This month is the 10-year anniversary of the start of the 2008-2009 financial crisis. There continues to be much to learn from this time period, and over the past two weeks we talked about how I now think about investment risk. This week we will conclude the conversation.
The last two weeks have been about tactical advice on how I now view risk within an investment portfolio. This week we will be staying more big picture about how this 10-year-old crisis still impacts the world today, keeping in mind that I am an investor and an adviser, not an economist. So my musings will be based on real-world observation and experience, of which academic economists may or may not take issue.
The last two modern recessions arrived at the end of a sustained period of growth and stability, and each began with the collapse of a speculative asset bubble that developed during the preceding period of growth. The 2000-2001 dot-com recession was ushered in by a collapse in the tech stock bubble, the 2007-2009 Great Recession by the collapse in the U.S. housing market and the financial products that had been used to finance it.
The 2007-2009 housing collapse was exceptionally dangerous because the financial products that fueled the housing bubble were largely concentrated in the banking system. When these products went bad, the banks that owned them became unstable and this ended up cracking the foundation of the financial system itself.
While this particular problem was American in nature, in a heavily debt-laden world, when the world’s largest economy sneezes the rest of the world catches cold. So when the American economy fell ill, debt cracks emerged in the financial system all over the planet, and the entire system destabilized.
Governments and central banks around the world understood the danger of this crisis and took a whole host of aggressive policy actions to stabilize the system. To do so, they took much of the systemic risk of the crisis and transferred it from the financial sector and banking system to the governments and central banks themselves. On a side note, to many this looked like a huge giveaway to the banks, and I believe resentment over this perception fuels much of the “socialism” momentum of today.
The intent of this massive transfer of risk from the private to the public sector was to use the strength and stability of sovereign governments and central banks to unwind risks over time through a variety of policy processes. The U.S. was able to achieve this fairly effectively and is actively unwinding these crisis measures today. Other developed economies were not quite as adept, in my opinion, and many emerging economies were simply not capable of this process.
The key takeaway for me from these measures is that much of the risk existing in the system wasn’t eliminated, but rather transferred. Much of these massive questionable debts still exist in various forms in the world financial system, and may still have the capacity to destabilize under the right circumstances.
The question is where and how? As an investor, I have learned the next crisis never looks like the last one. The crisis of 2008-2009 taught us that risk can come from unseen places, and the financial system itself is limited in its robustness. So while there are many lessons to be learned from this experience, awareness is my key takeaway.