Revisiting the global financial crisis and its impact

A range of factors lie behind the severity of the global financial crisis and its fall out over the last year. Shane Oliver, Sydney-based head of investment strategy and chief economist at AMP Capital Investors makes a list of these factors. They include financial deregulation, the search for high-yield returns while ignoring the risks, low interest rates earlier this decade, financial innovation, high debt levels, and of course, greed on the way up and fear on the way down.

The key lessons for investors from the last year, Oliver says, are: that the investment cycle is alive and well; higher returns come with higher risk; the role of sentiment can never be ignored; be wary of financial engineering; be wary of gearing; and government bonds should always be included in a well diversified portfolio.

ôThe past 60 years has not seen anything like the freezing up of lending between global banks, the disruption to credit flows or the need for so many financial institutions in the US and Europe to be rescued as we have seen in 2008,ö Oliver says.

The crisis was obviously the most far-reaching. For the world as a whole, it is the worst financial crisis in the post-war period.

How did it come to this?

While many are looking for easy scapegoats to blame, Oliver details the origins of the current malaise:

Financial deregulation. Over the last 20 years this helped unleash much greater competition in the global financial system and hence the greater availability of debt. It ultimately led to a failure of US regulators to keep up with new financial products and growth in leverage. This is not to say deregulation was wrong, but in some countries, such as the US, it went too far.

The shift from high inflation to low inflation. This saw interest rates fall, which was great, but it had the effect of encouraging borrowers to borrow more and drove investors to search for higher yields. This led them to greater allocations to investments such as listed property trusts and of course the complex securities at the heart of the current problem. This occurred without due regard for the extra risks involved.

Financial innovation. Amongst other things this saw a massive expansion of the securitisation approach to debt financing. This is where a financial organisation originates a loan to a borrower say a home owner. These loans are then sold to other organisations that package them up with lots of other loans into securities which are distributed to investors all around the world. The theory was that by combining lots of loans the risk would be low. Ratings agencies provided high credit ratings for securities whose underlying loans would normally be regarded as sub-investment grade. A problem with the originate and distribute model is that there was no bank manager looking after depositors funds.

The US housing boom. These developments, spurred by low interest rates early this decade, came together to drive the US housing boom which was increasingly underpinned by a deterioration in lending standards. This saw a huge growth in loans to subprime or high risk home borrowers in the US up until 2007.

In 2006, poor affordability and an oversupply of homes saw US house prices peak and then start to slide, Oliver notes. That made it harder for sub-prime borrowers to refinance their loans in order to maintain their initial low teaser mortgage rates. As a result more and more borrowers defaulted causing investors in the fancy products that invested in sub-prime loans to start suffering losses in 2007 û and this became the sub-prime mortgage crisis. Rising unemployment and falling house prices have since seen the problem spread to all US mortgages.

Oliver shares his views on why the subprime crisis dragged down the whole world:

First, the extent of bad loans and hence losses has been far worse than thought.

Second, record levels of debt in investment banks and hedge funds have accelerated the losses and the declines in key assets as positions had to be unwound to cut debt or meet redemptions. High household debt has also made the economic fallout far greater and this has seen the crisis spread to countries such as China.

Third, the distribution of securities investing in US sub-prime debt all around the world has led to a wider range of exposed investors and hence greater worries about which financial institutions are at risk.

Fourth, just as greed played a role on the way up, fear played a huge role on the way down. This is evident in the freezing up of lending between banks in the aftermath of Lehman Brothers failure on fears all banks are at risk or the dislocation in credit flows to good companies.

These factors all came together to result in a downwards spiral of falling share markets, falling confidence, reduced lending, reduced economic activity, more losses, then more falls in share markets, Oliver says. And this was all transmitted globally via trade flows, confidence effects and capital movements, he adds.

WhoÆs at fault?

Fault lies with a range of players, Oliver says, including the US home borrowers who werenÆt aware of what they were getting into, the lenders who relaxed their lending standards, the ratings agencies, investors chasing returns without regard to risk, US regulators, and financial organisations for taking on too much risk. And, as always, greed and fear also played a big role in magnifying the boom and then the bust.

How will the post-meltdown world look?

Oliver sees several major implications from the events of the last year:

Increased regulation of the financial sector. The damage caused by the financial crisis will lead to a rise in regulatory oversight of the financial sector globally.

Bigger government. This is already apparent with various governments taking stakes in financial institutions. A big increase in public infrastructure spending is on the way in China, the US, Australia, etcetera.

Back to basics investing. Given the problems sophisticated investment products have had and the rise in investor scepticism, we may see a return to simpler investment products with less reliance on financial engineering, leverage or claims of positive returns in all environments. We may well see a back to basics world re-focussed on shares, government bonds, cash and direct property/infrastructure with less reliance on in-between assets.

Slower growth in the financial sector. The crisis along with greater investor scepticism and more regulation is likely to slow the rate of growth in the financial sector after 25 years of above average growth.

A faster shift in economic power to Asia. The global financial crisis is likely to have accelerated the shift in relative economic power from the G7 countries, which have now suffered a loss of global credibility and are likely to be hampered by excessive debt (especially in the case of the US), to Asia which has high savings and has not seen its banking system come under threat. This will likely be reflected in a favourable relative performance of Asian assets in the future.