The dawn of the 21st century posed a collection of unique challenges to the world of finance. The dot-com crash of 2000 and the 11 September 2001 World Trade Center attacks (9/11) illustrated the fragility of the capital markets. Although the nature of each event was very different, both proved to be economic game changers. In many ways, the dot-com meltdown and 9/11 served as underpinnings for one of the largest losses of wealth in world history―the Global Financial Crisis Of 2008.
Of course, the roots of 2008's "Great Recession" aren't as obvious as a tech market crash or military conflicts in Afghanistan and Iraq. It was a product of unprecedented lending practices, consumption and securitisation. Due to its extreme size and scope, the Global Financial Crisis of 2008 has become the modern benchmark for economic catastrophe.
The Economic Impact Of The Great Recession
In nominal terms, crafting an accurate comparison between the dot-com crash, the 9/11 attacks and the Crisis of 2008 is challenging. Nonetheless, financial authorities have put forth estimates pertaining to respective monetary losses. For the United States alone, the damage sustained during the Great Recession dwarfs that of the other events:
Dot-com bubble: During the meltdown's peak (November 2000), the 280 tech stocks included in the Bloomberg U.S. Internet Index lost US$1.755 trillion in market cap from their 52-week highs. This figure represented a 12-month loss of more than 40%.
The 2001 World Trade Center attacks: The economic impact of the 9/11 attacks is multifaceted. In total, 9/11 is estimated to have cost the United States US$3.3 trillion from September 2001 to September 2011. These figures include physical damage, security costs, war funding and veterans care.
Global Financial Crisis of 2008: The loss of wealth stemming from the Global Financial Crisis of 2008 is enormous. Experts project the downturn to have cost US$10.2 trillion for the year of 2008. This 12-month figure includes a loss of US$3.3 trillion sustained by U.S. homeowners and US$6.9 trillion in wealth from equity market participants.
The events during the span of 2000 to 2010 changed the global economic landscape for years to come. 2008 proved to be a pivotal year during this period, bringing the collapse of several pillars of banking and investment. As a result of the intense financial pressures, failure of the 100-year old Lehman Brothers and America's largest bank, Washington Mutual, came to pass.
Origins Of The Crisis
Pinpointing the exact causes of the Financial Crisis of 2008 can be a challenging endeavour. To this day, the subject is hotly debated among analysts, politicians, bankers and traders. However, the broad consensus agrees that late-1990s financial industry deregulation led to subprime lending and the securitisation of toxic assets. Given these factors, the stage was set for a global credit freeze and a dramatic correction in the real estate and equities markets.
Deregulation: Repeal Of Glass-Steagall
One of the most commonly cited causes of the Great Recession is the 1999 partial repeal of the Glass-Steagall Act. Originally enacted in 1933, Glass-Steagall was put into place to prevent a repeat of the Depression Era U.S. banking failures during the 1920s and 1930s. It promoted a complete division between commercial and investment banking. In doing so, Glass-Steagall aimed to prevent the use of bank credit for market speculation, thus limiting institutional risk taking.
On 12 November 1999, the Gramm-Leach-Bliley Act (GLBA), also known as the Financial Services Modernisation Act of 1999, was ratified by the U.S. Congress. The GLBA rolled back a portion of Glass-Steagall, effectively removing restrictions that kept banking companies, securities companies and insurance companies separate.
Eventually signed into law by sitting U.S. President Bill Clinton, the GLBA enjoyed bi-partisan Congressional support in both the House of Representatives (362-57) and Senate (90-8). Critics of the GLBA contend that it removed safeguards that may have prevented the 2008 crisis from occurring.
"Subprime" Mortgage Lending
By far, the most frequently targeted culprit for the Crisis of 2008 was a practice called subprime mortgage lending. A subprime mortgage is one that is issued to parties deemed to have a greater risk of default. Accordingly, these mortgages carry higher interest rates to account for the lender's risk-premium.
In contrast to standard 30-year fixed mortgages, subprimes are frequently packaged as adjustable rate mortgages called "ARMs." An ARM is subject to a fluid interest rate based upon a benchmark such as the Federal Funds Target Rate. After a specific period of time, typically 5 or 7 years, the payment schedule of the ARM is modified up or down in relation to the benchmark.
