Five lessons from the Great Financial Crisis
It may be hard to fathom and remember but ten years ago, the world was falling apart. Stock markets were beginning a dramatic free-fall, people were afraid banks would close and the entire financial system was being questioned. Now after a decade of healing we can look back and learn. Here are five lessons learnt from the great financial crisis.
1. When people are involved … bad things happen.
What often separates a dislocation in a market and a panic or crisis is people. No matter how many times bad things happen, human emotions tend to exasperate them and magnify the effect. This crisis was no different. The loss of confidence and fear caused prices to fall far below fair value for many stocks and especially investment-grade credit. We may have become more sophisticated and wiser to the machinations of markets but one thing we should all learn is that human biases, emotions and reactions never change. The polarity between logic and emotions creates massive displacement and a detachment of fundamentals. We would be wise in turbulent times to remember Rudyard Kipling’s poem If (https://www.poetryfoundation.org/poems/46473/if)
To make it easier to keep your calm ensure you have an emergency fund and that assets invested are really being held for a longer-time horizon. Don’t mismatch near-term liabilities with longer term assets.
2. Scars heal slowly and some wounds never heal
The losses suffered by many were just too much. In fact, even for those who didn’t suffer personal losses knowing someone close and seeing the anguish and struggles left a permanent scar and repulsion for either owning a house or investing.
Amos Tversky and Daniel Kahneman suggested that losses are twice as powerful, psychologically, as gains. The unfortunate corollary of this is that many refused to re-enter the market at the very best time.
In fact, the post-traumatic stress of the GFC locked people in a bubble of fear and disgust and, even if they had the means, many did not participate in a near decade-long bull market — possibly one of this generation’s greatest. This is not unprecedented as those who suffered the Great Depression also suffered from distrust in markets and the banking system. Often people vowed to “never do that again”.
The lesson, however, is that it often does not pay to fight the last war or wait for the “inevitable crash”. We should try as much as possible to move forward and fade the Baader-Meinhof phenomenon — the name given to the illusion in which something that has recently come to one’s attention suddenly seems to appear with improbable frequency shortly afterwards — so we are afforded a non-distorted view.
3. Rip off the Band-Aid
The US recovery, although slow in comparison to other historic rebounds, has been much better than other developed markets. The returns seen in other developed markets since the crisis have been subpar compared to that in the US and this is especially so when comparing banks in the US to those in other developed markets.
The lesson is that policymakers should not err on the side of excess caution and deal with problems rapidly. The “extend and pretend process” used in Japan after its epic crash in the 1990s only exasperated a drawn-out deleveraging that crippled any hope of returning to rapid growth and more robust credit creation.
Creative destruction is a fire that cleanses capitalism — when it is extinguished, a clearing of the sclerotic underbrush is prevented, and a strong rebirth of economic resurgence is impaired.
4. Leverage is great on the way up but a disaster on the way down
Can the debt be repaid? Is leverage too high? One of the partners who mentored me at KPMG once said something that has stuck with me today: “Nathan, it’s not really the liabilities you need to worry the most about. It’s the assets not being what you think they are.”
When asset prices outstrip the general level of price inflation one should take note. While some point to greedy bankers and unscrupulous mortgage middlemen as the key to the problem, one would be remiss to simply ignore that it was also non-discerning buyers who accepted enormous levels of leverage on assets that were priced to perfection, if not absurdity.
Leverage on highly priced assets is a toxic mix. If you want another takeaway note the link between assets’ prices and the level of leverage associated with them: think margin levels and stock, mortgage credit and houses or even corporate bond levels to corporate equity. In most cases, you are assured to make or lose money when you buy.
Don’t worry about missing out, consider what could go wrong. Price matters and trees do not grow to the sky. House prices do fall. Levered house prices can fall further.
5. Financial crises breed populism
The crisis has created a giant rift in society. A large social and political gap has grown as the outcome post-GFC has been excessively more fortunate to the wealthy than the less fortunate. There has not really been widespread and inclusive growth.
The level of inequality seen in the US has not been this stretched since 1930s. As a result, populism has become popular.
Policymakers will be able to appreciate that, for the next crisis, more needs to be done towards boosting productivity and opportunity and not just policies to bail out the financial system itself.
Governments were frozen by leverage concerns and inflation but could have done more through fiscal policy to enhance the recovery. A better mix of main street and Wall Street focused rescues would have likely not led us to this point.
It is unlikely that populist political leanings and policies will fade and we should expect further polarisation. Ironically, we are probably at the point, especially in the US, where we may be seeing the natural reversion of increased returns to labour over capital.
The GFC was a very stressful time for all of us in the financial industry. The sleepless nights and anxiety felt every day took their toll. Just like mistakes, every great calamity offers its lessons. I would hope we could all learn from them but I’m not so confident we will.
Advances in prospect theory: Cumulative representation of uncertainty, by Amos Tversky and Daniel Kahneman, https://link.springer.com/article/10.1007/BF00122574
• Nathan Kowalski CPA, CA, CFA, CIM is the chief financial officer of Anchor Investment Management Ltd and can be contacted at firstname.lastname@example.org. Disclaimer: The sole responsibility for the content of this article, lies with the author. It does not necessarily reflect the opinion, policy or position of Anchor Investment Management Ltd. The content of this article is not intended to be relied upon as a forecast, research or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy or for any other purpose. The information and opinions contained in this material are derived from proprietary and non-proprietary sources deemed by the author to be reliable. They are not necessarily all-inclusive, are not guaranteed as to accuracy and are current only at the time written. Past performance is no guarantee of future results. There is no guarantee that any forecasts made will come to pass. Reliance upon information in this material is at the sole discretion of the reader. Investment involves risks. Readers should consult their professional financial advisers prior to any investment decision. The author may own securities discussed in this article. Index performance is shown for illustrative purposes only. You cannot invest directly in an index. The author respects the intellectual property rights of others. Trade mark or copyright claims should be directed to the author by e-mail
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