In 2008 we were a hair’s breadth from a total collapse of the global financial system. The dramatic chain of events and its repercussions on both the real economy and the financial markets will most likely have far-reaching consequences in the years ahead.
An extreme year
The year’s financial turmoil was preceded by several years of booming economic development in which globalization was a key driver. Growth optimism and low interest rates created incentives to borrow, spend and invest. There was abundant access to cheap capital, but also willing lenders.
Eventually, however, it became clear that lending was growing out of control. Around year-end 2007 the relentless credit expansion in the banking systems of the US and other Western nations had pushed down the solvency ratio – the relationship between total equity and distribution credit – for certain banks and financial firms to dangerously low levels. As a result, the creditworthiness of many large banks and residential mortgage institutions came under scrutiny.
Following a turbulent start to the year, the US Federal Reserve acted in March to save Bear Sterns, a major investment bank in New York. The rescue created the illusion of security, temporarily boosting trust in the banking and financial sector. Although the markets and economic outlook appeared to have normalized, the situation in the credit markets soon worsened again and the availability of credit between banks and to the public tightened progressively.
Changed expectations
When Lehman Brothers declared bankruptcy in September, waves of panic reverberated throughout the financial markets. Something the market never believed could happen, that the authorities would allow a major bank to topple, had in fact occurred. The bankruptcy reshaped all rules and expectations.
The private sector, the public, pension fund managers and other asset managers lost all desire to extend credit to banks and businesses and the focus shifted to saving capital and avoiding credit losses. Government borrowing was the only credit that was viable and accepted. Reactions to the bankruptcy and its spillover effects were so powerful that few had been able to anticipate them, and the authorities were ill prepared for the instability that ensued.
In order to avoid a breakdown in the financial system, national governments were forced to launch rapid rescue initiatives. In nearly all Western countries, the local banks were furnished with various types of government guarantees. There were also cases of government takeovers or forced mergers and the injection of new equity capital. Aside from the collapse of the Icelandic banking sector, these efforts kept the financial system largely intact. In spite of all measures, however, the credit markets remained under an enormous strain that was visible in very high interest rate margins on virtually all loans not backed by government guarantees.
Turnabout
In retrospect, the inflationary assumptions and interest rate hikes made by both the European Central Bank and the Central Bank of Sweden as late as summer proved misguided. By autumn, steeply falling global equity markets and a sharp turnabout in the price trend for oil and other commodities, from sharp rises to vertical falls, sparked fears of deflation rather than inflation.
Change in the consumer price index
Source: Reuters EcoWin
Crude oil (Brent Crude)
Source: Reuters EcoWin
Several interest rate cuts in the USA and Europe in the latter half of the year and a downward slide in bond rates signalled the start of a recession. By year end, the key interest rate in the USA was slashed to nearly zero. Long-term bond rates fell by over 1 percentage point over the year and reached a new historical low of around 3 percent. A radical reassessment of corporate earnings forecasts, global trade growth and economic conditions took place in pace with a rising level of financial unrest. Hopes that any part of the global economy or any activity would remain unscathed were dashed. On the contrary, developments clearly illustrated a global interdependency.
10-year bond rates
Source: Reuters EcoWin
Credit spreads
Source: Reuters EcoWin and Moodys
Falling asset prices
Asset prices fell across all asset classes. In the first half of the year raw material producing countries and emerging markets were regarded as winners in the global economy, but later saw their economies and asset values tumble as steeply, or more so, than those of high-income nations.
The assets that benefited most from cheap credit were hardest hit in the subsequent downturn. The housing markets in many countries nosedived and increased the pressure on households. At the end of the year this caused households and companies to significantly lower their expectations and retrench. Economic activity slowed dramatically during the autumn, causing what seems as the worst economic slowdown since the Second World War.
Stock market: MSCI index, local currency
Source: Reuters EcoWin
The stock market crash in the USA and several other countries in 2008 was on the same sale scale as in the depression years of the 1930s. A broad-based stock index like the MSCI US fell by 37 percent and the comparable index in Sweden fell by 38 percent. Movements in the foreign exchange market were also violent, with the US dollar first eroding by 9 percent against the euro only to climb back by more than 20 percent at the height of the financial crisis. The Swedish krona weakened against all currencies, by as much as 50 percent against the Japanese yen and by 16 percent against the euro.
Exchange rates
Source: Reuters EcoWin
The Fund’s activities
In the spring of 2008 Första AP-fonden completed a new ALM study aimed at reassessing the Fund’s long-term investment orientation. The study showed that the Fund needed to raise the share of real assets, such as equities, in its portfolio in order to create the long-term return of 5.5 percent necessary to fulfil its mission (see section Strategies for realizing the mission ).
Before beginning the implementation of this new portfolio in May, the Fund studied the imbalances described above, trends and development in the equity and fixed income markets over the past few years, in which various scenarios were analyzed. Based on these the Fund decided to carry out the implementation successively throughout the remainder of 2008, since a scenario containing aspects of the financial crisis that later arose was deemed highly improbable. In view of later developments, it would have been more prudent to wait. The implementation was halted in September, partly in response to widespread uncertainty about stock market development and partly due to high volatility and low liquidity in many markets.
