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An insider's view of the last financial crisis

On The Guardian newspaper’s website, there is a timeline of the Global Financial Crisis. It starts, not as many would expect when Lehman Brothers filed for bankruptcy in September 2008, but a year earlier. ‘The day the world changed’ was 9 August 2007 when BNP Paribas froze redemptions on three of their funds because they could no longer value the assets held in them. Those assets were backed mostly by sub-prime mortgages in the US and a crisis of confidence had engulfed that market.

For people involved in the money, fixed interest and credit markets, the stresses in the financial system from August 2007 until 2009 were almost unimaginably intense. I don’t think many Australians have ever understood what was happening. To this day I encounter people who look back on, for example, a relatively mild pull back in stock prices in September 2007 and wonder what all the fuss was about.

It started with falling US house prices

While not predicting the severe events that eventually unfolded, I’d been concerned through 2006 that credit markets were taking on more risk, but pricing it too cheaply. Sub-prime mortgages were just one example, and by early 2007, this market was in trouble. Arrears were rising rapidly, which isn’t surprising since the loans were to people who by definition couldn’t afford them. This wouldn’t have caused problems for structured products built on sub-prime quality if house price inflation had come to the rescue, as was naively assumed. But house prices had been falling for nearly two years, taking away the ‘get out of jail free’ card. Refinancing of delinquent loans became almost impossible and several origination firms went bankrupt.

Credit markets were still priced for a very benign economic environment. It was generally expected that the sub-prime crisis could be contained to structured securities and the financing vehicles of some of the banks. However, Phil Preston, who was a member of my team, wrote in March 2007 that “the impact on the finance sector should be modest unless one or two more events hit markets in quick succession, in which case there is a risk of withdrawal of liquidity, price spirals etc.”

By July 2007, that ‘unless’ started to become reality. Credit rating downgrades became more commonplace, especially for financial corporations. Credit spreads widened sharply that month and concerns were beginning to extend beyond those that were directly involved in the US housing and sub-prime markets.

The BNP announcement brought the crisis to Europe - and then the world

Then came August 2007 and the BNP announcement. This required fund managers to assess carefully their exposures to BNP. It also led to questions being asked about the quality of the balance sheets of all financial institutions.

It also became apparent that the Australian corporate bond market was far from being Australian. I clearly remember facing the Investment Committee of one superannuation fund in late 2007 and being asked, “So tell me again why the travails of an American home loan lender are giving my Australian bond fund such grief?”

That American lender was Countrywide, and its story provides a snapshot of this turbulent time.

Countrywide was one of the US home lenders that had ventured into the sub-prime loan market.  We were keeping a close eye on their credit quality as they had an $A bond maturing in December 2010. In late 2006 the bond was trading at around 0.35% over swap. By March 2007 it had widened out to 0.55% over, then in July the market’s assessment of their risk spiked and the bond was marked out to 1.0% over swap. The trend continued, and by early September 2007, the Countrywide bonds were at 2.7% over swap. In reality these prices were probably just market guesses; I doubt a real market for Countrywide bonds actually existed at that time. Liquidity was being withdrawn.

After the BNP Paribas announcement, Countrywide debt jumped to 3% over swap. It was a vicious circle for them - as the extent of the sub-prime problems became better understood and that market declined even further, the willingness of other lenders to refinance them diminished. By the end of 2007 they were at more than 10% over swap.

Of course, the price of the bonds plunged - from around par in late 2006 to 69 cents a year later. Even though Countrywide was only a very small member of the UBS Composite Bond Index, its price decline was enough to have a sufficiently negative impact on the returns of the market that it needed to be mentioned in client reports.

In the end, Countrywide bonds recovered. The company was bought by Bank of America in early 2008, when the US was still trying to engineer bailouts of troubled lenders. Their $A bonds matured on 16 December 2010 at par value – 100 cents in the dollar. Anyone who’d had the courage to buy them three years earlier did very well.

Banks stopped lending to each other

A chain of events followed BNP Paribas’ announcement in August 2007. From the collapse of Britain’s Northern Rock later that month, to the rescue of Bear Stearns by JP Morgan in March 2008, then eventually to the failure of Lehman Brothers, Washington Mutual, Wachovia, AIG and many others in the US and elsewhere later that year, the train wreck that we now call the Global Financial Crisis hit us. Confidence in the global banking system was shattered.

During this period even the big four Australian banks became reluctant to lend to one another, due to a lack of confidence about problem exposures in all counterparties. The Reserve Bank of Australia, along with all central banks globally, injected massive liquidity, imposed new rules regarding security for central bank loans to the banks and cut interest rates to stave off a complete failure of the inter-bank lending system on which the economy stands. Governments either guaranteed or bought out banks to prevent their demise. Contrary to some opinion, all of this was not just whining by banks wanting taxpayer bailouts, but a genuine fear that the world was such a toxic place that no credit could be trusted.

The global funds management system grappled with the questions the crisis posed about what to do with the funds that our clients had entrusted us.

In the end we held to the view that governments would respond to restore confidence and at least buy time for the world economy to recover. They did this in spades and although it’s been anything but smooth sailing since, the alternative is too awful to think about.

