Hussman Weekly Market Comment: The Grand Superstition

In general, the larger the events, the more important the events are to survival, and the closer in proximity those events occur, the more likely an organism is to believe those events are tied together by cause and effect. This makes the 2008-2009 credit crisis an ideal playground for superstition.

When we examine the 2008-2009 credit crisis in retrospect, there’s no question that the central concern at that time was that massive bank failures would trigger a “global financial meltdown.” The risk of widespread failures was driven by losses in mortgage-backed securities and related assets held by major banks, and by highly leveraged financial institutions like Bear Stearns and Lehman, representing the “shadow” banking system.

The balance sheet of a major bank looks like this: for every $100 of assets, the bank typically owes about $60 to depositors and $30 to bondholders, with the other $10 representing retained earnings and “equity” capital obtained by issuing stock. With $100 in assets against $10 in capital, a bank like this would be “leveraged 10-to-1” against its equity capital. At non-banks like Bear Stearns and Lehman, the leverage ratios were 30-to-1 or higher. Given 30 times leverage, it only takes a decline of just over 3% in the value of the assets to completely wipe out the capital and leave the company insolvent (as the remaining value of assets would be unable to pay off the existing obligations to customers and bondholders). In such an environment, a “run” on the institution can force asset sales, which accelerate capital losses and increase the likelihood of insolvency.

Under existing accounting rules, banks and other financial institutions were required to report the value of the securities they held, using prevailing market prices, a requirement known as “mark-to-market.” As asset values collapsed in 2008 and early-2009 because of mortgage losses, financial institutions across the globe found themselves rapidly approaching insolvency.

As the willingness of investors to buy mortgage securities seized up, and economic activity plunged, the Federal Reserve stepped into the financial markets and became the major purchaser of existing and new mortgage securities issued by Fannie Mae and Freddie Mac. This arguably helped to support continuing activity in the housing market, but it is not what ended the crisis.

Rather, the crisis ended – and in hindsight, ended precisely – on March 16, 2009, when the Financial Accounting Standards Board abandoned mark-to-market rules, in response to Congressional pressure by the House Committee on Financial Services on March 12, 2009. The decision by the FASB gave banks “substantial discretion” in the values that they assigned to assets. With that discretion, banks could use cash-flow models (“mark-to-model”) or other methods (“mark-to-unicorn”).

The problem for investors is that this was quite a subtle event – hardly memorable, and certainly not grand and obvious like the Federal Reserve’s intervention was. But we are wired for survival, and the larger the events, and the closer they are in proximity, the more likely we are to draw cause and effect connections between them. That’s particularly true if there is at least a weakly logical way that they might be related (as was true the Fed’s mortgage support).

Importantly, the impact of the FAS 157 change is easier to appreciate in hindsight than it was in the fog of war. Its success relied on regulators to go along with the new numbers, and bank depositors and customers to believe them. I've frequently discussed our own response to the crisis, which was to insist that our methods to estimate market return/and risk were robust to Depression-era outcomes (even though our existing methods had anticipated the crisis and performed admirably during the market collapse). It's no secret that we missed returns in the interim as a result. We are evidence-driven investors, and similar economic and financial disruptions were simply out of context from the standpoint of post-war evidence. Nevertheless, it's critical to go back and understand the actual mechanism that ended the crisis, so that we as investors don't allow ourselves to be misled into an increasingly false sense of security about Federal Reserve actions. It's probably also worth observing how heavily banks have relied on the release of "loan loss reserves" in order to beat earnings estimates in recent periods.