For the years preceding late-2007 and 2008, the subprime mortgage lending sector boomed. In 2006, non-bank underwriters extended 12 million subprime mortgages worth an estimated US$2 trillion in the U.S. alone. The result was a staggering load of debt obligations and a spike in real estate values.
The GLBA's passage in 1999 set the stage for the lending culture of the early 2000s. In addition to the ascent of subprime mortgages and ARMs, consumer borrowing exploded during this period. From 2000 until 2008, U.S. consumer debt grew nearly three-fold, ballooning from approximately US$4 trillion to US$12 trillion. This phenomenon is largely attributable to the aggressive lending practices of non-traditional banking entities.
A large portion of the new debt obligations came in the form of conventional and subprime mortgages. To capitalise upon this budding market, many commercial banks focussed efforts on the securitisation of such assets. Under securitisation, a cross-section of mortgages were "bundled" into securities reminiscent of mutual funds. These new products were referred to as mortgage-backed securities (MBS) and were swapped between institutional participants.
In theory, the MBS market was not inherently risky. However, due to the sheer number of subprime loans "bundled" in these offerings, the MBS products themselves were exposed to a number of systemic risks. For the year of 2005, 20% of all mortgages were considered to be subprime; of that 20%, about 70% were ARMs. Thus, any economic downturn, or uptick in lending rates, would very likely lead to a glut of defaults.
Global Credit Freeze
When economic pressures began to mount in late 2007, MBS participants experienced a host of catastrophic failures. Subsequently, the lending market quickly dried up, bringing on a global credit freeze.
A credit freeze occurs when lenders cease extending credit to consumers, businesses and other lenders. The results are slowed economic growth, rising unemployment and lagging equities market performance. During the fourth quarter of 2008, the global credit markets became essentially "frozen." Lending fell across the board, to the degree of 47% quarter-over-quarter and 79% year-over-year. The result was economic paralysis, with U.S. GDP posting negative annual growth for 2008 (-0.1%) and 2009 (-2.5%).
The Exodus From "Risk Assets"
Given the capital market turbulence of 2008 and subprime meltdown, investors aggressively shifted their liquidity out of perceived "riskier" assets. The results produced dramatic revaluations of entire asset classes.
To illustrate the rapidly evolving financial environment during 2008, below are several key performance metrics:
- Dow Jones Industrial Average (DJIA): The DJIA fell by 33.84% in 2008, the worst single-year performance since 1931.
- Standard and Poor's 500 (S&P 500): S&P 500 values plummeted by 38.49%, the worst single-year performance since 1937.
- U.S. real estate: U.S. home prices posted a record 18% annual decline and contributed to a 27-month losing streak.
- Oil: Hindered global economic growth projections led to plunging oil prices. For the year, West Texas Intermediate (WTI) crude oil fell 53.5% from US$99.64 to US$44.60 per barrel.
- Gold: Gold bullion rallied by 8.29% for the year, extending a 6-year bullish trend. Gold's uptick in 2008 added to a 27.61% gain realised in 2007.
In contrast to the performance of equities and commodities, the U.S. dollar (USD) fared well vs the forex majors throughout 2008. Due to the global credit freeze, the USD was viewed as being a "safer" alternative than many other global currencies. Below is a look at 2008's track record against several majors and traditional safe-havens:
- GBP/USD: The British pound sterling (GBP) struggled mightily vs the Greenback. For the year, values of the GBP/USD fell by 5486 pips (-27%).
- EUR/USD: As the world's second reserve currency, the euro (EUR) fared better than the GBP. 2008 brought a measured decline of 654 pips (-4.4%) to the EUR/USD.
- USD/CHF: In chaotic financial times, the Swiss franc (CHF) typically performs better than most other currencies. This was the case for 2008, with values of the USD/CHF sliding 620 pips (-5.4%).
- USD/JPY: Over the course of 2008, many currency investors viewed the Japanese yen (JPY) in a positive light. For the year, the USD/JPY fell by 2086 pips (-18.67%).
- XAU/USD: The most traditional safe-haven, gold continued its multi-year rally vs the USD in 2008. Gains of 4640 pips (5.5%) were posted for the 12-month period.
