More than five years have now passed since the housing bubble burst in spectacular fashion and fanned the flames of a financial crisis that rivaled only the Great Depression of the 1930s. This latest downturn has since become known as the Great Recession and it is now widely agreed that the United States officially went into recession in December 2007. The following year, some of the largest financial institutions, including a handful of the largest banks in the country, either failed or were forced into the hands of rivals at fire sale prices. The Great Recession officially ended in June 2009, but the economy has yet to fully recover. In fact, many market pundits are concerned that the economy will double-dip back into recession.
Now that nearly a decade has passed since the housing market peaked, what lessons can investors and banks learn from the banking crisis brought on by the Great Recession? Financial regulation has increased significantly since the crisis but has arguably not dealt with core issues. It's hard to see that regulation will ever completely eliminate the odds of a future crisis. However, there are important lessons to be learned, such as how to successfully avoid a double-dip recession. The Federal Reserve appears to have learned a number of lessons from the Great Depression, but investors still have not yet figured out to avoid financial bubbles.
The Crisis Redux
The events leading up to the Credit Crisis and Great Recession have been covered in great detail from a number of leading authors and financial market authorities. These include the Big Short by Michael Lewis, Too Big to Fail by Andrew Ross Sorkin, On the Brink by Henry Paulson and After the Music Stopped by Alan Binder. More recently, a series of four lectures that Ben Bernanke gave at George Washington University, in March 2012, were published in a book entitled the Federal Reserve and the Financial Crisis. All provide a detailed recap of the crisis and each is worthy of a read for those interested in the actual events that transpired.
Bernanke's second lecture dives into the details and opines that the period between 1982 and up to 2000, which is known as the Great Moderation, lulled the economy into a complacent state that was due for some shocks. The bursting of the dot-com bubble removed a number of excesses that had built up in the stock market, and the bursting of the housing crisis deflated an extended period of above-average residential home price appreciation.
House prices jumped 130% between the late 1990s and into 2006, but the market was increasingly being driven by a decrease in lending standards. In many markets, down payment requirements were lowered from 20 to 10% of a home's value or even became nonexistent. Documentation on income and the ability to afford mortgage payments became lax and, in certain instances, "liar loans" came into vogue where loan application details were not verified. Teaser rates with extremely low initial interest rates (such as 1%) and negative amortization loans, where mortgage loan balances were allowed to increase for a short initial period, also became popular. Bernanke estimated that in 2007, 60% of nonprime loans possessed very little documentation.
According to Roddy Boyd, author of Fatal Risk: A Cautionary Tale of AIG's Corporate Suicide, the absolute high point of the housing market frenzy in the United States occurred toward the end of the first quarter of 2005. From a low point in 1990 of around 1 million, annual housing starts embarked on a bull run that lasted approximately 15 years. But, for reasons that will endlessly be debated, they peaked in early 2005 at around 1.75 million and plummeted to depths well below any period in the last three decades. After bottoming out at around 250,000 annual housing starts around 2008, they hovered around 500,000 for several years following the crisis.
As debt levels increased and loan requirements reached the lowest common denominator, the increase in housing prices suddenly reversed course. This lesson has played out time and time again during past financial crises. In the classic text The Great Crash 1929, first written in 1954, famed economist John Kenneth Galbraith stated: "A bubble comes from rising prices, whether of stocks, real estate, works of art or anything else. A price increase attracts attention and buyers, which results in even higher prices. Thus, expectations are justified by the very action that sends prices up. The process continues and optimism about the market effect is the order of the day. Prices climb even higher. Then, for reasons that endlessly will be debated, the bubble bursts."
Galbraith's quote refers to the market crash of 1929 that led to the Great Depression but could have easily been written for the dot-com, housing bubbles, and any financial bubble that has ever burst or will deflate in the future. A key error in most financial models supporting mortgages, and the exotic securities based off of them, was the assumption that housing prices do not go down. Unfortunately, bubbles burst without notice and to this day there has not been a systematic way to avoid them.
It is also very surprising how few people and entities predicted the timing of the bursting of the housing bubble or the severe adverse impact it would have on the U.S. and global economies. A paper entitled Wall Street and the Housing Bubble, by Ing-Haw Cheng, Sahil Raina and Wei Xiong, looked into agents that helped securitize mortgages leading up to the housing crisis and detailed "little awareness of securitization agents' awareness of a housing bubble and impending crash in their own home markets." Like many home speculators, they continued to sell existing homes for new homes with ever larger mortgages and loan balances.
Bernanke's views are that the Federal Reserve learned enough from the Great Depression to stem the Great Recession from turning into an extended depression. In his lectures he detailed charts showing that the stock market and unemployment trends were on the same course as in the 1930s, until the Fed intervened to stop runs on banks, money market funds and key related financial institutions, such as broker dealers and insurance giant AIG.
It is also important to note that the Federal Reserve is being cautious to not raise rates too quickly and contribute to a double-dip recession. A student in Bernanke's first lecture at George Washington astutely pointed out that the Great Depression was actually made up of two recessions: the "sharp recession between 1929 and 1933 and another in 1937." He suggested that the Fed raised rates prematurely and the government was too quick to reduce its budget deficit and tighten its fiscal policy. This could very well end up being a precursor to the current situation as politicians fight to reduce deficits, boost taxes and pursue policies that could very well hamper a full economic recovery.
Takeaways for Banks
Financial institutions are now subject to Dodd-Frank legislation that seeks to boost capital requirements and help avoid the failing of banks that are considered vital to the health of the overall economy. Bernanke did admit that regulation during the Credit Crisis was disjoined and failed to take a holistic approach to ensuring the health of the overall financial system. Going forward, money center banks, as well as large broker dealers and insurance firms, will have higher capital standards to offset against loans going bad and balance sheet assets falling in value.
Banks have also increased lending standards while most subprime loan originators have gone bankrupt. Arguably, lending standards have become too stringent in many instances, but this is hardly surprising given the severity of the number of loans that went bad in markets such as Florida, Arizona and Nevada.
The Bottom Line
The Federal Reserve has two primary mandates: to keep inflation in check and maximize employment. It plans to keep interest rates low until unemployment falls closer to 6%. It does appear the Federal Reserve has learned from history and helped keep the Great Recession from mirroring the 25% unemployment levels that occurred during the Great Depression. Unemployment peaked at around 10% back in 2009 and has somewhat steadily decreased. As for politicians and others that will help create future bubbles, it appears they have not yet learned their lessons on how to recover from or avoid bubbles in the first place. The best advice might be to simply avoid investments that have had huge runs and increased in value in a short period of time. Or at least, investors can sell as an investment increases in value over time and use the proceeds to buy other stocks and assets that look more reasonably valued.
Originally posted on Investopedia.com INVESTOPEDIA ULC ©2013