APPROACHING THE 10TH-YEAR ANNIVERSARY / CREDIT BUBBLE BULLETIN

Approaching the 10-year Anniversary

Doug Nolan


We're rapidly Approaching the 10-year Anniversary of the 2008 financial crisis. Exactly one decade ago to the day (September 7, 2008), Fannie Mae and Freddie Mac were placed into government receivership. And for at least a decade, there has been nothing more than talk of reforming the government-sponsored-enterprises.

It's worth noting that total GSE (MBS and debt) Securities ended Q3 2008 at $8.070 TN, having about doubled from year 2000. The government agencies were integral to the mortgage finance Bubble - fundamental to liquidity excess, pricing distortions (finance and housing), general financial market misperceptions and the misallocation of resources. GSE Securities did contract post-crisis, reaching a low of $7.544 TN during Q1 2012. Since then, with crisis memories fading and new priorities appearing, GSE Securities expanded $1.341 TN to a record $8.874 TN. Of that growth, $970 billion has come during the past three years, as financial markets boomed and the economy gathered momentum. A lesson not learned.

Scores of lessons from the crisis went unheeded. The Financial Times' Gillian Tett was the star journalist from the mortgage finance Bubble period. I read with keen interest her piece this week, "Five Surprising Outcomes of the Financial Crisis - We Learnt the Dangers Posed by 'Too Big to Fail' Banks but Now They Are Even bigger."

Tett's article is worthy of extended excerpts: "What are these surprises? Start with the issue of debt. Ten years ago, investors and financial institutions re-learnt the hard way that excess leverage can be dangerous. So it seemed natural to think that debt would decline, as chastened lenders and borrowers ran scared. Not so. The American mortgage market did experience deleveraging. So did the bank and hedge fund sectors. But overall global debt has surged: last year it was 217% of gross domestic product, nearly 40 percentage points higher - not lower - than 2007."

A second surprise is the size of banks. The knock-on effects of the Lehman bankruptcy made clear the dangers posed by 'too big to fail' financial institutions with extreme concentrations of market power and risks. Unsurprisingly, there were calls to break them up. The big beasts are even bigger: at the last count America's top five banks controlled 47% of banking assets, compared with 44% in 2007, and the top 1% of mutual funds have 45% of assets."

A third counter-intuitive development is the relative power of American finance. In 2008, the crisis seemed to be a 'made in America' saga: US subprime mortgages and Wall Street financial engineering were at the root of the meltdown. So it seemed natural to presume that American finance might be subsequently humbled. Not so. American investment banks today eclipse their European rivals in almost every sense… and the financial centres of New York and Chicago continue to swell…"

Then there is the issue of non-bank financial companies. A decade ago, investors discovered the world of 'shadow banks', when they learnt that a vast hidden ecosystem of opaque investment vehicles posed systemic risks. Regulators pledged to clamp down. So did the shadow banks shrink? Not quite: a conservative definition of the shadow bank sector suggests that it is now $45tn in size, controlling 13% of the world's financial assets, up from $28tn in 2010. A regulatory clampdown on the banks has only pushed more activity to the shadows."

A fifth issue to ponder is the post-crisis retribution. Back when lenders were falling over by the dozens, it seemed natural to presume that some bankers would end up in jail. After all, there were hundreds of prosecutions after the US savings and loans scandals of the 1980s. But while banks have been hit with fines in the past decade, totalling more than $321bn, (almost) the only financiers who have done jail time are those who committed crimes that were not directly linked to the crisis, such as traders who rigged the Libor rate."

The FT's Martin Wolf weighed in with, "Why So Little Has Changed Since the Financial Crash." I greatly respect Gillian Tett's insight. Martin Wolf is exceptionally knowledgeable and an esteemed journalist, but I don't hold his perspective in the same high regard.

Wolf: "So what happened after the global financial crisis? Have politicians and policymakers tried to get us back to the past or go into a different future? The answer is clear: it is the former… After the crisis of 2008, they wanted to go back to a better version of the past in financial regulation. In both cases, all else was to stay the way it was."

