Some takeaways from the Global Financial Crisis of 2007

IT SEEMS momentous things happen in years ending in seven - well, at least in the last 50 years starting with the "Summer of Love" in 1967 and the introduction of the Chevrolet Camaro.

But after that, it was downhill with Elvis leaving the building in 1977, the 1987 share market crash, the Asian crisis of 1997 and the global financial crisis (GFC) that started in 2007. Lehman Brothers didn't go bankrupt until September 2008, but the GFC's initial tremors occurred in 2007. Financial markets really started to take notice in August of that year, with shares taking a big hit before rebounding to new highs for US and Australian shares in late 2007, ahead of a roughly 55 per cent decline into March 2009. This note looks at the main lessons for investors from the GFC and whether it can happen again.

What drove the GFC

But first, some history. The GFC was the worst global financial crisis since the Great Depression. Lending between banks froze, multiple financial institutions needed rescuing, share markets fell by more than 50 per cent, and it was the worst post-war global economic contraction.

At the core of the GFC was something very basic. In an environment of low interest rates (with often initially low "teaser" rates), too many loans were made to US homebuyers that set off a housing boom that went bust when interest rates rose and supply surged.

So, no big deal, it happens all the time. However, it was what went on around it that turned it into a global crisis.

The music stopped in 2006, when poor affordability, an oversupply of homes and 17 interest rates hikes from the Fed over two years led US house prices to peak and then start to slide. This made it harder for sub-prime borrowers to refinance their loans at their initial "teaser" rates. As a result, more and more borrowers defaulted causing investors in the fancy products that invested in sub-prime loans (like CDOs) to start suffering losses.

The problem really caught the attention of global investors in August 2007 after BNP froze redemptions from three of its funds because it couldn't value the CDOs within them, which in turn set in train a credit crunch with sharp rises in the cost of funding for banks and a reduction in its availability, triggering sharp falls in share markets. Shares rebounded, only to peak in late Octobe/November 2007 before commencing roughly 55 per cent falls as the credit crunch worsened. The global economy fell into recession, mortgage defaults escalated and multiple banks failed.

The crisis went global as losses mounted; these were magnified by gearing, which forced investment banks and hedge funds to liquidate sound positions to meet redemptions, thereby spreading the contagion to other assets. The distribution of securities investing in US sub-prime debt globally led to a wide range of exposed investors and hence, greater worries about who was at risk; this all led to a freezing up of lending between banks. All of which affected confidence and economic activity.

The fault lay with home-borrowers, the US government, lenders, ratings agencies, regulators and investors and financial organisations for taking on too much risk.

It came to an end in 2009, after significant monetary easing and fiscal stimulus helped restore the normal operation of money markets, confidence and growth. That said, aftershocks continued with sub-par global growth and very low inflation.

Lessons from the GFC and its aftermath

Will it happen again?

Of course there will be another boom and bust. History is replete with bubbles and crashes and tells us it's inevitable that they will happen again as each generation forgets and must relearn the lessons of the past. Fortunately, in the post-GFC environment seen so far, there has been an absence of broad-based bubbles on the scale of the tech boom or US housing/credit boom. E-commerce stocks like Facebook and Amazon are candidates, but they have not achieved the gains or infinite PEs seen in the late 1990s tech boom.

On the global debt front, a concern is that after a post-GFC pull back, it has grown to an all-time high relative to global GDP. However, just because global debt has grown to a new high doesn't mean a crisis is upon us. It has been trending up for decades, much of the growth in debt in developed countries after the GFC has been in public debt, and debt interest burdens are low, thanks to low interest rates in contrast to the pre-GFC period.

Furthermore, the other signs of excess that normally set the scene for recessions and associated deep bear markets in shares like that seen in the GFC are not present on a widespread basis just now. Inflation is low, monetary policy globally has barely tightened, there has been no widespread over-investment in technology or housing, and bank lending standards have not been relaxed to the same degree as seen prior to the GFC. Financial regulations have also been tightened significantly.