September 18th was the 16th Anniversary of the Fed’s decision to cut interest rates in the wake of growing concerns about the emerging credit crisis in the US economy. More memorably perhaps it was also the 15th Anniversary of the famous meeting where Ben Bernanke demanded a $700bn fund to bail out the toxic mortgage situation with the words…
"If we don't do this, we may not have an economy on Monday"
Ben Bernanke 18th September 2008
That marked the end of an incredible week in financial markets (see here for the Wikipedia timeline) that had seen Lehman go bust, Bank of America take over Merrill Lynch and the US government take over AIG. Most important perhaps was that the Money Market Fund Reserve Primary had ‘broken the buck’ as all its bonds referenced to Lehman had to be marked to zero. While this didn’t attract the headlines in the same way, this, to our mind, was the key reason that the financial market crash impacted the real economy in the way it did. And a key reason we were more optimistic than many in the spring of 2009 as we saw these negative impacts reversing.
The day before Bernanke's dramatic speech, investors had pulled $144bn from Money Market Funds and because the system had been allowed to evolve such that almost all major corporations used short term commercial paper to fund working capital and that this commercial paper was being bought by those same money market funds, the impact of the ‘run’ on Money Markets was to freeze the working capital system.
The real problem in September 2008 was not Lehman, but that the Money Markets failed in the wake of Lehman’s bankruptcy
When companies lose access to working capital, they immediately cut spending and start selling inventory, both of which happened almost immediately - although the drop in new orders and selling prices were widely ascribed to an upcoming ‘Great recession’ that was somehow related to the US housing market. In effect economists who had (correctly) been warning of the dangers in the US housing market bubble then ‘explained’ events through this narrow lens and were subsequently lauded as having predicted the financial crisis, when they did nothing of the sort. Incidentally, the most high profile of these (Nouriel Roubini, aka Dr Doom) is ironically back in the news currently prescribing ever higher rates for the UK. To a man with a hammer as they say.
This is not to say that the housing market wasn’t a problem nor that the mess of Credit Default Swaps and the inverted pyramid of toxic leverage described in ‘The Big Short’ wasn’t an accident waiting to happen, but it wasn’t the reason the world economy froze. And thus it wasn’t the reason it started up again.
The Global Financial Crisis was just that, it wasn’t a Great Recession, it was a system failure based around Money Markets.
September 2008 represented a systemic failure and because it was actually a classic liquidity crisis, the economic effects were fixed quite quickly. Most importantly, the Fed started providing necessary liquidity by announcing in early October that it was buying commercial paper , allowing the working capital machine to start up once more. This coincided with our own bottom-up analysis of companies warning about working capital shortages to give us a clearer picture of what was really happening and meant we were not waiting for a signal from the US housing market to start putting money back into markets. Instead, we were watching private sector inventories, in real terms they rarely go negative, but when they do, they can heavily distort measures like GDP, as well as show up in lower orders or lower inflation.
To us then, the lessons to take away from 15 years ago would be that financial bubbles don’t burst without a catalyst - the doomsters had been predicting the housing bubble crisis for years before it came and, as noted, the Fed were already a year into easing monetary conditions- but when they do, they can also have unforeseen knock-on impacts. Bubbles are almost always about leverage and when they burst it is usually because there is a sudden change to either its price or its availability. In this case it wasn’t the housing market that collapsed nor the Fed raising rates sharply, but rather the CDS market created on the back of housing that ran out of liquidity. Meanwhile, the reason the crisis extended beyond the financial sector was that nobody had noticed that the corporate sector had switched their working capital requirements to the money markets, such that when they seized up, so did everything else.
Ironically, the Fed had fixed the problem with their CP purchases, but by applying the wrong cure to the wrong problem for another decade - near zero interest rates to bail out the losers of the system failure - the real legacy was to introduce the seeds of the next crisis through Quantitative Easing, which through more than a decade of mis-priced and thus misallocated capital led to the fragility of the system that ultimately melted down in September last year.
Today, we have the Money Markets back in the ascendency as the Fed’s tightening has led to them crowding out liquidity across capital markets. In effect another system failure, but rather than replacing working capital bank liquidity with fee paying funds, they are instead replacing cash deposits with fee paying funds. They are thus, once again causing liquidity problems, only this time in the capital markets rather than the real economy. Let’s hope it ends more peacefully this time.
