November 21, 2013
Five years after the worst financial crisis since the Great Depression, we asked key T. Rowe Price leaders to reflect on where we've been and where we go from here. Our interviews, conducted through November 11, 2013, include the following investment professionals: Brian Rogers, chairman and chief investment officer of T. Rowe Price and manager of the Equity Income Fund; Chris Alderson, president of T. Rowe Price International; Bill Stromberg, head of global equity; Mike Gitlin, head of the Fixed Income Division; Mark Vaselkiv, manager of the High Yield Fund; Brian Berghuis, manager of the Mid-Cap Growth Fund; Gonzalo Pángaro, head of the firm's emerging market investing team and manager of the Emerging Markets Stock Fund; and Alan Levenson, chief economist.
What we're really talking about is a debt crisis that was all about the use of leverage to amplify returns on equity, on real estate, and on our lifestyles through increased consumption. Leading up to the crisis, there was an explosion in the amount of outstanding debt held by households, business, and government. It wasn't just that the value of real estate assets was turning into a bubble, but it was that people were borrowing against those assets. And when that turned, it was just a vicious cycle because debt is a two-edged sword.
A crisis like that occurs because of accumulated imbalances—too much debt, too easy lending standards, too much leverage in the financial system, too many houses being built—everyone's overextended.
What stood out most was how banks (and nonbank financial institutions) and broker-dealers lost access to the short-term funding markets so quickly. It was probably the worst "run on the banks" that we've seen in many decades. The lack of liquidity was also exceptional. The same banks and broker-dealers that were facing funding problems were the ones that had traditionally provided liquidity in dislocated markets.
I don't think the issue in 2008 and the years leading up to it was "too big to fail," but too illiquid and too leveraged to fail. The basic problem was too much debt against illiquid assets.
I remember, in June 2009, looking at the balance sheet of one of the top five investment banks in the United States, which had about $1 trillion of assets on its balance sheet. That was a leverage ratio of 24 to 1. That's outrageous. That would be like you buying a $1 million house with $40,000 down and borrowing $960,000. Most prudent individuals would never do that.
Yes, or substantially so, in the sense that financial institutions are massively less leveraged than they were in 2008 and better capitalized, having written off a lot of bad assets. We've not fully addressed the too-big-to-fail issues, but the financial system is far less fragile than it was on the eve of the 2008 crisis.
We don't see any of the systemic risks that we saw going back in 2006-2008 with an over-levered banking system, a crazed housing sector, or very aggressive investor behavior.
While the credit markets are not 100% healed—credit spreads are still higher than pre-crisis—and economic growth has not fully normalized, leverage in the system is certainly lower than it was. Consumer leverage has declined significantly, and corporations are cash rich.
It seems to me that very little has been done to address the risks of derivative securities. Very few of us, including most regulators, understand how many of these securities work and how they might threaten the financial system. But the banks are intricately involved in these securities, and that's a blind spot.
There are clearly fewer imbalances in global economies today than there were heading into the crisis. Corporate America and, particularly, financial institutions around the world, have less debt and are considerably less risky. Financial services institutions, including major banks and insurance companies, are in much stronger condition. I would also say that much more rigorous and robust risk management processes have been put in place at those institutions.
The European Central Bank [ECB] reacted less quickly and less strongly but ultimately took meaningful steps to restore confidence. The ECB encouraged banks to increase their capital cushions. In addition, it reduced the cost of money by lowering interest rates to almost zero and implemented modest amounts of quantitative easing. These measures succeeded in restoring confidence and removing fears of a meltdown. But cost-reduction efforts, known as "austerity," limited the Continent's economic growth, and Europe has more work to do to improve its economic viability.
Japan's central bank also took belated, but still meaningful, steps to restart its economic growth after two decades of stagnation. Prime Minister [Shinzo] Abe's efforts to jump-start the economy are serious and appear to be working in the short term. Additional reforms will be needed for sustained healthy growth.
Europe, in fact, has the largest current account surplus of any of the major blocs in the world. It has a bigger current account surplus than China, which I don't think a lot of people would have recognized today, and so Europe is in a position where the governments are rebuilding quite a lot of reserves again, and that's clearly very healthy.
I think emerging markets have coped with the crisis very well. As a result of economic crises in the '80s and '90s, most countries have had sensible macroeconomic policies for 15 years now. Emerging markets proved the strength of their different economies and financial systems in particular.
I would have expected more economic growth over the last five years. Coming off a downturn that was so severe, I would have expected the employment gains to be sharper. That's been one of the political sticking points of this recovery. The financial sector is doing better, but where are the new jobs? That's been a big disappointment.
You typically accumulate pent-up demand during a recession as people pull back on purchases. Then, when the recession ends, the labor market gets better, and households start buying credit-financed items and their saving rate goes down because they're spending more than they're earning. But the saving rate was already so low that we've been rebuilding savings, so we haven't had that push.
Also, we haven't been firing on all cylinders. Normally, after a deep housing recession, housing activity adds about a percentage point and a half to GDP [gross domestic product]. The housing market bottomed in 2009 in terms of construction, but it didn't start to grow at all until 2010 and not steadily until 2011, so we've not had that leg.
I think it could be argued that we've been very, very slow to unwind some of these [monetary] mechanisms, particularly the zero interest rate policy that might actually be restraining the economy.
The Fed reduced interest rates to very low levels, which allowed everyone to reduce interest expenses. It also encouraged investment at a time when few wanted to invest. Consumers and businesses have reduced their debt meaningfully.
At the same time, many American companies have been diligent about managing costs, restructuring, and improving productivity. Profit margins and profits themselves grew to record levels. One reason stock prices have gone up as much as they have is that earnings have grown a lot through productivity and efficiency improvements.
The government also helped some companies access the debt markets by guaranteeing debt offerings and also provided confidence to the money markets. Companies were quick to cut costs and gain operating efficiencies, which helped.
The regulatory response has been appropriate in some respects, but in other respects it has resulted in a bit of a witch hunt in terms of regulators going after certain financial institutions.
There are still pockets of the financial services world where government is trying to remove risk through regulation. Government officials are trying to legislate conservatism that may be unwarranted and may inhibit growth. Many of the details of the Dodd-Frank regulation aren't final yet, but some view it as overreaching and believe that it could inhibit entrepreneurialism and growth. Hopefully we will find the right levels of regulation.
We're going to have to finish the reregulating of housing finance particularly in order to get that sector going a little faster.
There is another bubble waiting for us somewhere down the road. That's why investors need to protect themselves by not overextending themselves financially, remaining well diversified, keeping their tolerance for risk at the forefront of their investment decisions, and establishing a long-term investment strategy.
At the same time, one of the lessons investors should take away from the financial crisis is that the world doesn't end that often. The world has endured many crises. Had we put our investment capital under the mattress each time a crisis reared its ugly head, we never would have benefited from the market rebounds that followed.
Those who did the best throughout the great financial crisis were once again those who stuck to their long-term investing programs, and we encourage everyone to follow this course. The best advice I can give is to invest for the long term and to diversify.
I think there are two important lessons: (1) Keep a balanced portfolio—don't get too heavily overweight one particular asset class, and (2) Don't panic during a crisis, but rather maintain a long-term orientation. Too many small investors sold securities because they were afraid of a full meltdown. Everyone was afraid—institutional investors alike—but investors have done well over time by buying fear and selling greed rather than vice versa.
This material is provided for informational purposes only and is not intended to be investment advice or a recommendation to take any particular investment action. The views contained herein are as of November 2013 and may have changed since then.