In the waning days of 2018, as the market teeters between a sizeable correction and continuation of a long-running bull market, the second chapter of Jeremy Siegel’s book, “Stocks for the Long Run,” is particularly timely.
What caused the 2008 financial crisis?
Siegel listed six factors that led the nation, and much of the world, into what he called “the world’s deepest economic contraction and the deepest decline in equity prices since the Great Depression”:
- The Great Moderation, which is the name for the long periods of economic stability that led up the Great Recession (the post-crash period). Because of reasonably low volatility, during Alan Greenspan’s tenure as head of the Federal Reserve (1986-2006), investors came to expect the central bank would head off any severe economic shock. It also led to lower risk premiums and increasing leverage. In addition, the Great Moderation is thought to have drawn in many speculators, as well as “swindlers who engage in Ponzi schemes.”
- Subprime mortgages. They got much attention after the crash, with Siegel among those pointing a finger: “the primary cause of the 2008 financial crisis was the rapid growth of subprime mortgages and other real estate securities that found their way into the balance sheets of very large and highly leveraged financial institutions.” Again, investors were too complacent, believing the Fed’s “safety net” would take care of them. Institutional investors also held that belief and, because of their size, magnified the problem.
- Bad ratings also made a significant contribution to the problem. In the 10 years between 1997 and 2006, housing prices had risen more quickly and for longer than in the past. An assumption this trend would continue was part of the mix. There were also assumptions built on the idea that local real estate risk could be reduced if mortgages from many localities were combined. According to Siegel, the major ratings agencies, including Standard & Poor’s, Moody’s and others, analyzed subprime mortgages based on these assumptions, and using standard statistical tests.
- A real estate bubble was well underway thanks to low interest rates and even secondary factors such as a boom in second homes. Of course, there were also new mortgage instruments, including subprime and “full-funding” mortgages (the latter made it possible for home buyers to get into a home with no money down—a moral hazard). The National Association of Realtors announced in January 2006 that 43% of first-time buyers used no-money-down loans, and that the median down payment on $150,000 homes was just 2%
- Regulatory failure also contributed to the 2008 crash. Many agencies, including the Federal Reserve, raised no red flags, despite the housing inflation data. Siegel wrote that Greenspan should have done more, but at the same time did not hold him responsible for the bubble.
- Overleverage by financial institutions, in risky assets, was also a problem. Siegel wrote, “at the peak of the real estate market, Wall Street was up to its ears in housing-related debt. As noted earlier, in a declining interest rate environment, investors were hungry for yield, and these mortgage-based securities carried interest rates that were higher than comparably rated corporate and government debt. This tempted investment banks, such as Bear Stearns, to sell these bonds to investors with the promise of higher yield with comparable safety.”
To the rescue
While Siegel lays some responsibility for the crash on the Federal Reserve, he also gives it the central role in mitigating the crisis. In situations such as that of 2008, credit is sharply curtailed, which can make a bad problem worse. Fortunately, Fed Chairman Ben Bernanke had been quite aware of his organization’s failure to support the banking system in 1929 and subsequent years.
Central banks are also considered “lenders of last resort,” so after the bankruptcy of Lehman Brothers, the Fed under Bernanke provided the liquidity needed to keep the system afloat. It was involved in several initiatives:
- On Sept. 19, 2008, it announced it would insure investors’ full holdings in most money market funds.
- Created a credit facility to provide nonrecourse loans to banks that bought commercial paper from mutual funds.
- Established the Money Market Investor Funding Facility.
- Entered into an agreement with the Federal Deposit Insurance Corp. (FDIC) to backstop the loans of Citigroup (C, Financial). A similar deal followed with Bank of America (BAC, Financial).
- With the FDIC, it created the Temporary Liquidity Guarantee Program.
One thing the Fed did not do was bail out Lehman Brothers. Siegel argued that Lehman was not bailed out for political, rather than economic, reasons. Specifically, the government has received a great deal of criticism for its earlier bailouts of Bear Stearns, Fannie Mae (FNMA, Financial) and Freddie Mac (FMCC, Financial). As a result, Lehman Brothers was given a warning to get its house in order rather than the $40 billion loan it requested.
Yet, the Lehman Brothers failure was mainly of its own making. The company had borrowed heavily to buy subprime mortgages, had lent $17 billion to one firm to buy out another and was left holding $5 billion worth of unsold real estate. Siegel stated that while Lehman’s CEO continued to insist the bank was solvent, traders knew it had little chance of surviving because of the failing real estate market. The company had made a major bet on real estate—and lost.
American International Group (AIG, Financial), the big insurance company, did get a bailout because the Fed and Treasury were very concerned that its failure, in the immediate wake of the Lehman collapse, could have caused a financial panic and might even bring down the global financial system.
Of course, there was also the TARP, or Troubled Asset Relief Program, which will be covered in the next chapter.
What did the crisis mean?
Reflecting on the crisis afterward, Siegel observed there had been no shortage of causes, including the six listed above. However, he argued that management of many of the financial companies should be held most responsible, saying, “They were unable to grasp the threats that would befall their firms once the housing boom ended, and they abdicated responsibility for assessing risks to technicians running faulty statistical programs.”
Siegel also maintained the crisis put an end to the myth that developed while Greenspan ran the Fed, that the central bank could fine-tune the economy and eliminate the business cycle. While the Fed was slow to appreciate a crisis was developing, it did act quickly—and effectively—to prevent the recession from becoming a depression.
Based on what Siegel has written, it’s clear it wasn’t just circumstances behind the crisis of 2008, it was also the result of investors and management falling for some age-old issues. They include stretching too far for yield, not being aware of a bubble that has emerged in the background and management not managing risk properly. We can see the possibility of another such crisis looming; will history repeat itself?
(This article is one in a series of chapter-by-chapter digests. To read more, and digests of other important investing books, go to this page.)
Disclosure: I do not own shares in any company listed, and do not expect to buy any in the next 72 hours.
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