In total, 2008 was not a good year for risk assets. The global credit freeze dampered growth projections, which devastated equities values and market participation. Subsequently, the DJIA and S&P 500 showed Depression Era weakness and underwent severe corrections.
Conversely, safe-haven assets such as gold, the Swiss franc and Japanese yen posted solid gains. Although the USD did rally vs the GBP and EUR, the bullish moves were largely a product of institutional angst toward the stability of the international monetary system.
Remedies And Recovery
The Global Financial Crisis of 2008 proved to be a nearly unprecedented event. Lasting effects were felt across society, influencing everything from market structure to consumption patterns. Because of the extreme nature of the downturn, experimental measures were needed to restore stability to the monetary system. To accomplish this task, programs such as quantitative easing (QE) and government stimulus were adopted.
One of the primary weapons used to fight instability during the Great Recession was government stimulus. Efforts in this area were led by the administration of President George W. Bush and the Economic Stimulus Act of 2008. Upon the act's passage on 13 February 2008, the U.S. government pledged 1% of GDP (US$152 billion) to ease economic pressures, officially beginning the stimulus era.
Later in 2008, the U.S. Treasury Department unveiled plans for a sweeping aid package known as the Troubled Asset Relief Program (TARP). Authorised by Congress under the Emergency Economic Stabilisation Act of 2008 (EESA), TARP earmarked US$700 billion for injection into the U.S. economy. The funds were to be distributed among banks, creditors, automakers, insurance companies and distressed homeowners.
The ultimate value of TARP and associated government stimulus programs proved to be much more than the initial US$700 billion. According to a 2011 audit of the U.S. Federal Reserve (FED), aggregate funds disbursed to banks and corporations, both domestic and international, totalled a staggering US$16 trillion.
The onset of the Great Recession brought a swift evolution to monetary policy around the world. While government stimulus packages were introduced to promote economic growth and liquidity, they were not enough to thaw the frozen credit markets. To kickstart lending, central banks from all corners of the globe introduced policies of QE.
For the world's reserve currency, the USD, QE meant lending rate cuts and massive asset purchasing programs by the U.S. FED. From 2008 to 2015, the FED introduced three separate QE packages (QE1, QE2, QE3). Ultimately, these policies reduced the Federal Funds Target Rate from 3.50% to a near-flat 0.25%. Almost all of these cuts came during 2008, which saw rates slashed from 3.50% in January to 0.00% in December.
The FED also engaged in the mass purchasing of "toxic assets." For the period of 2008 to 2015, the FED increased its balance sheet from US$900 billion to US$4.5 trillion.
Following the introduction of the FED's QE1, a majority of international central banking authorities chose to adopt similar policies. The European Central Bank (ECB), Bank of England (BoE) and the Bank of Japan (BoJ) were a few that established their own QE policies relatively quickly.
Over the past 100 years of world history, the Great Recession of 2008 is the second-largest global economic downturn. International GDP growth slowed from 5% in 2007 to 2% in 2009, and the results were devastating, impacting people and markets from all corners of the globe. A product of the U.S. subprime mortgage bubble, securisation of toxic assets and reckless consumption, the Great Recession left a footprint on the world of finance still visible in 2020.
However, through the implementation of government stimulus and QE, monetary authorities argue that a second Great Depression was avoided. In the decade that followed, equities markets eventually recovered, as did employment and economic growth. From a strictly empirical standpoint, the stimulus and QE delivered a return to pre-crisis levels.
According to former FED Chairman Ben Bernanke, the FED now has the tools to competently manage recessionary cycles: "QE and forward guidance should be part of the standard toolkit going forward." Given these new crisis strategies, as well as legislation such as the Dodd-Frank Wall Street Reform and Consumer Protection Act, an argument can be made that the financial industry is now better prepared to deal with another Great Recession.
Senior Market Specialist
Russell Shor (MSTA, CFTe, MFTA) is a Senior Market Specialist at FXCM. He joined the firm in October 2017 and has an Honours Degree in Economics from the University of South Africa and holds the coveted Certified Financial Technician and Master of Financial Technical Analysis qualifications from the International Federation…