The Next Crisis
Jamie Dimon, CEO of J.P. Morgan, was once asked by his daughter, “What is a financial crisis?” His response was, “Well, it’s the kind of thing that happens every seven to 10 years.”1 While his response may appear to be somewhat facetious, go back half a century and it’s about right.
Investors are now asking if COVID-19 could cause the next financial crisis (based on Mr. Dimon’s math we are overdue). Before answering this question, let’s first explain what likely caused the last one. Two events transformed what should have been a garden-variety recession into a crisis that crippled the global financial system.
The first was a rule implemented by the Financial Accounting Standards Board (FASB) on November 15, 2007. FAS 157, also known as “mark-to-market accounting,” changed the way banks and financial institutions reported the value of “illiquid” assets on their books.
An asset’s liquidity is measured by how easy it is to sell. A publicly traded stock is very liquid because it can be sold quickly with relatively low transaction costs. The more liquid an investment, the more accurate the market price due to so many buyers and sellers transacting.
A house is an illiquid asset because transactions take time and have relatively high transaction costs (broker fees, etc.). Therefore, determining the market price for a house is harder due to fewer transactions.
Liquidity can change over time. Those who have tried to sell a house in a buyer’s market know this all too well and often must choose between accepting whatever price is offered by the few buyers out there or taking the house off the market.
Banks that take deposits and use them to buy illiquid assets must follow strict regulations. If a large number of depositors were to ask for their money back at once, they must comply. FAS 157 was meant to ensure banks maintain enough capital and liquidity. It required banks to solicit daily bids on all assets on their books to be sure the total value of those assets could cover their liabilities to depositors.
On paper, this is completely logical and works fine in normal market conditions. But when all the buyers leave a market like they did in 2008 as the U.S. economy began to fall into a recession, the law of unintended consequences quickly reared its ugly head.
Illiquid assets also tend to be volatile. If only a handful of buyers exist, lowball offers can swing market prices violently. Consider a bank that purchased an illiquid asset for $100 that paid interest on time and showed no signs of impairment. FAS 157 still required this bank to solicit bids from buyers. If the only bid one day was for $10, the bank would be required to write down the value of that asset by 90%.
This not-so-hypothetical example is what created so much unnecessary chaos in 2008 because banks could not maintain their “capital ratios.” These are used by regulators to ensure a bank is capable of paying back its depositors.
To keep these ratios above water, banks were forced to sell assets at fire sale prices to raise capital or risk being shut down. In effect, the crisis became a self-fulfilling prophecy because FAS 157 ultimately required banks to sell real assets to cover the paper losses it created.
Think about it this way. Assume a homeowner puts her house on the market during a recession. If the only offer submitted was for 80% below what she paid, she probably would not accept it. But banks did not have that option so let’s subject the homeowner to FAS 157.
Here, she would be required to pay back her mortgage or post more collateral if the market price for her house fell below some threshold. She must also try to sell her house periodically because the mortgage provider felt th-is best determined the market price of the house.
In this instance, she would be required to hand over more cash to the bank to cover the paper loss generated by a lowball offer. If she did not have the cash on hand to do so, she would be forced to accept the offer. The fact that the house was in the same condition as the day she bought it (no sign of impairment) and the mortgage had been paid on time would have been irrelevant.
The chart below is no coincidence. Soon after FAS 157 infected corporate America, the stock market began its death spiral and did not stop until FASB proposed easing guidelines in early 2009.
What doused the economy in a pool of gasoline hid mostly in plain sight because it was too boring for financial news. Bizarre accounting rules do not sell ad space as well as evil hedge funds, corrupt lenders, and complex financial instruments. But gasoline on its own is not all that dangerous, so let’s now discuss the proverbial match that ignited it all.
Lehman Brothers was one of the most prestigious firms in the world. They hired only the best and brightest to transact in some of the most sophisticated corners of finance, and their bankruptcy in September 2008 created a level of panic in financial markets unseen since the Great Depression.
