wasn’t hyperbole. Moreover, they have been grudgingly prepared to turn a blind eye to moral hazard and swallow the pain of the unintended consequences of their actions.

Those unintended consequences include – but aren’t limited to – not allowing failing banks to fail, with low to no-cost bailouts and unlimited sub-zero funding at the ready; central banks taking on excess leverage in the private sector via massive QE programmes; and driving government bond yields into negative territory for years.

If it comes to it, despite the negative consequences which have played out over the past decade, they would likely do what it takes again.

We feel the economic outlook remains relatively promising, with forward-looking surveys and indicators suggesting that growth will continue over the coming two to three years, albeit at a slowing rate.

In addition, due to improved regulation, banks are generally in a far better place to withstand a slowdown than they were in the lead-up to Lehman’s fall from grace.

They have simplified their business models, with fewer investment banks and off-balance sheet liabilities.

They have little reliance on wholesale funding and strong liquidity reserves.

We have created a rigorous, macro-focused investment process that aims to identify potential economic weakness. We then focus on high-quality issuers that should be able to withstand a slowdown, and maintain a derivative protection strategy at all times to reduce tail-risk and dampen volatility throughout the cycle.

The economic outlook remains relatively promising

 

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  1. I still think the retail high street banking side should be totally separate from the investment side of banking. Open to other views however, that can point out the downside.

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