It has been five years since Lehman Brothers have crashed, sparking a market meltdown and many investors worry that it could happen again. Risks including new and different ones that are not yet fully understood, still lurk and pose a potential threat to markets, according to money managers, investment strategists, risk experts and academics.
September 10, 2013
It's been five years since one of Wall Street's storied firms crashed, sparking a market meltdown. Could it happen again?
In September 2008, it was a bundle of bad real estate loans that delivered a 1929-style knockout punch to Wall Street firm Lehman Bros. and the stock market.
If there's a next time, the TKO will likely come from a "new unknown," or a risk that investors are already aware of but pooh-pooh, or any number of scary "What If?" scenarios that strike unexpectedly, causing maximum surprise, alarm and financial panic.
History never repeats itself, at least, not exactly. That's why anxiety persists on Wall Street even though the broad U.S. stock market, having fully erased a paper loss of $11.2 trillion, is now trading just shy of its new record high five years after Lehman's bankruptcy nearly caused Depression 2.0.
Risks, including new and different ones that are not yet fully understood, still lurk and pose a potential threat to markets, say money managers, investment strategists, risk experts and academics.
The Fed's eventual exit from its experimental QE bond-buying program, for instance, could prove messy, causing both bond yields and market instability to skyrocket. A cyberattack targeting Wall Street might sound like science fiction, but it's not. A global currency war or a new financial crisis born in emerging markets could foment capital flight from markets. Another "Flash Crash," or market drop caused by a failure of the market's technological plumbing, could also prove fatal.
"History shows that crises are part of life, and they are more apt to arise when the majority of investors are comfortably positioned without worrying about other possibilities," says Woody Dorsey, an expert in market psychology and president of Market Semiotics.
Stuff that seems dramatic at first and gets priced into markets, like the doubling of government bond yields, a chemical weapons attack in the Middle East or a massive loss at a big bank due to risky bets, can also cause more drama later if old story lines lead to newer, spookier market narratives.
"What if the yield on the 10-year Treasury bond doubles yet again?" says Dorsey. "What if there is a sarin (nerve gas) event in the states? What if JPMorgan has more skeletons in the closet? Those things can happen."
For now, at least, Wall Street's vital signs have stabilized.
With a big assist from government bailouts and performance-enhancing stimulus injections from the Federal Reserve, the Dow Jones industrial average and other U.S. stock indexes have rebounded to record highs. A "fear gauge," which spiked three-fold to levels never seen before and never seen again, has returned to normal levels. And jittery Main Street investors, after yanking cash out of U.S. stock funds for nearly four years, are just now getting comfortable again with the idea of buying stocks. Markets rose Monday, and the Dow Jones Industrial Average closed at 15,063, up more than 140 points.
Yet, the psychological fallout lingers. Fear of another "Lehman moment" still haunts investors. Fear of not being able to get money out of the bank, losing a job or a house, or watching a 401(k) balance get cut in half, has a way of sticking with people.
"We learned anything is possible," says Mellody Hobson, president at money management firm Ariel Investments.
When asked if another Lehman-like event could strike, Hobson said: "I don't know how many black swans, (or unpredictable, highly improbable events with huge impact), you see in a lifetime. But I hope I don't see one again. It's like the terror of a plane flying into a building. You can't prepare for it. But anything can happen. Like a Formula One race, you can be in the lead in the last lap and get a blowout."
The Lehman bankruptcy, which was sparked by a loss of confidence in the then-fourth-largest investment bank, due to a mountain of mortgage debt on its books that was too big too overcome, is now part of Wall Street lore, like the 1929 crash and Black Monday in 1987. While it didn't pack the emotional punch of, say, the attack on Pearl Harbor in 1941, JFK's assassination in 1963 or the 9/11 terror attacks, the demise of Lehman is seared into investors' memories like a blood-red tattoo on capitalism's forehead.
That's why the debate about whether another Lehman-style meltdown is possible won't die.
Betting that a big market breakdown can't happen again will likely be a losing wager, says Nassim Taleb, author of the best-selling book The Black Swan and an expert on risk. "It will happen," says Taleb.
He says Wall Street is still relying on "defective" and "broken" risk models that are "not infallible." Dangerous risk-taking by bankers, he adds, still occurs due to financial incentives that still prod them to take big risks with other people's money.
