Reflections 10 years on - Part 2

August 2018

Brett Lewthwaite: Global Chief Investment Officer, Fixed Income | Global Co-Head, Fixed Income


The top five investing lessons
learned from the GFC

This year marks 10 years since the Global Financial Crisis (GFC). This is the second in a three-part series reflecting on that incredible time in financial markets.

We began the series looking at the GFC’s central cause; an acute liquidity event exacerbated by the proliferation of what was a relatively new and poorly understood series of security structures. Complacency relating to risk, value, and the unquestioning trust in a ‘AAA’ label was widespread and entrenched, and with that complacency, the importance of considering liquidity risk diminished. 

In our first reflection we were careful to acknowledge that writing in hindsight is a wonderful thing. While we avoided investing in Collateralised Debt Obligations (CDOs) and sub-prime securities due to our research into liquidity and the hidden risk in these structures, we, like everyone else, felt each and every bump along the way.

Down memory lane

In this next instalment, we reflect on some of the key events of the GFC and the five key takeaways and lessons we observed as we navigated that time in markets.

To do this, we went back through our trading journals, morning meeting notes, newsletters, and all the best of our research collected during that chaotic time (yes, we keep it all!).

What became apparent to us on our trip down memory lane was that while time heals and memories fade, the experience of the GFC reinforced well-known principles of investing, and taught us lessons that we, and all investors, should never forget.

Lesson #1: Watch credit markets; the initial cracks are always visible

Looking back on 2007/08, the broadly accepted postscript that no one could have seen the GFC coming or that it was a black swan event, in our minds is false. In fact, it was there for everyone to see; with cracks appearing as early as late 2006 and clear warning signs through 2007. To us as credit market portfolio managers, the bigger surprise was that it took so long to be reflected in all financial markets. Key early events included: 

  • February 2007 - HSBC declares $US10 billion in sub-prime losses
    This was an incredible number for a highly respected global bank with a relatively small US presence (it was not a US bank), and if this was the scale of their losses, what else was out there? Credit markets reacted immediately with markedly reduced liquidity, and other banks soon followed declaring billions of sub-prime losses.  
  • June 2007 - distress in short-term funding markets
    Short-term funding markets began showing acute signs of distress as many ‘out of sight’, leveraged, off-balance sheet, ‘structured investment vehicles’ struggled to roll their funding forcing investors to sell. In response, credit markets effectively closed. These leveraged investments operate by borrowing in the short-term money markets to fund their longer term securities, and when the short term market shuts, these securities must be sold creating forced sellers.  
  • July 2007 - BNP Paribas closes investment funds
    BNP Paribas announced it was closing some of its investment funds due to illiquidity. Many point to this event as the start of the GFC, but the reality is, it started months prior.

Perplexingly, all other markets continued to trade like the cracks in the credit market did not matter, with equity markets rallying and reaching new highs in September 2007.
I recall our bond and currency desks looking on bewildered as to why the stress emanating from the credit desk was not impacting their markets. This all changed in January 2008, albeit incredibly it took more than a year for reality to hit home. Lehman didn’t fail until September 2008, and markets didn’t bottom until around March 2009. 

“In economics, things take longer to happen than you think they will, and then they happen faster than you thought they could” Rudi Dornbusch

Credit markets were flashing deep red ‘ALERT’ at least nine months before the GFC took hold. The flow of credit is like the flow of blood to the heart; if credit isn’t flowing, the economy will stop, and markets will go into cardiac arrest. There was ample time to exit, yet most chose not to pay attention. 

The lesson | Pay attention to credit markets – they are an early warning sign.  

Lesson #2: Understand the vested interests of the experts; treat them with skepticism

All professions have vested interests, and in financial markets these vested interests are largely for markets to climb higher and higher. 

It was clear by late 2006 that something was very wrong in US subprime mortgages. One reason for the delayed market reaction is central bankers, policymakers and market commentators were keen at each and every milestone to paint a picture that the issues were ‘contained’. These parties allowed their vested (and often business) interests to affect their behaviour and cloud their vision. 

Policymakers, as an unspoken rule, will never (and I mean never) tell you the outlook is challenging. Banks, market commentators, and the ‘talking heads’ always try to place a positive spin on the situation. We came across this classic quote in our search through the headlines at the time, clearly showing the extent commentators were willing to go for that positive story. 

