Here’s some good news for anyone worried about troubled markets. The last time the world financial system went haywire, it wasn’t so bad.
That wasn’t the 2000 tech bust, which stayed mostly in the equity markets. It was the 1998 cascade of troubles. The Asian financial crisis was followed by the Russian debt default, which was followed by the sudden failure of a big hedge fund, Long Term Capital Management (LTCM). It looked really bad for the financial world.
World equity prices fell by 20%. The investment bank revenues for the five biggest US players tumbled by 40% in two quarters, according to S&P. In the third quarter of 1998, Goldman Sachs managed to report negative revenue in fixed income—$671 million worth.
But then it was over. The LTCM damage was limited and overnight interest rates were cut. Equity markets climbed back to record levels by the end of the year. No big bank actually fell into loss for even a quarter. And the new Asian government strategy of accumulating dollars rather than debts provided durable support to fixed-income markets.
Supposed 2007 is no worse than 1998. Second-half profits would fall by 70% in at the biggest 11 investment banks, according to an S&P simulation. That sounds like a lot, but the base is very high. The pre-tax profit margin would still be 21%, a paradisiacal level for most industries.
Employees might not be too happy with this resilience, since it comes along with a 47% decline in compensation. But, it is comforting to think that a crisis large enough to freeze up global money markets would not bring losses, let alone bankruptcy, to any of the big players.
The simulation, though, may be too optimistic. The world economy has become significantly more leveraged in the subsequent nine years, with a higher proportion of non-government borrowers. Also, most asset prices are higher, even after taking account of economic growth in the interim. So, compared to 1998, there is more debt to lose value and further for prices to fall. It could easily be worse this time.