Did Markets fail seven years back?

Did Free Markets fail 7 years back | Blog | NPI

Last week marked the seventh anniversary of the Market (S&P 500) bottom in 2009.

In the search for an edge on the market, we strive to shy away from conventional/ crowd wisdom. As opinions are many but facts are sparse, especially when it comes to the great recession of ‘07/’08. Conventional narrative holds that the Capitalistic system did not work and Bankers took on too much risk. (Full Disclosure: I was in Banking in prior times)

Let me offer a different view…

After the Great Depression of 1930’s, the Banking Act of 1933 was enacted, which created the ‘Deposit Insurance’ concept, which aimed to end Bank runs. One consequence of this Act was a creation of the concept of ‘moral hazard’. This theorized that Bank management because of deposit insurance would now be free to make riskier bets, as they would always be bailed out.

To end this new monster of moral hazard, the FDIC prescribed ‘minimum capital requirements’ on commercial Banks and S&L institutions, but the requirements were loose. They did not distinguish asset classes or riskiness within asset classes, instead asked for flat capital minimums (8 to 10%)

With that said, entered the Basel committee in 1974, which came out with a Capital framework in 1988 called the ‘Basel I’. They created the concept of ‘risk adjusted capital’ (for example Assets like Cash and Government securities (US or UK or Greek) were assigned a 0% risk weight (the lowest risk), while Consumers and Business loans were assigned 100% risk weight (so most risk) and between these two goalposts were other securities like GSE (Fannie/ Freddie) paper with a 20% risk weight.

This created a distortion in lending, where Banks would prefer to originate Mortgages or buy GSE backed paper, rather then making loans to consumers or businesses.

So to rectify this new wrinkle, the ‘Recourse Rule’ was finalized in 2001 by the FDIC/Fed /OCC which applied the concept of ‘external ratings’ based approach to assets (for example AAA rated securities required the lowest capital while B rated securities required 200% risk capital)

Given this regulatory backdrop, plus the push by the Federal government for home ownership, Wall Street increased its ABS (Asset backed securities) issuance from approximately $500Bn in 2001 to about $2,200Bn in 2006*.

In September 2006, another regulator (SEC with the FASB) promulgated FAS 157 (an accounting standard). This required Banks to mark securities based on market observable pricing (e.g. CDS (credit default swap) pricing) in absence of actual transactions.

The Market panicked in 2006 (as it does from time to time) because it expected delinquencies to be large in subprime/Alt A mortgages. It started selling any and all securities at fire sale prices.

Our new friend ‘MTM’ required banks to price securities to market. Thus the accountants started writing down the assets but this time unlike before the write-downs were not based on actuals or models. They were based on ‘current’ market prices, and they triggered large Capital losses for the Banks. These Capital losses got the banks closer to prescribed legal capital minimums. The result: Banks saw the capital erosion and stopped lending.

To get a sense of the severity of markdowns… At one point in 2008, CDS pricing, suggested loss rates of 60% in the ABS market, reality however was different- foreclosure rates for subprime ARM’s peaked at 7% in 2009*.

Bank lending fell by 7% between 2007-08 making it the fastest pace of contraction in 40 years. Even more important bank lending to businesses fell by 67%*.

Many bailouts or federal programs (e.g. TLGP, TARP) happened in the space of 2007-’08 but the market (S&P 500 index) continued its downward spiral. Only when Congress pushed the FASB (accounting regulator) in March 2009 to set right the MTM standards, did the panic subside. By way of coincidence, S&P 500 also bottomed in March 2009.

In my opinion Capitalism was not broken, rather overseers of the market (e.g. SEC, Fed) had accidentally engineered a financial crisis as they tried to eliminate issues created in prior regulations

Key takeaways. First be aware of the regulatory environment, it can move markets. (My focus is to look for second order effects of regulations, as prior and current/proposed laws intersect). Second, free markets are not perfect but they largely work, are prone to panics time and again but with the right financial planning services, you have the potential of getting extra insight.

Don’t forget to take a look at our other blog posts for more information!

 

 

A brilliant and cohesive book on this topic is “Engineering the Financial Crisis Systemic Risk and the Failure of Regulation” by Friedman.J and Kraus.W from which much of the data above is taken*.

**Past performance is no guarantee of future results. A risk of loss is involved with investments in capital markets. Please consider investment actions in light of your goals, objectives, cash flow needs, time horizon and other lasting factors