“The Dow Jones fell 500 points today, but that’s actually good news as it was down 750 points at one stage….” 

Further, we recall a meeting with a company (with vested interests) that investors generally rely on, at a time where it was clear that trust in credit markets had collapsed. They revealed they had yet to commence a crucial review of the quality of the problematic security types at the heart of the unfolding crisis – we were dumbfounded.

The lesson | Don’t treat policymakers, market commentators or talking heads as experts; rather treat them with vested interest skepticism. When investing, this means trusting your research and exiting the market early if you believe problems lie ahead. It is never easy going against the crowd, your patience will be tested, but this is what good investors do. And as we learned, the market always catches up - eventually.

Lesson #3: ‘Keep it simple’

If an investment appears too good to be true – it probably is! Complex structures claiming to offer higher returns for seemingly lower risk and seamless liquidity were exposed for what they really were – illiquid investments with questionable collateral. 

The lesson | This one is easy – avoid complex vehicles and securities altogether. Watch out for the “new thing”, the new wave of investing that everyone thinks is fool proof. Could the next vehicle with issues be large passive vehicles or ETFs, particularly those with lower liquidity, and high yielding securities with ‘same day liquidity’? Time will tell. 

Lesson #4: Always consider the true nature of liquidity

One of my favourite quotes from a fund manager during this time is “indiscriminate pricing of otherwise sound collateral”, stated as a reason for poor portfolio performance. This particular fund closed within a month as redemption requests piled in and could not be met due to illiquid holdings. 

When liquidity dries up, people sell what they can, not what they should. As such, higher quality investments often move lower first as they can still be sold, and those in low quality investments can feel a false sense of security. However, all that has really occurred is that no price has been struck - yet. As soon as someone needs to sell (and someone always does), the re-pricing is usually severe. This price will not reflect value (it rarely does), it simply reflects what someone will pay, and if there are no buyers, prices will fall a lot more than you think – indiscriminate indeed. 

The lesson | Don’t find yourself staying late in the market cycle in fear of missing out, seeking incremental gain in ‘riskier’ securities, only having to rush to the exits with the crowd. That incremental gain is not worth the latter regret and pain. Also, pay attention to investments vehicles with no buy/sell spread – they will likely lock up.

Lesson #5: Bear markets are volatile markets

Falling markets are highly volatile markets. The complacency and fear of missing out that breeds as bull markets grind higher and higher, is quickly replaced by an escalating contagion like panic, offering a sharp reminder to those who stretched for those last remaining gains. One day the market drops like a stone, the next it rebounds in the hope the problem has been resolved. Bear markets are a disorientating, confidence sapping rollercoaster ride of anguish and fear. 

Bear market rallies are even worse – this is when the market believes the situation is fixed and rallies hard on hope, sucking everyone back in. Think about Bear Sterns and the old saying “when a big scalp is claimed, this is the signal that the market has bottomed” and consider when Bear Sterns was rescued by JP Morgan in March 2008, nothing was fixed. In fact, the situation was getting worse by the day, yet markets squeezed everyone, rallying 15% over what felt like a very long two months and almost regained the market highs - before falling 60%.

The lesson | Be wary of the fear of missing out (see #4). Likewise, don’t try to ‘pick the bottom’ or ‘catch the falling knife’. In fixed income, credit spreads are a good barometer of uncertainty; when fear is everywhere, credit spreads gap wider and wider. Fear is a feeling that doesn’t heal quickly and, in this manner, neither do credit spreads. There is no need to hurry back in, there will be plenty of time and opportunity as the fear recedes. 

Finally, expect the unexpected

If there was one thing that surprised us more than anything else, it was the reaction and behaviour of the crowd. Crises are stressful times and fear, panic and contagion rear their heads in all directions. Investors will behave irrationally. There will be indiscriminate selling and demands for redemptions, and it does not matter how good your performance is or how much you communicate with your clients. They will want to sell, and unfortunately it will be at the worst possible time. 

Always remember your clients have clients too and the pull of the crowd behaviour is overpowering. Expect the unexpected and then multiply it several times over. Be prepared for anything and everything, and be sure to have ample liquidity on hand.

Learn more about Macquarie Investment Management’s fixed income capabilities.