Lehman’s Lesson Lost6 min read . Updated: 26 Sep 2013, 01:14 AM IST
Shashank Khare on the forgotten lessons from the Lehman debacle
Shashank Khare on the forgotten lessons from the Lehman debacle
The financial markets have bounced back in the first half of September to observe the five-year anniversary of the demise of Lehman Brothers. The liquidity unleashed by central banks in the aftermath of 15 September 2008 has at least lifted the spirits of financial market participants, if not the general economy. Unfortunately, it has blurred the memory of the underlying causes of the event that marked one of the greatest financial catastrophes in recent history.
Lehman Brothers was a culmination of two decades of ‘‘no-consequences" financial speculation encouraged by the Greenspanian Fed and policymakers. This involved two major changes that eviscerated the capitalist system while maintaining its façade. The first was changing the focus of policy to benefit the financial markets over the real economy. Starting with a rate cut in October 1987 in response to the stock market crash, which suddenly reversed policy, then US Federal Reserve chairman Alan Greenspan went on to achieve a maestro status as the saviour of financial markets through the Greenspan Put. Subsequently, we have been indoctrinated to believe that a rising stock market is a great thing, while a falling one is disastrous. You only have to hear and read the shrill cries of punditry-beseeching policymakers to arrest market declines to realize the ubiquity of the belief. Its ridiculousness can be gauged from the fact that only a minority is affected by the swings in the stock market. In the US, the top quintile own 80% of all equity and mutual funds. In India, estimates of the proportion of people investing in the equity markets vary from 1% to 3% (one datapoint in the middle of the range). At this point, the economists among you will start jumping up and down citing the wealth effect. If such sophistry had been known in the 18th century, then the French Revolution might have been avoided simply by making Louis XVI and the French aristocrats richer.
The second shift that gutted capitalism was policies designed to prevent failure in the financial system and thus socialize losses in the name of ensuring the survival of the system. In India, this absence of failure is not new given that even serial loss-making airlines plod on zombie-like ostensibly to benefit the aam aadmi. However, in the US and other truly capitalist economies, every bailout strengthened belief in the infallibility of the reckless. Therefore, Dick Fuld’s (CEO of Lehman Brothers when it filed for bankruptcy) chagrin at not being bailed out was quite justified. This shift has led to the formalization of ‘‘too big to fail", with banks designated as systemically important and benefiting from taxpayers’ backstop.
The result has been that the imbalances within the global financial system keep growing even as policymakers blow up one more bubble to counter the bursting of the last one. The current financial markets have been supported by the ultra-loose and highly experimental policy of western central banks. Paradoxically, while they’ve enriched your portfolio, they also pose the greatest threat to it. The recent ‘‘taper" fear that is partly responsible for the carnage in India and other emerging markets is proof.
Global financial markets now, as in the heady days before Lehman hit a brick wall, are characterized by artificially low interest rates. This has three pernicious effects. First, by depressing yields for savers and investors, it forces them to buy riskier assets in an attempt to keep their income from falling or to match their liabilities. Second, it allows speculators to buy on the margin since the cost of debt is cheap. The third being the natural outcome of the first two is rising asset prices and falling yields, which not only give a false sense of security, but also strengthen this cycle of risk-taking and speculation. Whether due to intellectual hubris or a bleeding heart on part of central bankers, low interest rates combined with a belief in state bailouts have again led to risk taking verging on the reckless. Lulled by promises to keep rates low for ‘‘as long as necessary", investors have piled into risky assets across the globe, from London property to Indian equities. Therefore, even the mere hint of a “taper" has investors reacting in the manner of a drug addict being told he won’t get his next fix.
The worrying aspect of this massive dose of monetary stimulus is that it seems to be failing in achieving its end objective. The underlying global economy is only improving at a glacial pace. Even as China and other emerging markets slow down, the developed world is nowhere close to picking up the baton. The US may be recovering slowly, but Europe has papered over its crisis believing that propaganda and time will heal all ills. This means that rising asset prices are even more disconnected with fundamentals. Moreover, at zero interest rates, the Fed and major developed market central banks are out of spirits to add to the punchbowl.
So the question is how should you, as an investor, position yourself as the unbalanced system starts another attempt to balance itself (the credit crisis being the first attempt)? Broadly, there are two scenarios through which rebalancing can take place.
One way is for the Fed to start tapering in the mistaken belief that the markets and economy have recovered. The US, through its position as the source of the international reserve currency and a safe haven for capital, effectively determines the interest rate floor (risk-free rate in technical parlance) for the world. Investors who piled into emerging market bonds at 6% (for example, Mexico’s 100-year bond sold at 6.1% in 2011) are going to look pretty silly if 10-year treasury yields go to 5%, the prevailing pre-Lehman level. Similarly, all asset classes are likely to re-price. In fact, as the sell-off in emerging markets demonstrates, they are already in the process of doing so.
Another way out of the current situation is for central banks to throw the dice and keep their current policy of transferring wealth from creditors to debtors. The hope being growth will cause rebalancing over time. However, this approach only works when growth is faster than the rate at which speculative positions are created. Unfortunately, this is not true currently where asset markets have outpaced both gross domestic product and employment growth.
Although the taper might not be initiated now given the relatively weak employment data from the US, the current situation is untenable unless you believe a zero interest rate world with quantitative easing to be the norm. This means that developed market bonds are the worst assets to have in your portfolio. Debt-heavy emerging markets or those that experienced significant hot-money flows post-Lehman are not great choices either. Real estate is a safe option if you can find good deals in reasonably priced markets (i.e. not London). Equities are also a good option provided you approach them as a value investor rather than chase the latest hot stock (although steer clear of financials since that is just taking indirect ownership in a massive bond portfolio). However, with the markets still bubbling, it’ll pay to set some capital aside and wait. As Baron Rothschild said, the time to buy is when blood is in the streets. Once again central bankers have ensured that the unhappy circumstance will soon be upon us.
Shashank Khare is an investment professional and writer. After studying engineering at IIT-D and business administration at IIM-A, he entered the world of credit derivatives before CDS became a four-letter word. Having successfully batted through the crises, he now indulges his passion for economics, finance and policy through writing and trading.