Not Too Big to Fail

Lessons from the Financial Crisis

written by Paul Feinberg and Bryce Edmonds
photography by Gregg Segal

 
Lessons from the Financial Crisis - Play Video
Financial Crisis Icons
Housing prices in the United States peaked in mid-2006. The S&P 500 peaked at 1,565 in October 2007. But by mid-2009, home prices had fallen 30 percent while the S&P 500 bottomed out at 676. Between the peaks and troughs, in the fall of 2008, the wheels of history’s economic cycles spun to a place unseen in any of the economic crises since World War II. Lehman Brothers proved it wasn’t too big to fail, and the Great Recession was upon us. Five years later, growth rates are slow, employment levels are yet to rebound and consumer confidence remains low.

UCLA Anderson alumni were on the frontlines in a variety of financial industries, and the school’s faculty and researchers continue to debate the collapse’s place in economic history.

Below, we spoke to a cross-section of Anderson experts and asked them some simple questions. Their responses were anything but simple.
Ed Leamer
Professor Edward E. Leamer

Currently: Director, UCLA Anderson Forecast and UCLA
Anderson’s Chauncey J. Medberry Chair In Management

Position five years ago: Director, UCLA Anderson Forecast and UCLA Anderson’s Chauncey J. Medberry Chair In Management

For more than a decade, Ed Leamer has been the director of the UCLA Forecast, the UCLA Anderson research center that issues quarterly economic prognostications for the U.S. and California economies. In that role, Leamer has done a deep dive on the causes of recessions and recoveries, working with a team of economists to dissect what has happened and predict what’s coming next. For him, the causes of the 2008 recession are rooted in the housing cycle. “Too many houses were built,” he says simply. In fact, he foreshadowed the Great Recession a year earlier with his paper “Housing and the Business Cycle,” which he presented at the Federal Reserve Symposium in Jackson Hole, Wyoming. A full year before the collapse of Lehman Brothers, Leamer wrote, “Of the components of GDP, residential investment offers by far the best early warning sign of an oncoming recession. Since World War II we have had eight recessions preceded by substantial problems in housing and consumer durables.” Five years after the events of 2008, Leamer’s views haven’t changed.

Is it fair to call the most recent recession The Great Recession?
In truth, it was not that different from eight of the previous economic downturns. What was unusual was the extreme nature of the most recent recession, but the causes, originating in the housing sector, were similar.

What caused the recession in 2008?
I have a list of culprits. First are the actions of Alan Greenspan and the Federal Reserve. The Fed kept mortgage rates too low; Greenspan was asleep at the switch. Second are the ratings agencies. They failed to accurately rate the quality of mortgage-backed securities. I’d say half the blame is on Greenspan and the ratings agencies. Their job was to make sure Wall Street behaved properly.

And the other half?
Some of the blame lies in the securitization and compliance at the lending banks. Some blame lies with the originators, those writing the bad loans. Lending practices were incredibly relaxed and it was well-known that a lot of the sub-prime loans were not good loans, all while we celebrated the rise in home ownership from 65 percent to 69 percent. Then, there were what I refer to as “Chinese savers,” because the global savings glut caused lower real interest rates worldwide. The SEC was also complicit. They let bank leverage ratios get too high.

Five years later, what worries you now? Have we learned any lessons from the past?
Of greater concern to me now is having a survivable banking system. We need to get rid of financial institutions that are “too big to fail.” The financial sector is too big too fail in a completely inappropriate way. As a nation and as individuals, we have huge savings in equity—and when that happens you don’t know if you’re rich or poor. We have investments, but not deposits. The SEC was also complicit. They let bank leverage ratios get too high.

Could we have another recession like the last?
It absolutely could happen again. Like I said in Dallas (Note: Leamer recently spoke at the Housing, Stability and the Macroeconomy: International Perspectives conference held at the Federal Reserve Bank of Dallas), we have to elevate the lending standards. The ratings agencies won’t make the same mistakes again, that part will self-correct. But, I still worry about the originator process. Going forward, we need to make sure loan officers have an agency relationship that’s either legal or personal. We need to give the originators of loans some skin in the game. In 2008, we were fooled by the housing bubble, which let us think that the economy was strong. This lulled us to sleep as we transitioned from the industrial to the post-industrial world. We need to continue the transition from an industrial society to a post-industrial, savings society. We need to get there, but so far there has been no progress. The SEC was also complicit. They let bank leverage ratios get too high.

What needs to be done to make the economy more stable going forward?
The economy needs to make a pair of transitions at the same time. One transition is from industrial to post-industrial, which means a new kind of workforce development. The other is from a spending society to a saving society, because someone is going to have to pay for our retirees.