Wolf: "The financial crisis was a devastating failure of the free market that followed a period of rising inequality within many countries. Yet, contrary to what happened in the 1970s, policymakers have barely questioned the relative roles of government and markets."

I've never viewed the 2008 fiasco as a "failure of the free markets." It was instead an abject failure of policymaking - of government policy and central bank doctrine and methods. At its roots, the crisis was the inevitable consequence of unsound money and Credit - finance that over time became increasingly unstable specifically because of government intervention and manipulation. "Activist" central banks were manipulating the price of finance and the quantity and allocation of Credit, along with increasingly heavy-handed interventions to backstop dysfunctional markets.

The crisis was a predictable failure in inflationism. Sure, it's reasonable to blame the reckless behavior of Wall Street. But risk-taking, leveraging, speculation and chicanery were all incentivized by policy measures employed to inflate both asset prices and the general price level.

Instead of crisis focusing attention on the root causes of perilous financial and economic fragilities, it was a panicked backdrop conducive to only more egregious government and central bank intervention. Rather than exhaustive discussions of the roles played by "The Maestro's" "asymmetric" market-friendly policy approach, Bernanke's pledge of "helicopter money," and central bank "puts" in inflating the Bubble, Dr. Bernanke was the superhero figure with the smarts, determination and academic creed to reflate the securities markets for the good of humanity. It was a grand illusion: Enlightened inflationism was viewed as the solution - and not the core problem that it was. And inflationists - including the FT's Martin Wolf - cheered on zero rates, Trillions of QE and the resulting inflation of the greatest Bubble in human history.

It became common to compare 2008 to 1929, and we were darn lucky that chairman Bernanke had trained his entire academic career to ensure a different outcome. This comparison continued for some years, 2009 to 1930, 2011 to 1932, and so on. I never bought into this line of analysis. As it turns out, 2008 did not mark a major inflection point in finance, in policymaking or in economic structure. I would argue that the unprecedented reflation merely extended the cycle, with essentially the same policy doctrine, financial apparatus and market structure that ensured the previous crisis. Same cycle, but just a much more comprehensive Bubble, across markets and economies on a global scale - and on powerful steroids.

It's popular to blame the rise of populism on the financial crisis. I believe the issue is more about economic structure. It is interesting to note that back in 2006, at the height of the U.S. Credit expansion, manufacturing jobs actually contracted during the year. The financial backdrop ensured that it was much easier to generate profits lending money, in structured finance and speculating in the markets than it was producing goods in the U.S. Productive investment (and manufacturing employment) has bounced back somewhat in recent years. Yet post-crisis inflationism has only widened the gap between real economic investment and the easy returns available from asset inflation, securities trading and financial engineering.

It's very much a minority view. But I believe we'd be in a much better place today had we not reflated the previous Bubble. It was a mistake to aggressively promote securities market inflation, once again incentivizing financial speculation; once again favoring the Financial Sphere over the Real Economy Sphere. Such favoritism specifically favors segments of the economy and population over others. The ongoing financial incentive structure foments financial and economic instability (ensuring a more outlandish and protracted cycle of central bank inflationism).

Warren Buffett is known for his focus on ensuring the right incentives are in place. Few have benefitted more from central bank-created incentives and securities market favoritism - along with inflationism more generally. I would add that no investor's reputation has gained as much from crisis policymaking. If there is a paramount investment truth today, it's that we all must invest for the long-term like the great Warren Buffett. Buy and hold, never try to time the market - but simply invest in America for the long-term. It's a sure thing.

As part of 10-year crisis anniversary coverage, the Wall Street Journal interviewed Buffett. The title of the video was enticing: "Warren Buffett Explains the 2008 Financial Crisis.

Buffett: "In 2008, you had something close to a bubble in home real estate. Fifty million people had mortgages roughly at that time, out of 75 million homeowners. When that bubble burst, it hit home to probably 40% of the households in the country - these people that had mortgages on their houses. Fear spread in the month of September 2008 at a rate that was like a tsunami."

WSJ: Who do you hold responsible for that?

