Financial crisis ten years on: what has been learnt?

Graham Smith, Market Commentator, 09 August 2017

The first manifestation of the global financial crisis struck in August 2007, not in America, but in Germany. While the underlying cause lay stateside, news of surprising losses at the relatively unfamiliar German lender IKB signalled the start of a seismic global upset. 

Imagine the scene. IKB, known as a lender to German businesses, warns in late July that its forecast €280 million profit for the year would be overrun by losses from the US subprime mortgages market.

That may have been shocking enough, but nothing to compare with the response from other German banks. They came together in early August with a rescue package for IKB worth an eye watering €3.5 billion1. Something immense was happening in the financial world and it was transcending country borders.

Once the idea of toxic assets permeating bank balance sheets had taken hold, trust withered and banks became reluctant to deal with one another. So the seeds for the global financial crisis, as it was to become known, had been sown, with dire implications for all of us.

The crisis bubbled into the UK in dramatic fashion a month later as news broke the mortgage lender Northern Rock had sought and received monetary support from the Bank of England. The news sparked a run on the bank the next day, with queues of depositors outside branches featuring in the headline news that night2.  

The crisis came to a head almost exactly a year later, after the US government decided not to rescue the large investment bank Lehman Brothers3. Up until then, it had been assumed that governments would always save troubled financial institutions.

The dire ramifications of the Lehman collapse on world markets and in terms of credit drying up led governments the world over to inject cash into their banks. The banks were saved at great cost but the crisis still permeated into the real economy.

At the heart of the crisis lay complex financial products backed by mortgage debt – so-called mortgage backed securities – which few really understood. Irrespective, they were bought and sold among banks and other financial institutions the world over.

The principal idea behind these products was that you could bundle many different types of subprime mortgage together and, in so doing, engineer a high and steady return with low volatility. Volatility would be low because, as one mortgage defaulted another would perform well, or so the theory went.

The problem was that the complex maths used to design these products was faulty. So when a downturn in the housing market in America came, one subprime mortgage performed much like the next, that is to say, poorly.

Prices for these complex instruments then plummeted, leaving large black holes in bank balance sheets and steep losses for the “low risk” hedge funds and fixed income funds that had bought them.

The reason the world came to know the financial crisis alongside the banks was that the crisis curtailed the ability of banks to lend to businesses and consumers and led to governments using taxpayers’ money to bail out the hardest hit institutions.

Ten years on, the case can be made that not much has been learnt. Mortgage backed securities are back in large quantities. June’s drop on the high-tech Nasdaq Index in the US after a warning on valuations from Goldman Sachs came as a reminder that some investors continue to accept high risk in exchange for the prospect of a high return4.

Next time US house prices start to drop, who’s to say a crisis can’t happen all over again? Well it could, though probably not for quite the same reasons as last time.

The light regulation that prevailed in 2007 has been replaced with a stricter regime, meaning that banks have to hold more capital in reserve to cover off potential losses. Second, professional investors in mortgage backed securities are considerably more familiar with the risks involved and have adapted their strategies accordingly.

The final piece of this jigsaw – the ring-fencing of retail banking from investment banking – has been long talked about but meets stiff resistance. It’s happened to some degree in Europe and the UK, but has yet to become a feature in the US.

One concern is the US Federal Reserve’s planned reversing of its quantitative easing programme, under which the central bank bought bonds to prop up the economy. Getting out of the mortgage backed securities it owns, worth a cool US$1.8 trillion, is likely to have a knock-on effect on the cost of mortgages in the US5.

Few investors did well out of the financial crisis. Even those sticking steadfastly to golden rules such as maintaining a diversified portfolio, investing for the long term and keeping some cash in reserve for market dips will have seen paper losses in the ensuing years directly after 2007.

However golden rules outlive financial crises. Regular savers, though it would have taken time, would have benefited ultimately from buying cheap fund units or shares in the depths of the downturn in world markets. Investing the same amount each month means buying the most when others are most fearful.

With world stock markets now well above their peaks in 2007, long-term, diversified investors will also have ridden out an albeit painful storm6. Investors in single shares, banks particularly, may not have been so fortunate and may still be nursing losses, on paper or otherwise.

Though we, and the regulators, may be wiser today than ten years ago one thing remains very hard to guard against, and that’s a temporary loss of confidence, for whatever reason, in paper assets. In 2007 – 2009, contagion was a preoccupation, meaning that even relatively unaffected assets from a fundamental standpoint saw their prices fall.

Gold was the standout exception demonstrating, once more, its credentials as a defensive asset in a crisis. Investors with already diversified portfolios of equities and bonds can always consider adding an exposure to gold as an additional diversifier and a way of reducing the impact of an unforeseen crisis on their wealth. Fidelity’s Select 50 list of favourite funds contains the respected Investec Global Gold Fund, with its diversified portfolio of world gold producers.

Another strategy is to invest in an absolute return fund. These funds typically aim to achieve modest or moderate positive returns over a one to three year period, irrespective of market conditions. While they may not always achieve this, their strategies tend to be relatively cautious and constantly attuned to ways of limiting losses in negative markets. The Select 50 list contains two such funds, the Aviva Investors Multi-Strategy Target Return Fund and the Invesco Perpetual Global Targeted Returns Fund


1 FT, 02.08.07

2 BBC News, 15.09.07

3 BBC News, 16.09.08

4 Nasdaq, 30.06.17

5 Federal Reserve Bank of St. Louis, 02.08.17

6 MSCI, 31.07.17

Important Information
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