The summer of 2007: is the market any safer 10 years on?

As one of the defining events of recent economic history, most investors will remember where they were when the global financial crisis began. In the summer of 2007, I remember being called off vacation and returning to my office on news that BNP Paribas had suspended three funds exposed to the US subprime mortgage market. What happened next is, of course, history. Looking back, 10 years on, there are parts of the economy, asset classes and industries that are yet to recover – and lessons that are yet to be learned.

Stéphane Monier
Head of Investments, Lombard Odier Private Bank

When economies break their speed limits
Over the 10 years that have passed, I have come to think of economies as similar to cars on a motorway – and speed as a metaphor for debt. In modern economies, leverage is as essential to growth as speed is to distance. But every car, depending on the model, has a rate of speed that is optimal for its performance. My first car, for example, would drive like a dream at 80mph, but if I pushed it to 95, the car would start to feel a little less stable. In many ways, an economy is quite the same. If the level of debt in the system rises beyond what is optimal for that economy, the system becomes unstable. With that, confidence becomes equally shaky, and lenders start to worry that they won’t get their money back. It is ultimately this loss of confidence that turned what was a crisis in the subprime segment of the US mortgage market into an economic catastrophe.

Moral hazard
Had authorities and governments intervened when the crisis was contained to the mortgage sector – a bailout of approximately $20 bn would have sufficed by most estimates1 – the global financial crisis would probably never have happened. Instead, in 2007, decision-makers opted to sit on their hands. This decision to leave the subprime sector to the mercy of market forces in the summer of 2007 was made for a simple reason related to the concept of moral hazard.

Moral hazard is the risk that one or more counterparties to a contract may gain from acting in a manner that is contrary to the principles of that contract. In 2007, the market was rife with such risk. Lenders across the US and in many other developed economies, were giving mortgages and other loans to borrowers who had little or no means to paying it back in full. Rightly, governments wanted to put an end to this practice and sought to penalise the sector by allowing the crisis to play-out unheeded. They expected that the most-distressed borrowers would declare themselves bankrupt and the lenders would, over time, clean-up their books.

What the authorities failed to factor-in, however, was the stunning interconnectedness of the financial system – and the sheer complexity of the now infamous CDOs2 that packaged good loans in with bad. Authorities, indeed, failed to foresee the speed at which the contagion would spread to the wider mortgage market and then into the banking system as a whole. Within just a year, the crisis had claimed the US’ fourth largest investment bank. By the morning after Lehman Brothers had filed the biggest bankruptcy protection claim in US history any remaining confidence in the global financial system had evaporated.

If we return to the motorway, this is the moment when the car is about to swerve off the side of the road. And the driver now has one of two options.

The authorities’ two options
When economies exhibit symptoms of crisis, authorities and governments may choose to do one of two things. They may decide to do nothing, allowing market forces to assert themselves in a process that often culminates in some kind of crash. This step has been taken countless times in economic history – and we know, for sure, that it works. The obvious problem with this strategy is that it is extremely painful (for economies, for industries, and for individuals). This was the option that authorities took, most famously, in 1929. Because of this, we know that economies that go bust will eventually boom again – even if they have to endure economic depression, social unrest, political upheaval and even war beforehand.

The second option is to bailout the institutions that pose the greatest systematic risk and inject fresh liquidity into the system. Having chosen option 1 in 2007, global authorities had had something of a change of heart by the end of 2008 after the speeding car in our metaphor had already taken out a long list of financial institutions.  In the US, the Federal Reserve pumped unprecedented quantities of reserves into the economy. The monetary base went from about $850 billion in July 2007 to $4 trillion in July 2014, when the quantitative easing effort was near its peak3 (considerably more than the $20bn4that they may have spent only a year earlier).

While the unorthodox monetary support delivered via the central banks averted a full-blown depression – a possible c.20% contraction in global growth – today, 10 years on, the global economy would probably be growing at a rate of 4-5%5. Instead, by choosing to deploy everything from quantitative easing to negative interest rates to stringent regulations across the financial services, central banks have softened the impact of the economic malaise – although, in doing so, they have also prolonged it. The global economy now finds itself in a new growth paradigm characterised by slow, if stable, economic growth, along with low investment returns. This growth profile, I believe, is here to stay.

The new paradigm
Rightly or wrongly, the decision of the central banks to relinquish their independence and rescue their respective economies has transformed the economic paradigm in which we now operate. A decade on, our metaphoric car is pretty beaten-up, but back on the road – the question, however, is what did the driver at the wheel learn about speed? Current data on national and corporate debt suggest that the driver hasn’t learned all that much. In all the major economies, government debt as a percentage of GDP has risen significantly since 2007.

Total debt in the US currently stands at 352.4% of GDP (considerably higher than it was in 1929); while, China had added $24 trn to its debt pile since 2007. This comes despite considerably slower growth. Clearly, the car is still driving above its optimal speed.
Source: Datastream

Is it time to worry?
While we still live in a heavily indebted world, an intelligent investor can use the lessons of the crisis to build portfolios that are suited to the new economic paradigm we are in. Three of the most important lessons that we have learned – and use as the basis for how we position portfolios at Lombard Odier – are as follows:

• Liquidity is a function of quality: if the holdings in a portfolio are of sufficient quality, an investor will be able to sell them whatever the economic conditions. So as we seek to build resilience into portfolios, quality is our first consideration.
• Where risk modelling is concerned, perspective is key: any single risk model will give us an assumption of the relevant risk drawn only from its unique perspective. Different risk models will present different estimates of risk – each as valid as the other. It is vital, therefore, to have several risk models at work at the same time.
• Liquid assets attract liquidity: when central banks inject liquidity into a system, that cash is most likely to flow into the market’s most liquid assets classes, i.e. financial assets (stocks and bonds), ultimately inflating their value. Real assets (private equity, real estate, infrastructure) – being less liquid – attract fewer inflows in the first stages of a recovery, making it less easy for bubbles to form. As a result, we seek to build portfolios that are appropriately diversified across liquid and illiquid asset classes.

As we continue to build portfolios that reflect the learnings of the crisis, I am pleased to have recently returned from a summer vacation that was notably uninterrupted. I resettle into the task of managing portfolios, ready for whatever the economy sends our way and confident that our clients’ wealth is safer as a result of the lessons of the last 10 years.

¹ Lombard Odier estimates
² Collateralised debt obligations are pooled investment vehicles for which a debt obligation serves as collateral for investors
³ US Federal Reserve
⁴ Lombard Odier calculations
⁵ Lombard Odier calculations

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