US Congress has temporarily addressed the debt ceiling issue this week, but it will be back again in early 2014. People must have confidence in the financial system and the markets need a risk-free asset they can trust.

Warren Bird was Co-Head of Global Fixed Interest and Credit at Colonial First State Global Asset Management until February 2013. His roles now include consulting, serving as an External Member of the GESB Board Investment Committee and writing on fixed interest, including for KangaNews.

Warren Bird
September 12, 2018

There's a good series of articles in the AFR this week about the GFC, with the 10th anniversary of the punctuation mark moment that was the Lehman collapse almost upon us. They go into just about all the issues I touched on in this 2013 piece in quite a bit of depth, plus a few that I didn't mention (such as today's article interviewing my former colleague Catherine Allfrey about the listed property trust sector and Centro's woes).

I was particularly interested in the article yesterday interviewing James Aitken, which starts with an anecdote he tells. In August 2008 someone told him, "go to the cash machine and get some money out", because you might not be able to tomorrow. This is the first time that I've read someone else putting it that way. I've had many conversations in the last decade with people who think the GFC wasn't that big a deal. I've tried to explain that confidence in the banking system was so low in the September quarter of 2008 that we came within a whisker of that scenario playing out - the collapse of the banking system. Not because our banks were unsound here in Australia, but simply because of the global spread of fear.

It started with fear among the banks themselves, not knowing which of their counterparts had a balance sheet you could trust. That led to the risk that they wouldn't lend to each other overnight, which would mean there was no 'cash' in the system and the risk that a customer might not be able to access funds from an ATM. No feeding the family that week, no paying the bills - it was potentially that bad.

Thankfully we had policy makers who were all over it. The other great article this week was this one, which explains how the RBA kept the banks going and ensured the system didn't get into meltdown:

Glenn Stevens in that article says something that I was thinking at the time as well. "My feeling has always been that having seen Bear Stearns get sorted, there was an assumption that entities bigger than them would always be sorted out ... When it became apparent that assumption was mistaken {because they let Lehmans go under}, then we were in a new ballpark."

Eventually, though, governments and central banks globally got it right. They pumped liquidity, they went into fiscal deficit spending and they eased monetary policy all the way to zero rates and beyond (viz QE). They had to. The world faced a structural headwind unlike anything seen since the 1930's and it needed a massive policy response.

Some people still question that response. While you can dispute the effectiveness of some specific measures (cash for school halls, for example) the macro policy did the trick. Critics point to the slow recovery as so-called evidence that it didn't, but my view is that the time it took for the system to repair and the economy to recover shows how bad things were and just why such a strong policy response was needed.

In any case, at the time I took the view that, while letting Lehman collapse was a mistake, and the US Congress was slow to recognise that, when they finally did get it right by later in 2008 it meant that we could go back into markets. In my case, this meant credit markets and high yield bonds, then trading at mammoth spreads. As a result, our funds did alright across the whole episode - our diversified fixed interest fund was -0.4% over the year to October 2008, but recovered by more than 15% over the next year or so and the rolling 3 year return from Dec 2006 to Dec 2009 (ie the GFC period) was +6.3% pa. We'd been lightly weighted to our global credit fund during the year it was down 12% (to Oct 08), but overweight when it rebounded to give equity-like returns of 20%+ in 2009 and 2010.

It was a scary time, but thankfully the average Australian didn't really notice it, because policy makers did a great job.

Justin Wood
October 23, 2013

This is a good reminder of the linkages between fragilities in credit markets and the resulting crisis. A June 2013 paper by Guillermo Calvo from Columbia University provides some further analysis of this. He discusses why the credit boom and liquidity crunch associated with securitization and shadow banking was overlooked by most economists and central bankers. He argues that most macro models then (and probabily still now) ignored the instability of credit and fragility of the banking system and the way these might impact the real sector. It's an interesting commentary on how most professionals developed a blind spot to the emerging risks.

URL is:

Ramani Venkatramani
October 18, 2013

It is instructive to chronicle the events leading to GFC, and the imperative forced on Governments to bail out institutions, their boards and managements who brought this on.
Packaging sub-prime and selling to credulous investors was snake oil strategy. Multi-million salaries and MBAs/ PhDs cannot rationalise this toxic conduct.
Consider this: had the triggers Warren lists not arisen simultaneously but the markets remained normal, do you think the taxpayers who bailed out Citi, AIG et al in the USA and the Australian version of fee free assignment of credit rating to our banks would have stood a chance of asking for more from them?
This post-facto insurance without paying a premium may have been justified to quell panic and preserve order.But what have we achieved?
1) Create a precedent for future bail outs: "profits you take, disaster I will cover"
2) Affected unwitting players (such as mortgage funds who did not receive the guarantee given to banks) causing a stampede.
No bank will guarantee a customer without commission and collateral, but they had no qualms receiving such a bonanza from treasurers more concerned with seizure of markets than the inherent asymmetry and injustice of it all. The lobby groups did not object (surprise!)
Unless we craft criminal penalties for the culpable we will perpetuate our two tier justice system. Those who think of it as white collar peccadillos, not on par with mass crime should pause and weep for the many who lost their lives (including suicides).
High finance, indeed.


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