Market Meltdown History Lesson
For those of you that are new to investing or haven’t experienced financial meltdowns like the one we’re seeing currently, I thought I’d write up a post on a somewhat similar situation which arose about twenty years ago. Contrary to what it may have seemed like the last 10 years, our capital markets are happy little places to put your money and watch it grow and grow.
Free markets, unfortunately, are prone to excess. In the end, we’re all speculators at heart. Most of us can remember pretty clearly what our most recent recession – mostly caused by the internet bubble bursting and exacerbated by 9/11. Outside of the bursting of a bubble, that market correction could be chalked up to natural business cycle more so than our current market turmoil which was created by the poor decisions of a handful of investment professionals. To find a true parallel, we have to look further back to the Savings and Loan Crisis in the late 1980s.
During the late 1980 more than 1000 savings and loan institutions failed, the crisis contributed directly to the recession in the early 1990s and threatened much of the banking system as we know it. What caused so many institutions to fail? Well, the same thing we saw unravel over the last few years – the popularization of a new breed of security, increasing leverage, realization of unaccounted for risks in the security, and rapid unwinding of positions.
In the 1980s, Michael Milken started the cult of the junk bond. Prior to Milken, bonds with junk status were typically fallen angels. These were good companies which had come upon hard times and had their credit ratings marked down to junk status. Not surprisingly, despite being labeled junk, default rates on these companies weren’t as horrific as expected as by the time these companies hit junk status their troubles were beginning to bottom out. Milken parlayed this phenomena into the creation of a market for junk bond originations. That is, underwriting bond offerings for companies initially trading as junk. Not surprisingly, the risk characteristics of these companies was profoundly different from the risk characteristics of fallen angels. These were companies which never had good balance sheets or strong credit ratings for whom a singe mis-step might result in a late payment or, worse yet, a default. Somehow, this was overlooked as the craze took hold. New metrics were designed to value junk companies with negative cash flow. And, junk bond prices skyrocketed.
Savings and loans institutions, hungry for yield now that Treasuries were trading at lower and lower rates, began to look at junk bonds as an option. They were convinced by Milken and the other devotees of the junk bond that such securities were not as risky as they seemed. Unfortunately, by the late 80s, default rates on junk bonds were rising and, by 1989 despite the high yields these bonds claimed to pay, return on junk bonds as an asset class turned negative. Savings and loan institutions, insurance companies, just about every large investor in junk bonds began to exit, sending the market for junk bonds crashing down and those who couldn’t unwind fast enough were stuck holding nearly worthless pieces of paper with little hope of waiting out coupon payments let alone principal repayments. In the end, the government was forced to step in and bailout a crumbling market. At the peak of the storm, the California Insurance Commission was forced to take over Executive Life, one of the largest insurers at the time. In addition, since the crisis hit many savings and loans and commercial banks which had deposit insurance on their consumers’ accounts, it is estimated that tax payers paid upwards of $124 billion as a result of the poor money management and speculation in the financial industry.
Sound eerily similar to what’s happened in the mortgage backed securities market? Well, it just goes to show you that though times may change, people don’t.
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Comments
[...] Meltdowns happen – Curious Investor provided some perspective on this – times change but people [...]
Oh Curious One
Over t trainee trader I see your blog is ranked at genius level. I think it may be all the fine print in your blog. If you use a loarger font, it becomes more readable to the preschoolers!
Anyways, I was glad only to have a high school grade level.
John Bougearel
SuccessfulTradingTips.com
Haha, thanks for the tip. I have been meaning to give this blog a face lift. I’ve just been so busy lately. It’ll be coming eventually and larger font is definitely on the to-do list.
[...] my last post comparing the Savings and Loans Crisis in the late 1980s to the current Subprime Mortgage Crisis, you might have gotten the impression [...]
Great history lesson – and source of flashbacks for those who are old enough to remember those days.
The lending environment out there really does remind me of the early 1990s. The silver lining is that once all that excess and the following pessimism was worked out, the markets did settle in for quite a nice little rally.