Priceless – Ten Years On, What Did We Learn From The Crisis

Ros Price, Investment Committee Member.

To those of us who were working in financial markets then, it seems as if it were only yesterday that the financial crisis started to emerge in the summer of 2007 with the implosion of a couple of hedge funds which specialised in so-called sub-prime debt . Where did the ten years go since it all began? Perhaps more importantly, have we forgotten the lessons it gave? Only in the few last weeks have our newspapers here in the UK been busy regaling the recent history of a court case for compensation relating to shareholders in the rescued Royal Bank of Scotland seeking redress for their losses in the debacle of its near collapse. The other ‘rescued institution’ has seen the UK government finally sell its residual shareholding. And yet to those of us in the thick of investment markets at the time it seems just like yesterday and not a whole decade since the horror story started unfolding. Indeed the real scars of the only narrowly averted financial Armageddon, in the form of exceptionally low interest rates, look to be with us for a considerable time to come as academics squabble about the impact of quantitative easing and financial repression that main central banks have imposed on us to try and solve the crisis. As yet we have to see if central banks can unwind all their special measures without impacting the real economy harshly and of course these same measures have impacted savers and borrowers badly. Savers, many of whom live on income generated by past savings, have seen their yields crater, whilst borrowers – house buyers especially have seen the cost of borrowing fall dramatically. To undo this financial repression will be no mean feat.

Source: Bloomberg

It all seemed so simple and such a good idea, a great wheeze even, at the time before the reckoning – banks and lending institutions adjusting the borrowing system so permitting many more people in the US with little or no savings and small earnings capacity to buy their own place to live despite their poor credit scores. The easy way to dispose of that credit risk this entailed for the lender was supposedly to disperse it via securitisation and sale to other institutions – which took us into the subprime debt overload at banks and via the securitisation to many other financial institutions as well. It all seemed so easy and so right at the time as debt in these securitised markets ballooned. In financial circles it was thought this economic system would go on into the future with the risks taken on by lenders neatly laid off elsewhere in the system – some sort of financial Nirvana. At the same time the success of the long running battle to bring down inflation meant yields dropped on bonds in particular and investors chased higher yields on their savings without really looking carefully  at the investment risks involved. Complacency on investment risk was widespread, after all securitisation by spreading risk pretty much removed it, didn’t it? At least the then Governor of the Bank of England did attempt to warn us saying we had had seven fat economic years so we should expect seven somewhat leaner years to come just before the system started to unwind. He did not specify what ‘leaner’ meant and markets took little notice of the warning.

Ordinary people could borrow huge sums relative to their financial means for property purchases – amounts which would have horrified their grandparents – and the credit card companies allowed credit limits to grow for other purchase too. Here in the UK, investment professionals used to discuss programmes on TV like the ‘Bank of Mum and Dad’, looking at the huge amounts of debt people ran up, as if it were some kind of amusing sport – until it all came tumbling down culminating with the near death of the Royal Bank of Scotland one gloomy Friday in October 2008. Here in the UK, the British government was forced to prop up this ailing institution by buying in its equity to public ownership and thereby in one fell swoop increasing its own borrowing to dramatic levels, tarnishing the Labour government’s record. The credit crunch had arrived with a vengeance and the western developed economies were crippled for some time to come. Central banks came to the rescue with their quantitative easing – pouring trillions of cash into their respective economies which has gradually dragged economies back from the brink. Governments, particularly the US administration, took steps to quickly impose tighter regulation on financial institutions aimed at dialling down the levels of risk they were permitted to take in the course of their operations.

The US recovered more quickly despite the fact that the crisis seemed to be caused by their sub-prime lending practices but some would argue that here in the UK and especially in the Eurozone, full healing has yet to be accomplished although the draconian measures taken at the time by the US authorities have led to a better result there to date. Even there in the US, the average growth rate seems more pedestrian than in the past. So deep was the crisis in the banking industry that the impact on the global economy almost led to a deflationary debt crisis, with negative interest rates in some European countries as central banks struggled to stimulate growth and activity. The impact has been felt by many workers via stagnant wages and lost jobs although unemployment is improving at last even in continental Europe and both the US and UK have what statisticians refer to as ‘full employment’. Governments watch anxiously at each and every development in the global economy in case the lack of economic improvement due to the lingering effects of the crisis is laid at their door, fearing the impact this may have on their electoral ambitions.

