- A look back at the 2008 U.S. Financial Crisis
- Current European Debt Crisis
- Volatility’s Impact on U.S. Financial System
In looking back at the 2008 U.S. financial crisis we can draw some similarities with the current situation in Europe. The 2008 crisis was caused by over-leveraged banks and financial institutions left holding toxic assets after the real estate bubble popped and the economy peaked. The main culprits who suffered the worst in the crisis were Lehman Brothers, Bear Stearns, Countrywide, Fannie Mae, Freddie Mac, Washington Mutual, Merrill Lynch and AIG. Even though Bear Stearns’ bail-out kicked things off in March of 2008, the financial crisis really picked up downside momentum after Lehman Brothers declared bankruptcy in September 2008. The initial effect was that the $64.8 billion Reserve Primary Money Market mutual fund ‘broke the buck’ due to its suddenly worthless $785 million Lehman commercial paper holding (1). The surprise bankruptcy by Lehman and unexpected impact on such a large money market mutual fund caused all commercial paper lending to essentially freeze. Eventually the Federal Reserve stepped in to provide emergency liquidity. The U.S. government’s overall solution though came in the form of the $700 billion TARP (Troubled Asset Relief Program), which bought toxic assets off of banks’ balance sheets and purchased equity positions in banks. This solution, though, came too late as major damage had been done at that point to the economy and to the market’s confidence.
The recent European debt crisis is somewhat on the same path. It was caused by Euro-zone member countries with stagnating economies piling up too much sovereign debt while having few fiscal and monetary controls in place to avert default. The main culprits in this crisis are Greece, Ireland, Portugal, Italy and Spain. The rest of the European Union and its bank regulators can be blamed as well for allowing such fiscally unsound countries to be part of the EU and for allowing banks to treat debt that they own from any EU country as being equal. The EU’s solution so far has been for major fiscal austerity measures in return for loan support. But this basically piles debt on top of debt and makes recession more likely for those receiving support. The most-recent plan, somewhat akin to the TARP in the U.S., is for the $601 billion (and growing) EFSF (European Financial Stability Facility) to buy sovereign debt from fiscally strained euro-zone countries and banks in return for re-negotiated debt terms and fiscal austerity. This plan must be approved by all 17 euro-zone countries first before going into effect.
With regards to a 2008-type of financial crisis happening this time around, some negative signs of downside momentum are steadily appearing. For example, June and July saw the 10 largest U.S. money market funds cut their European bank debt by 20%, according to Fitch Ratings. And in August, U.S. money market funds cut their European bank debt holdings again by about 14% according to JPMorgan (2). In the short-term the ECB and the Federal Reserve have stepped in to provide temporary liquidity to the banks (3), however this is not a long-term solution. The EFSF might be a longer-term solution, however since it was announced in July the global stock markets have continued to decline and the credit default markets have driven up the cost for insuring European bank and sovereign debts to all-time record high levels (4). So essentially, major market participants are growing very pessimistic of Europe’s ability to contain the situation. They are not only pulling much-needed money out of European banks but they are also willing to pay higher and higher prices to hedge themselves against default risk.
Overall, Europe is stuck between a rock and a hard place, and they are trying to take the right steps towards recovery, or containment. However, we are still only 3 years out from the 2008 events, so the markets memories of the negative Lehman and AIG surprises are still fresh in investors’ minds. This fear overshadows the actual stress within the US financial system, measured by four components, including financial institution default risk and the volatility in the markets. This stress, which is shown in the chart below, is hovering around a value of 500 compared to a level exceeding 2,000 during the peak of the 2008 crisis. Although the European financial system is under attack, so far the US financial system has not reached a level to cause a sense of panic.
Aggregate level of stress in the US Financial System
Source: Bloomberg.com (5)
We are expecting volatility levels to remain elevated, and this is likely to remain a European news-driven market for some-time. We also believe negative outcomes are currently being priced into the U.S. and European markets as prior preventative measures taken by the EU over the past 18 months have proven to only be a temporary fix. As a result, we remain cautious within our portfolio allocations. We continue to closely monitor the events within Europe as well as short-term model indicators to provide guidance on possible opportunities for re-investment and reducing the allocations into cash and money markets. If a timely and coordinated unwinding of the European debt crisis occurs, opportunities within higher yielding sectors such as utilities and corporate bonds will be attractive. On the other hand, if the EU continues to rely on inaction, assuming the problem will just go away, we will continue to remain defensive as the continued market risk does not justify the potential reward.
Ben Marwitz
Associate Portfolio Manager
Sources:
(1) USAToday.com. http://www.usatoday.com/money/perfi/basics/2008-09-16-damage_N.htm
(2) NYTimes.com. http://www.nytimes.com/2011/09/13/business/global/investors-reducing-exposure-to-french-banks.html and
(3) Bloomberg.com. http://www.bloomberg.com/news/2011-09-28/euro-crisis-makes-fed-lender-of-only-resort-as-banks-chase-dollar-funding.html
(4) Bloomberg.com and NYTimes. http://www.bloomberg.com/news/2011-09-26/corporate-bond-risk-rises-in-europe-credit-default-swaps-show.html and http://www.nytimes.com/2011/09/13/business/global/investors-reducing-exposure-to-french-banks.html
(5) http://www.bloomberg.com/apps/quote?ticker=HSCLOG:IND
Disclosure
Information provided comes from independent sources believed reliable, but accuracy is not guaranteed and has not been independently verified. The opinions expressed are those of the portfolio management at Weatherstone Capital Management and not to be construed as investment advice or offer to buy/sell a security, or a solicitation which should only be provided by a qualified financial advisor prior to entering into any investment that involves risk. Investment decisions should be made based on investor’s specific financial needs, objectives, goals and time horizon. All opinions and views constitute our judgment as of the date of writing and are subject to change at any time without notice.