Michele Havens
Michele Havens, CFP, (FEMBA '05)

Currently: Los Angeles Region President for Northern Trust

Position five years ago: Managing Director, Pacific Northwest, Northern Trust

Michele Havens has worked as client advisor, portfolio manager, senior investment officer and, now, a regional president. She’s seen many angles of the financial management world, and knows that when all is said and done, people will be people. “That’s why behavioral finance is becoming such an important part of what experts are talking through in our industry,” she says. And, while you might fall on either side of the diametrically opposed suppositions of irrational exuberance and the efficient-market hypothesis, you’ll always do it from a shared viewpoint—being human. “Bubbles will exist. We get excited and want to participate. It’s human nature,” she says. Working through that means making decisions from an informed place based upon what your financial planning needs are, and remembering that bubbles will exist.

From your perspective, what happened that weekend when things were starting to go badly, then, by Monday, a major U.S. corporation was gone?
On a daily basis, we would come into the office, take a look at the markets and look to see how big the veins were bulging on Joe Kernen’s face on CNBC’s SquawkBox, to paraphrase our chief investment officer. There was a camera on Wall St. watching CEOs as they came and went. It was a really disturbing time. Washington Mutual was next after Lehman Brothers. Clients in the Seattle market had loyalty to the local company that had produced significant dividends for years—they were seeing WAMU placed into receivership with the FDIC. That’s still in the month of September.

How did your clients react?
It was a stressful time for our clients. We were watching the markets fall, and it’s a painful experience to watch your life savings evaporate on paper without a clear end in sight.

In the immediate, how did you react?
Proactive communication is a value that we prioritize in terms of client service and messaging. And so we spent most of the time either on the phone or meeting with clients, making sure that even with the number of unknowns at the time, they had a sense of comfort in protecting the capital that they created.

Our job is to work with clients to make sure that they have investments that are strategically aligned with their goals and objectives. That’s the evolution of how we talk to clients about investment strategy. How much pillow money do they need to insulate themselves from another great depression? It’s life-driven investing. We create strategies to insulate them from having to sell in declining markets. Sure, you may want to take some chips off the table, but if you’ve allocated, say, similar to an endowment strategy, we think you can insulate yourself from some of the risk. The data [DALBAR Study] basically supports the fact that humans have a tendency to sell at bottom and buy at the top. I think that’s information that’s critical to this conversation. The SEC was also complicit. They let bank leverage ratios get too high.

What was the feeling at the time?
Of greater concern to me now is having a survivable banking system. We need to get rid of financial institutions that are “too big to fail.” The financial sector is too big too fail in a completely inappropriate way. As a nation and as individuals, we have huge savings in equity—and when that happens you don’t know if you’re rich or poor. We have investments, but not deposits. The SEC was also complicit. They let bank leverage ratios get too high.

What have we learned? Is it enough to keep us from repeating history?
In our global economy, all correlations converged. There were few places to hide. Diversification was defeated. Unless you had everything in treasury bills, every other class was negative. We said, ‘Let’s take a step back and understand the purpose for the wealth you’ve created. Were you taking the appropriate level of risk?’

At Northern Trust, we approach risk from the perspective that you’re really looking at volatility rather than risk of achieving your goals. Investors can manage their investments specifically to align with personal goals. We look at whether you are sufficiently allocated to achieve your goals and whether you are efficiently allocated. We see it as our job to educate and inform our clients. They might choose a different direction, but we want it to be deliberate and understood. The SEC was also complicit. They let bank leverage ratios get too high.

What needs to be done to make the economy more stable going forward?
The economy needs to make a pair of transitions at the same time. One transition is from industrial to post-industrial, which means a new kind of workforce development. The other is from a spending society to a saving society, because someone is going to have to pay for our retirees.

Dan Kim
Dan Kim (MBA '04)

Currently: Los Angeles Region President for Northern Trust

Position five years ago: Managing Director, Pacific Northwest, Northern Trust

Michele Havens has worked as client advisor, portfolio manager, senior investment officer and, now, a regional president. She’s seen many angles of the financial management world, and knows that when all is said and done, people will be people. “That’s why behavioral finance is becoming such an important part of what experts are talking through in our industry,” she says. And, while you might fall on either side of the diametrically opposed suppositions of irrational exuberance and the efficient-market hypothesis, you’ll always do it from a shared viewpoint—being human. “Bubbles will exist. We get excited and want to participate. It’s human nature,” she says. Working through that means making decisions from an informed place based upon what your financial planning needs are, and remembering that bubbles will exist.