Lehman owned what the media classified as “toxic assets,” which were illiquid debt instruments that became difficult to price when buyers vanished (per the reasoning above) as the economy worsened.
Despite the name, Lehman’s assets were not that toxic. Most paid on time, management had no intention of selling, and since Lehman was not a traditional bank that took deposits, the market value of these assets was less important.
The problem is that FAS 157 impacted all financial firms, so Lehman was required to write down the value of their assets and take massive paper losses. This made it impossible for them to access short-term funding to keep the business operational.
The irony is that despite assets far exceeding their debt at the very end, Lehman simply could not pay their bills and was forced to file for bankruptcy protection. Meaning, Lehman was illiquid, not insolvent. It is no different than stories about wealthy individuals who go bankrupt. They may own mansions all over the world, but they don’t have the cash to pay their bills and cannot sell houses fast enough to cover expenses.
However, Lehman going under was not enough to light the match. Bankruptcies happen all the time, and this was not the first high-profile victim of FAS 157. Bear Stearns almost failed six months prior for similar reasons until the government brokered a deal at the 11th hour.
The inconsistency of the government is what likely sparked the flame. They chose to save Bear but not Lehman, and this decimated investor confidence.
Not confidence that the government will save large institutions from bankruptcy. It’s often better to allow companies to fail than to waste tax dollars. Rather, it is the confidence instilled by consistency. The arbitrary decision to save Bear Stearns, let Lehman fail, and then days later nationalize AIG left investors scratching their heads.
The entire financial system is based on trust, and when that foundation is eroded from inconsistency and unpredictable decisions by regulators, lenders stop lending because the rules keep changing. After Lehman failed, the government quickly brokered deals to save other banks, but the damage had already been done.
The bankruptcy created an unprecedented credit contraction across the globe as banks stopped lending, collateral was seized, and foreign exchange lines were terminated (halting global trade). Lenders were terrified because nobody knew who would fail next.
It took the coordination of central banks and unprecedented government spending to save global financial markets and replenish confidence and trust back into lenders.
The Bottom Line
There’s an old joke that the only accurate number on a financial statement is the date, so it’s crazy to think that an accounting rule could cause so much mayhem when regulators, investors, and executives know that numbers rarely tell the whole story. But that’s what happened.
Subprime mortgages, corrupt bond rating agencies, unethical lenders, borrowers taking on too much debt, the Fed raising interest rates too high, and every other excuse that has been used to blame the crisis is incomplete. These created the recession, but what converted that mess into a crisis was a loss of faith.
Said another way, a financial crisis is a crisis of confidence. Therefore, a repeat must assume that COVID-19 could also collapse the underlying trust that supports financial markets. This is unlikely for two reasons.
First, we went into this crisis in far better shape than prior ones. The economy was firing on all cylinders prior to the pandemic. Financial markets were also healthier, making for a stronger economic “immune system.” Second, the power of the U.S. government cannot be overstated. We are a wealthy nation, and experience (mistakes) from the last crisis taught the Fed and Congress to act boldly and quickly.
But what if I am wrong? What if the government drops the ball? How can investors be better prepared?
These answers lie in accepting why investors lost so much in 2008, and neither FAS 157 nor Lehman were the culprits. People lost money because they misjudged their ability and willingness to take on risk and sold into the panic. It is that simple.
The bottom line is that best way to protect and prosper is to remain diversified and target a level of volatility that takes as much emotion out of the equation as possible. The better an investor sleeps at night, the less risk of making an emotional decision that will do little more than convert short-term pain into long-term misery.
Mike Sorrentino, CFA
Chief Investment Officer
Three Key Points
- Fears that the COVID-19 could cause another financial crisis are widespread.
- Two events converted a recession into the worst financial crisis in decades.
- Proper diversification is the key to avoiding too much exposure to risk.
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