Wednesday, October 15, 2008

The More Things Change . . .

Jim Parker, Regional Director, DFA Australia Limited

"The problem is leverage, clear and simple," was how one journalist summed up developments in financial markets, noting that markets were freezing up, liquidity was lacking and investors had become risk averse.1

The onset of recession, a weak US dollar and sinking real estate made for a gloomy combination, wrote another.2

The crisis had all the markings of the end of an era, observed a third,3 suggesting that it would take years to clean up the mess of debt and high-risk products left behind by the sharper operators of Wall Street.

The financial strains were accompanied by political tensions. In the US, the Bush administration was under attack over its handling of the war in Iraq, which had driven up oil prices, and its management of the economy.

Sound familiar? All of those observations were made within a few days of each other in January, 1991, more than 17 years ago.

At that time, the Anglo-Saxon economies of the US, Canada, the UK, Australia and New Zealand were all either in or flirting with recession.

The recession came on the heels of an era of financial excess, as exemplified on Wall Street by the junk bond king Michael Milken and in the movies by Gordon "greed is good" Gekko.

In the US, excessive and imprudent lending for real estate had contributed to the failure of hundreds of community-based 'savings and loans' institutions, triggering a multi-billion dollar government bailout.

In the United Kingdom, consumers who had leveraged themselves heavily to real estate suffered a severe blow when rising interest rates pushed house prices sharply lower, both in real and nominal terms.4

In Australia, too, market deregulation had given way to an era of increasingly reckless lending by financial institutions, which until that point had had little experience in managing risky commercial loans.5

The consequence in Australia was the failure of a number of major financial institutions, including the state banks of Victoria and South Australia, the Teachers' Credit Union of Western Australia, the Pyramid Building Society, merchant banks Tricontinental, Rothwell's and Spedley's and the Estate Mortgage trust.

Examining the causes of the early 1990s bust in the Anglo-Saxon economies, a Reserve Bank of Australia governor later observed that any boom built on rising asset values and financed by increased borrowing had to end.6

At that time, the crisis seemed intractable and insoluble. Journalists and economists talked of systemic breakdown and a global challenge for market capitalism, much as they are now.

Now, while no two market crises are ever the same, it is fair to say there are parallels between today's downturn and the events of early 1990s, particularly in the damage caused by excessive leverage and insufficient oversight by many financial institutions of the risks they were taking on.

For those who lived through that period as investors (or even market commentators), you might recall the sense of doom and gloom and the over-riding fear in the financial markets at that time.

The important point is that markets worked through that period of dislocation and uncertainty to emerge stronger. Indeed, the early '90s recession was followed by a stellar decade for equities, one that would have passed by those who had given up in 1991 and hunkered down in cash.

This is not to predict that today's markets are ripe for a similar Phoenix-like revival, but it is a sage reminder that nothing lasts forever and that if you want the returns available from risk assets, you need to stay in your seat...

Please email or text me if you would like a copy of the full article with tables... Andy

1'Deleveraging: Relief from a Big Debt Hangover', Corporate Cashflow Magazine,Jan 1, 1991
2'A Year to Forget? US Investors Left with a Chill After '90', Dallas Morning News, Jan 2, 1991
3'U.S. Securities Industry Going Through Rough Ride', Associated Press, Jan 2, 1991
4Roger Bootle, 'UK High Street Has Echoes of 1990s Recession', Daily Telegraph, Jan 15, 2008
5Ellis Tallman, 'Australian Banks during the 1986-93 Credit Cycle', Economic Review, 2000, Q3
6Ian Macfarlane, 'The Boyer Lectures: The Recession of 1990 and its Legacy', ABC, Dec 2006