From your perspective, what happened that weekend when things were starting to go badly, then, by Monday, a major U.S. corporation was gone?
On a daily basis, we would come into the office, take a look at the markets and look to see how big the veins were bulging on Joe Kernen’s face on CNBC’s SquawkBox, to paraphrase our chief investment officer. There was a camera on Wall St. watching CEOs as they came and went. It was a really disturbing time. Washington Mutual was next after Lehman Brothers. Clients in the Seattle market had loyalty to the local company that had produced significant dividends for years—they were seeing WAMU placed into receivership with the FDIC. That’s still in the month of September.

How did your clients react?
It was a stressful time for our clients. We were watching the markets fall, and it’s a painful experience to watch your life savings evaporate on paper without a clear end in sight.

In the immediate, how did you react?
Proactive communication is a value that we prioritize in terms of client service and messaging. And so we spent most of the time either on the phone or meeting with clients, making sure that even with the number of unknowns at the time, they had a sense of comfort in protecting the capital that they created.

Our job is to work with clients to make sure that they have investments that are strategically aligned with their goals and objectives. That’s the evolution of how we talk to clients about investment strategy. How much pillow money do they need to insulate themselves from another great depression? It’s life-driven investing. We create strategies to insulate them from having to sell in declining markets. Sure, you may want to take some chips off the table, but if you’ve allocated, say, similar to an endowment strategy, we think you can insulate yourself from some of the risk. The data [DALBAR Study] basically supports the fact that humans have a tendency to sell at bottom and buy at the top. I think that’s information that’s critical to this conversation. The SEC was also complicit. They let bank leverage ratios get too high.

What was the feeling at the time?
Of greater concern to me now is having a survivable banking system. We need to get rid of financial institutions that are “too big to fail.” The financial sector is too big too fail in a completely inappropriate way. As a nation and as individuals, we have huge savings in equity—and when that happens you don’t know if you’re rich or poor. We have investments, but not deposits. The SEC was also complicit. They let bank leverage ratios get too high.

What have we learned? Is it enough to keep us from repeating history?
In our global economy, all correlations converged. There were few places to hide. Diversification was defeated. Unless you had everything in treasury bills, every other class was negative. We said, ‘Let’s take a step back and understand the purpose for the wealth you’ve created. Were you taking the appropriate level of risk?’

At Northern Trust, we approach risk from the perspective that you’re really looking at volatility rather than risk of achieving your goals. Investors can manage their investments specifically to align with personal goals. We look at whether you are sufficiently allocated to achieve your goals and whether you are efficiently allocated. We see it as our job to educate and inform our clients. They might choose a different direction, but we want it to be deliberate and understood. The SEC was also complicit. They let bank leverage ratios get too high.

What needs to be done to make the economy more stable going forward?
The economy needs to make a pair of transitions at the same time. One transition is from industrial to post-industrial, which means a new kind of workforce development. The other is from a spending society to a saving society, because someone is going to have to pay for our retirees.

David Shulman
David Shulman (MBA ’66, Ph.D. ’75)

Currently: Senior Economist, UCLA Anderson Forecast

Position five years ago: Senior Economist, UCLA Anderson Forecast

David Shulman’s (MBA ’66, Ph.D. ’75) distinguished career on Wall Street included time spent working for a number of firms, including Salomon Brothers and Lehman Brothers, where he was managing director and head real estate investment trust analyst. In 2005, he retired from Lehman Brothers and formed his own LLC, while finding time to teach at both the University of Wisconsin and Baruch College. Shulman also returned to his roots, rejoining the UCLA Anderson Forecast, where he had served as a consulting economist in the late ’70s and early ’80s.

Today, as one of the authors of the renowned research center’s quarterly forecast for the nation, Shulman brings with him a perspective rooted in his private sector career. Professor Ed Leamer, director of the Anderson Forecast says, “David’s Wall Street; I’m Main Street,” in contrasting their points of view. It was Shulman who authored the Forecast’s recession call in December 2008, writing, “The news from the economy is bad. The recession we had previously hoped to avoid is now with us in full-gale force.” With five years past to provide perspective, we asked Shulman to recollect the events of 2008.

What were the causes of the 2008 recession?
The primary cause of the recession, which actually began in 2007, was the banking system, where normal banking and shadow banking spun out of control. (Ed. Note: Former Federal Reserve Chairman Ben Bernanke defined “shadow banking” thusly: “Shadow banking, as usually defined, comprises a diverse set of institutions and markets that, collectively, carry out traditional banking functions—but do so outside, or in ways only loosely linked to, the traditional system of regulated depository institutions.”) There was too much leverage in all elements and not enough capital. The subprime loans were all backed by short-term funding from the shadow banking system, all with too much debt. Ultimately, there was way too much leverage in the system and too much of the leverage was short-term. There was insufficient capital in the system and when money started to be withdrawn, the system crashed.