Limited credit losses
The year’s massive value losses and poorly functioning financial markets have severely impacted the Fund’s portfolio. The net investment loss of SEK 48.0 billion, equal to a decrease of nearly 22 percent, is above all attributable to development in the equity market, which declined by 40 percent overall.
The Fund’s strategy to spread risks across many asset classes and regions in order to create a high and stable return over time did not produce satisfactory results in the past year. When diversification effects were needed most, they were least effective, since all risky assets have essentially fallen to the same extent. The diversification strategy also relies on liquid markets, a condition that was lacking in the latter half of the year.
The Fund has always taken a cautious stance toward investment in structured products, due to the difficulty of assessing and monitoring the risks associated with these. Despite this, the Fund has been affected by two cases of insolvency, of which one was connected to the Lehman bankruptcy. Fortunately, the Fund’s credit losses were limited to SEK 0.5 billion.
Dealing with the financial crisis
The autumn’s turmoil in the financial markets altered the underlying conditions for the Fund’s asset management. Impaired liquidity in the financial markets, rising costs, higher risks in exposure to derivative instruments and uncertainty about bank solvency demanded changes in the Fund’s investment process.
Transaction volumes decreased, partly through a decision to postpone implementation of the new ALM portfolio, and active management was also pursued with greater caution.
The Fund’s day-to-day management involves a large number of transactions with banks and financial institutions. In the uncertainty that arose during the autumn regarding the financial health of individual banks, the Fund took a number of steps to reduce risk exposure to these. Counterparty limits for banks and financial institutions were continuously reviewed and lowered and the Fund cut back its trading in derivative instruments. All cross-currency transactions were paid via CLS Bank, since this makes it possible to net buy and sell transactions in the same currency and thereby reduce settlement risk. Furthermore, the Fund’s large currency hedging portfolio was distributed more evenly between selected banks.
Time for reflection
When the worst of the storm in the financial system has died down, a number of conclusions can be drawn. The USA in particular, but also the UK and several countries in the Mediterranean and Eastern Europe, have been able to live beyond their means thanks to the availability of cheap credit. This easy credit has also led to the postponement of sorely needed structural changes. The countries that have exported this capital, regardless of low returns, have also played a part. A structural imbalance has accumulated as economies like the USA produce too little in relation to their consumption, while other countries, primarily China, produce more than they consume in order to meet this excess demand.
Interest rate policy in the USA and therefore also other parts of the world has been overly lax for several years, further adding to the creation of imbalances. The financial system has been weakened by its own mistakes. Not even well informed participants, such as central banks, seemed to understand what was happening, and several of them raised interest rates and warned of inflationary risks just a few months before the system’s near collapse.
Market collapse
Regulation and risk controls in the financial system proved to have grave shortcomings that were further aggravated by a conviction that the markets would always remain liquid. Market prices were previously regarded as reliable reference for valuations, regardless of the size of asset portfolios. When liquidity in the markets dried up and the price of securities was more an expression of forced sales than a fundamental belief in the value of an asset, valuation losses arose that would have been manageable under more normal circumstances. The common assumption that the markets will always function and show prices that reflect the actual value of a security proved false.
In retrospect, it seems that many investment banks in particular have been overly risk-seeking. It is also clear that the credit rating institutes made serious errors. The events of recent years can be seen as a failure for both economic policy at the global level and for the international capital markets. Far too much capital has been channelled to the wrong users at the wrong price.
New market conditions
In the market correction now underway, the global economy must be rebalanced. Credit-financed demand should, and is expected to, decrease. This will require countries like China, Japan, Germany and even Sweden, which have a savings surplus, to pursue a policy that stimulates investment and spending rather than the export of capital. Banks in several countries, not least the USA, are still undercapitalized and incapable of granting even normal credit. Measures to restore these functions will require the injection of new working capital.
The general trend in which many players are trimming their balance sheets will remain troublesome. Households that previously expected to live off the value appreciation on their homes and equities will now need to save more.
An interweaving of markets and financial policies is underway and is leading to the formulation of new rules for the markets. Independent market pricing was long considered infallible, but is no longer. Regulation and political intervention of the type already seen will continue, at least for a time and the mutual interdependency between markets and political policy will also increase. For example, it is unlikely that any major bank will be permitted to go under now, and this protection itself can lead to new problems such as conflicts of interest further down the road. There will be an increased risk of moral hazard. In the process of change that we are forced to undergo, the risk for errors and missteps is high.
Budget deficits will widen in most countries, in some cases dramatically, which can further exacerbate financial problems. The risk for additional bankruptcies and corporate downsizing remains significant and rising unemployment rates are heightening the risk for protectionist policies. The foreign exchange markets can set off various competing devaluations in reaction to problems in individual countries.
Investment opportunities
In the present situation, risk premiums in the capital markets have risen and are expected to remain high until various problems have been addressed. In this respect, the current climate offers opportunities for an investor like Första AP-fonden.
However, the poor risk rewards and low returns on assets during recent years call for a reassessment of the assumptions underlying this analysis. What return can an asset owner expect in this environment? The new conditions and insights must be evaluated. The Fund’s long-term perspective should provide the necessary endurance to prosper in this new environment, despite all that has happened. At the same time, the current uncertainty about, and difficulty of, predicting future development present a major challenge.