"Bubbles are always hard to ascertain the originators of it. There really aren't originators. Everybody got caught in. Some were foolish, some were crooked - some were both. But you had a mass illusion that it could go on forever. You had Wall Street firms participating. Mortgage originators participating. But you had the public participating. It was a lot of fun. It was like Cinderella going to the party. We were all going to turn and buy some pumpkins at midnight, but nobody wanted to leave until one minute to midnight. And the rush for the door couldn't be handled."

WSJ: For you, what were the lessons you learned in 2008?

"I didn't really learn any new lessons in 2008 or 2009. I had emphasized to me some of the things that I'd always believed. That you do need somebody who can say 'do whatever it takes.' The U.S. government had to do the right things - not perfect things - but generally the right things starting in September. And they did a fantastic job, actually, of getting the train back on the tracks. There was still damage for a long period thereafter. But it was really important to have fast action at that time. We were very fortunate we had the leaders we did. If we'd had people that would have waited for all the information to be right, or for committees to work - that sort of thing - it would have been far, far worse. People talk about a fog of war, but there's a fog of panic too. And during that panic you're getting inaccurate information, you're hearing rumors. If you wait until you know everything, it's too late."

…I can understand how people that lost their houses or lost their jobs - whatever may have happened to them - feel that there must be somebody out there that was profiting from this that did it doing some things that should send them to jail. The people that ran most of the institutions - the big institutions that got in trouble - probably shouldn't name names - they went away rich. They may have been disgraced to some degree, but they went away rich. So I don't think the incentive system has been improved a lot from what it was ten years ago."

WSJ: What could the next crisis look like?

"If I knew what the next crisis would look like, I might be a little helpful in stopping it. But there will be other crises. There's no way of knowing, when we're in a situation like we were in the fall of 2008, when or precisely how it will end. You know the United States will come back. The factories don't disappear. The farm land doesn't disappear. The skills of the people don't disappear. But you had a system which was going to put them in an idle position - or could do it - there's no way to know how far it was going to go.

"What's left from the crisis is pretty much memories. The tracks are still there. The train in still there. But we had a big interruption in 2008 and nine - and now the train has been running pretty darn well. We've shown that America can't be stopped."  

I find Buffett's comments disappointing. For someone with his experience and intelligence, it seems there should be deeper insight regarding the forces behind such a major financial crisis.

For me, it's reminiscent of the mindset at the market top in the late-twenties. And, of course, the factories, farms and human skills didn't disappear after the Great Crash. America wasn't stopped. But the financial apparatus that inflated to extraordinary excess during the boom came to a grinding halt, with momentous ramifications for economies, societies and geopolitics.

In contrast to 2008, that crash and the resulting crisis in confidence - in the markets, in finance, in policymaking and in the real economy - concluded the cycle.

Hopefully the bullish consensus view is correct. But the current backdrop sure seems late cycle - "permanent plateau" - manic wishful thinking to me. This whole buy and hold and ignore risk delirium - the product of decades of "activist" central banks jamming too many "coins in the fuse box" - espoused by the great market oracle Warren Buffett - is a trap. It's been awhile since investors have experienced a protracted bear market. Central bankers have too quickly come to the markets' defense. The next crisis could prove much more difficult to manage. Long-term investors, convinced to hold tight, may find it's a long time before they see these securities prices again.

The way I see it, a lot of faith has been placed in enhanced bank supervision, larger bank capital buffers and the almighty power of "whatever it takes" central banking. But despite the propaganda, irresponsible bank lending was not the root cause of 2008 fragilities. It was dysfunctional financial markets, replete with mispricing, misperceptions, rank speculation, leverage and resource misallocation. It was a massive and unwieldy derivatives marketplace. It was the view that the securities and derivatives markets were too big to fail - that central banks could ensure uninterrupted liquid and robust markets.

And this is where critical lessons went unlearned and, as a consequence, where danger lurks today. From my vantage point, all the previous key forces fomenting latent fragilities are greater today than a decade ago. From a global perspective, unsound "money" and Credit back in 2008 appears pristine in comparison. And if you think populism, nationalism, socialism and mayhem are on the rise, just wait until this global Bubble bursts.