Taleb argues that just as risks were hidden under the surface leading up to the 2008 financial crisis and resulting Great Recession, he says there is "monstrous risk" lurking again.
"We are just as fragile as we were before," he argues.
The Federal Reserve's massive bond-buying program, dubbed QE for "quantitative easing," which he says has artificially boosted economic growth and asset prices such as stocks and bonds, is masking potential problems. Like "novocaine on a root of a tooth," Taleb says.
Once the Fed starts to taper, or cut back, its bond-buying program, which could occur as early as next week's policy meeting, interest rates will rise. History, he warns, shows rising rates expose the system's weaknesses.
"Policies (such as QE) cause problems to mutate elsewhere," says Taleb.
Taleb says he doesn't know how bad the next financial crisis will be, or what will precipitate it. What he does know is that another bad chapter for markets is brewing.
"I can't predict the truck that will make a vulnerable bridge collapse," says Taleb. "But I can tell you the bridge is vulnerable. Are we safer than we were? No. That is the problem."
Pimco CEO Mohamed El-Erian, the man who coined the phrase "The New Normal," a term to describe a long post-crisis period marked by weak economic growth and high unemployment, says he isn't in the camp that says everything's on the verge of falling apart.
"I am not a doomsayer," says El-Erian. "But nor am I saying everything is fine."
Three days after Lehman collapsed, El-Erian called his wife to tell her to withdraw as much cash as she could from the ATM because he was worried that banks might not open the next day.
Despite the 2008 scare, El-Erian doesn't see the financial system's payments and settlements apparatus "freezing up" again like it did five years ago when "banks didn't trust one another" and everyday transactions that grease the gears of finance stopped getting done, leading to "cascading failures."
The "whatever it takes" strategy implemented by Congress and the Fed during the financial crisis got the markets functionally normally again, he says. The financial system, he argues, has also "strengthened enormously." Banks, due to more stringent regulations and deleveraging, now hold larger capital reserves, have improved the quality of the assets on their books and cut back on some of their "reckless risk-taking."
Philip Strahan, a finance professor at Boston College, says another Lehman-moment "is possible, but unlikely." He notes that the use of leverage, or borrowed money, by the nation's biggest banks to amplify returns has dropped by roughly half. Near the peak of the crisis, for every $20 of assets, roughly $19 were borrowed, he says. Bigger cash piles at banks and corporations, he adds, act as "a buffer" in times of crisis. That enables them to better absorb losses and avoid spillover effects that can cause contagion.
The irrational exuberance and signs of excess that ordinarily pre-date financial crises are not currently in place, which lowers the odds of another financial Armageddon, adds Jim Paulsen, chief investment strategist at Wells Capital Management.
"I definitely think we will get to a time when investors get overly optimistic, think the good times will never end, get overextended, or start investing in risky assets and buying second homes again," says Paulsen. "Are we close to that now? I don't think we're anywhere close."
Still, El-Erian notes that financial markets and many asset classes, including stocks and bonds, have benefited from artificial support from policymakers. But, in addition to causing distortions, that tailwind is morphing into a headwind now, as the ability and willingness of the Fed to continue providing support is declining.
That poses risks, especially given that the unprecedented stimulus thrown at the economy and financial markets the past five years has goosed asset prices, but has not provided a big enough jolt for the economy to achieve escape velocity. He believes that, given their disappointing impact on the real economy, the policies have also prodded investors to take bigger investment risks in search of gains, which could end particularly badly if investors start suffering losses and start to sell en masse.
Rhupal Bhansali, an international portfolio manager at Ariel Funds, says there are clear signs that investors are again gravitating to higher-risk investments. Small-company stocks, for example, are outperforming large-cap stocks. Investors have also piled into riskier bond plays, such as high-yield, or junk, bonds, which provide fatter yields than U.S. government bonds.
"Investors are voting with their money in ways that suggest risk appetite is back," says Bhansali. "That doesn't mean another crisis is imminent. It just means when investors don't pay enough attention to risk, that it often comes back to haunt them."
"We have to realize there are unintended consequences of three years of high policy experimentation," says El-Erian. "We don't know what they are. There's lots of uncertainty. That's why resilience becomes so important."
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