This chapter will provide an overview of historical financial crises and then explore the similarities between those crises and the 2008 credit crisis. An understanding of the common causes of financial crises will assist investors in navigating any future crises they may encounter.
What Is a Financial Crisis? A financial crisis is often preceded by a bubble. A bubble occurs when many investors are attracted to a market sector, usually due to attractive fundamentals. Speculators then rush to this newest hot market, searching for quick profits and driving prices even higher. At some point, the amount of money flowing to the market increases to the point that valuations are no longer supported by attractive fundamentals, signaling the end of a bull market and the beginning of a bubble. Although many market participants may realize that valuations are stretched, greed drives them to bid prices ever higher. (For more on types of markets, see Digging Deeper Into Bull And Bear Markets.)
When enough market participants eventually realize that valuations are not supported by the fundamentals, the market begins to decline. As prices fall, more and more investors rush to sell. This wave of selling quickly escalates, driving prices even lower. As this downward spiral continues, fear replaces greed, and market participants stop making rational decisions and instead rush to sell their holdings at whatever price they can get. Profits made over the course of many years can turn into losses in a frighteningly short time. A sufficiently bad downward spiral is commonly referred to as a crisis. (To learn more, read Panic Selling - Capitulation Or Crash?)
Famous Financial Crises One of the most famous examples of an early market crisis is the Dutch tulip craze of the 1630s. Tulips were widely sought after for their beauty and the scarcity of certain unique color patterns. As more and more speculators began crowding into the market, prices soared. Eventually, some rare tulip bulbs were worth as much as a fine estate. As some market participants began to take profits, prices fell. Anxious to lock in profits, more and more tulip owners rushed to sell, leading to a downward spiral in prices. Tulip prices soon returned to the tulips' intrinsic value, but the bubble and ensuing crash had resulted in catastrophic losses for many people and caused an economic depression.
The most well-known market crash in the U.S. is the stock market crash of 1929. Stock speculation had become a national obsession during the Roaring Twenties, and newcomers to the market borrowed heavily to bid up prices. When the economy began to slow in 1929, prices started to decline, and panic set in as the market crashed in October, culminating in Black Tuesday on October 29, 1929. Many investors were wiped out almost overnight, and news reports told of bankrupt stockbrokers leaping from the roofs of buildings. Ultimately, the market would fall 89% from its highs and would not fully recover for more than 20 years. (For more, see The Crash Of 1929 - Could It Happen Again?)
Following industry deregulation in the 1980s, savings and loans (S&Ls) began paying higher interest rates on short-term deposits and investing in riskier assets. This combination eventually led to very large losses across the industry. As this important corner of the financial system approached insolvency, the federal government formed the Resolution Trust Corporation (RTC) to rescue the industry in 1989. While the government's actions prevented a financial collapse, more than 500 S&Ls ultimately failed, and the country suffered a relatively severe recession from 1990-91. The RTC has been cited as a template for the Troubled Asset Relief Program (TARP) that the government created in 2008 to assist financial firms during the credit crisis. (To learn more, read Liquidity And Toxicity: Will TARP Fix The Financial System?)
The U.S. suffered its worst ever one-day stock market decline on Black Monday, October 19, 1987. The cause of the 22.6% decline is still debated, but excessive valuations and overconfidence among market participants played a role. Although the one-day decline was extremely severe, aggressive actions by the Federal Reserve helped assure the solvency of the financial system. The U.S. economy avoided a recession, and ultimately the crash proved to be a momentary pause in a long-term bull market. (For further reading, see What Is Black Monday?)
Prior to the current credit crisis, the Asian Contagion of 1997-98 was generally considered the worst financial crisis since the Great Depression. When Thailand devalued its currency in July 1997, panic swept across Asia. The crisis soon spread, eventually reaching Russia in the summer of 1998. Investors indiscriminately sold risky securities and rushed to the safety of U.S. Treasury bonds. This "flight to safety" caused massive losses for the hedge fund Long-Term Capital Management (LTCM). Gravely concerned about the effects of an LTCM collapse, the Federal Reserve gathered the heads of the largest Wall Street banks and instructed them to find a solution. The bank leaders ultimately orchestrated a plan for the orderly unwinding of LTCM's positions, negating the possibility of a financial system collapse.
In the U.S., the 1990s witnessed a remarkable bull market in stocks. Fueled by the internet explosion, investors rushed to purchase the shares of nearly any company involved in technology. While the internet represented a once-in-a-generation technological breakthrough, valuations in technology stocks came to far exceed those justified by the fundamentals. Market participants eventually realized that future profits might never justify the current lofty valuations, and prices began to fall. The Nasdaq composite ultimately lost more than 75% of its value, and the economy sank into a recession. (For further reading on past crashes, check out The Greatest Market Crashes.)
Commonalities Between the 2008 Credit Crisis and Previous Crises In addition to the emotions of greed and fear, a review of the historical record shows that several factors have been present at the onset of many financial crises. These factors include an asset/liability mismatch and excessive leverage and risk. Frequently more than one factor is present, and each factor can multiply the damage caused by one of the others.
Asset/Liability Mismatch - When a financial institution has a wide differential between the duration of its assets (loans or investments) and its liabilities (depositors or creditors), it is experiencing an asset/liability mismatch. Asset/liability mismatches are the main reason why the business model of the standalone investment bank came into question during the 2008 credit crisis. Investment banks are extremely dependent on short-term financing to conduct their operations. However, the assets (investments) of the firms are longer term in nature, particularly during periods of market illiquidity when selling is difficult. Asset/liability mismatches are part of the reason why Bear Stearns and Lehman Brothers collapsed and Goldman Sachs and Morgan Stanley chose to become bank holding companies.
While commercial banks also have asset/liability mismatches, their customer deposits are seen as a relatively stable source of funding and have become the preferred method of financial company financing.
Excessive Leverage - Under normal circumstances, asset/liability mismatches are manageable. However, the mismatch becomes a problem when financial institutions employ excessive leverage. While commercial banks have traditionally employed leverage of 10-12 times their capital, investment banks such as Bear Stearns and Lehman Brothers saw their leverage ratios increase dramatically in the years leading up to the onset of the credit crisis. Leverage ratios in excess of 30-times capital were not unusual for investment banks. As so often happens, this leverage proved fatal when markets began to experience much higher volatility levels.
Excessive Risk - Financial crises often occur when excessive risk-taking is present in the financial sector. This may occur intentionally, such as when S&Ls invested in risky real estate deals in the 1980s, or unintentionally, such as when investment banks purchased 'AAA'-rated mortgage-backed securities prior to the 2008 credit crisis. Excessive risk, whether intentional or due to miscalculations in valuation models, has been a part of nearly every financial crisis in history and is likely to be an important factor during future crises as well. (For further reading, see Risk Tolerance Only Tells Half The Story.)
Conclusion Several factors explain why the current credit crisis has been so severe. First of all, a wide variety of asset classes enjoyed an unusually long period of prosperity leading up to the crisis. This resulted in a sense of complacency among many market participants. Second, this crisis has involved many financial instruments that are relatively new and/or difficult to value. Previously esoteric securities such as collateralized debt obligations (CDO), structured investment vehicles (SIV) and credit default swaps (CDS) were at the center of the 2008 crisis. Confusion over the true value of these securities led to uncertainty among market participants about the size of financial companies' losses. Finally, the globalization of financial markets caused the credit crisis to spill beyond its origins in the U.S.subprime market to encompass nearly every asset class in nearly every country of the world. The combination of these three factors resulted in the most severe credit crisis since World War II.
Credit Crisis: Foundations