So here we are, ten years on and what has changed? In some major economies, sadly when it comes to indebtedness despite the efforts or regulators to improve and protect the economy from excessive borrowing, not much when you peer into the economic entrails. Of course as the market saying goes, history does not repeat itself but it can certainly rhyme with the past. In the US whilst there have been concerns for a notable time about the delinquencies in student loans, lenders are becoming more concerned about auto loans. There has been something like 70% growth in outstanding auto loans in the US since 2010 meaning that at the end of Q1 the outstanding debt stood at USD1.17 trillion. Under the new rules brought in after the sub-prime mortgage crisis, lenders were specifically required to steps to make sure whether home buyers could handle their payment schedules. If those steps were not taken then the buyers had legal redress open to them.  When it comes to car loans, there is no similar protection available to borrowers. Needless to say, lenders have manipulated the terms of loans more and more – extending the length of loans from the usual term of 60 months to as long as 84 months for example and emulating the practices pre- credit crunch of home lenders to raise loan to value terms and debt to income ratios. So many people will have expensive debt to repay where the amount outstanding will be far more than the value of the car bought. As an FT article says – echoes of the sub-prime mortgage crisis all over again. Add to that the fact some of this lending is undertaken by institutions specialising in ‘sub-prime’ lending that other institutions have packaged together and sliced into saleable securities. Using all these tactics, it would seem that since 2010 the share of auto loans labelled as deep sub-prime has risen from just over 5% of the total outstanding to32.5% at the end of 2016. Do we never learn? At least the Office of the Controller of Currency has issued a warning about the increasing credit risk in car loans and as losses on some of these loans are already affected by the fall in used car prices  some banks and lending institutions are retreating from that particular market. On the positive side, the scale of the problem is not as large as the mortgage lending crisis, but it is big enough to impact the banks as any higher default levels on these loans leading to high levels of repossessions would hit used car values in turn hitting amounts lenders can reclaim and would certainly hurt lenders’ balance sheets. No need to panic yet perhaps but definitely cause for concern if growth continues in like manner but it may be good news that some new recent data out of the US does indeed show a falloff in lending in several categories including auto loans. Not actual outright declines in lending, but a gentle deceleration in the growth rates particularly since the start of this year. So just maybe the pain of the crisis ten years on is finally being remembered in the US. Let us hope this is the case.

Source: Bloomberg

No need for smugness on this side of the Atlantic either.  After a short period of a couple of years or so where unsecured debt and indeed total debt levels reined in here in the UK as the pain of the immediate crisis bit into economic activity and consumers stopped shopping and actually saved, following the massive cash injections from the Bank of England’s gilt edged buying spree that was quantitative easing the economic conditions stabilised. Interest rates fell and so did mortgage rates. People felt comfortable in this new regime and gradually rediscovered their love of shopping malls. Growth did indeed recover but the shopping addiction carried on too and in the last few years unsecured borrowings have taken off again just as the savings rates has plummeted. Now unsecured borrowing levels are at new record highs just as inflation levels begin to creep up in the prices of ordinary everyday items.  All seems well as this occurs because unemployment is at such low levels although wages are stagnating. Some bankers are starting to be concerned about this state of affairs and rightly so. Were the economy to slow for any reason defaults would no doubt rise harming banks once again and curtailing their ability to lend to industry and start-ups once again. It is notable too, that when there are pauses in the ascent of the levels of unsecured lending, then growth here disappoints. Once the borrowing takes off again, then GDP growth picks up once more.

Whilst no-one is expecting another crisis like 2007-2008, it is fair to say the current substandard economic recovery is nowhere near as strong as might have been expected although the upturn is running for longer than many thought it may. Of course after a financial bust such as we had then recoveries are thought to be weaker and longer but that is of no comfort to those whose savings yield little. Our economy seems to some extent to be a prisoner of our shopping and borrowing whims these days and none of this takes into account the current levels of government indebtedness or just how central banks are going to unwind the special measures taken over the last decade to rescue the economy. There are market fears that these moves will raise interest rates to levels where private borrowers will be hurt in regimes where borrowing is not fixed at the point of taking out the loans. But that is a story for another time.

Central banks have managed to stabilise the private sector indebtedness through the quantitative easing and have taken the debt onto their balance sheets. This will continue to weigh on future generations. Is it any wonder that both debt and loan, like risk, are four letter words?