What was the mood like on Wall Street?
There was real fear we were going into the Great Depression 2.0. That didn’t happen. On a personal basis people were worried about their own financial security.

What were the lessons learned from the experience?
The key lesson was insufficient capital in the system and also sloppy underwriting. There were people knowingly putting bad mortgages into the system. But even if all the loans were good, the system could have failed, it was a house of cards.

The banks are still too leveraged?
Yes, they are still leveraged up, but not with home loans.

Are there solutions, remedies to prevent what happened in 2007 and 2008 from happening again?
The government solved some of what went on with TARP (Troubled Asset Relief Program), but we still have institutions that are “too big too fail.” For example, J.P. Morgan, Bank of America, Goldman Sachs—they would have to be rescued if there were another crisis.

I see two ways to handle things to prevent a similar situation from reoccurring. One is to break up the banks—no more “too big too fail.” That makes some sense. But you might not want to break up the big banks. It would be hard for them to compete globally. We need big banks for big customers.

The other way is through more regulation and more and better capital requirements. In that case, if there are losses, just the bank’s shareholders get hurt. So, one way is to make the banks smaller and the other is less leverage at the bank level. We have more chance on the capital requirements, which is actively being talked about now. Without the capital requirements, there will be more regulation. The fastest growing area of hiring in banks is in compliance. The SEC was also complicit. They let bank leverage ratios get too high.

You’ve written and spoken a lot about Fed policy over the past half decade. How would you assess these policies?
Fed policies have been terrific if you already owned stocks and had a large equity position in your home. Fed policies of the last five years made the rich richer but really haven’t helped the broader middle class.

Suzanne Trepp
Suzanne Trepp, CFA, (FEMBA '98)

Currently: Senior High-Yield Analyst at Western Asset Management Co.

Position five years ago: “Believe it or not it was the same. Now I have the same position but with a bigger sector responsibility.”

Suzanne Trepp’s job is studying the markets and companies rated below investment grade, and there’s one thing she knows for sure. “So many times, clients expect us to have a crystal ball,” she says. When it comes to the financial crisis she knows something else, “Nobody saw it coming” As the drama unfolded, she recalled lessons learned in Professor Bill Cockrum’s class. “You make assumptions, then you can never stress test it too far,” she says. “What is the market pricing? How bad can it get? How really bad can it get?” And, ultimately, she says one of Cockrum’s idioms represented the lower benchmark during the crisis and in the ensuring years of recovery. “‘Cash is king,’” she says. “If companies have enough liquidity they can usually make it though the cycle. That was really one of the key lessons.”

From your perspective, what happened that weekend when things were starting to go badly, then, by Monday, a major U.S. corporation was gone?
In my mind, it seemed like financial meltdown—and everybody was panicking. And, panic creates opportunity. The world was not coming to an end. WAMCO used that as an opportunity, and we revisited credits that we owned, looked at what we didn’t own and where we thought the market had mispriced risk. And we made sure we had enough liquidity.

In the immediate, how did you react?
I would say that we were all in shock. Our performance took a hit, but when the economy came out of it we were ready. We were negative like others, but we did not panic so we had an outsized recovery. Initially we underperformed, but a year later we outperformed the market and our competitors. It’s really been such an interesting lesson. For instance, Hawker Beechcraft bonds traded all the way down to the single digits because everyone thought private jets were going away. But we bought Hawker Beechcraft bonds as the company had ample liquidity and no near-term refinancing risk.

We definitely didn’t sell at the bottom unless we were forced to. We’re extremely focused on fundamentals and marry that with valuations to determine the best opportunities. We were not lemmings. We did a full analysis and tried to explain to our clients what our thinking was.

How did your clients react?
They were understandably concerned. Everybody was trying to figure out how much worse it could get, and it caused people to question the stability of the entire financial system. It was really frightening. There was so much uncertainty. We were handholding a lot of clients and we definitely lost some business. Some panicked and sold at bottom and just wanted out. But, the clients who stayed with us are still with us today.

What have we learned? Is it enough to keep us from repeating history?
Yes, they are still leveraged up, but not with home loans.

Are there solutions, remedies to prevent what happened in 2007 and 2008 from happening again?
It wasn’t probably until the end of 2009 or early in 2010 when we saw the solid companies come through and start thinking about refinancing. Then you could see who had access to capital and whose business models where truly resilient.

No, I don’t think we’ve done enough to make sure history doesn’t repeat itself. For example, airlines have been able to issue unsecured bonds again for the first time since 2007, which is a red flag for me. Unsecured airline bonds are historically wiped out at the end of the day. Unless you can repo a plane, unsecured airline bonds are fairly worthless.

On the macro basis, interest rates are basically zero, so people are reaching for yield in problematic places. Collateralized loan obligations are coming back in fashion. That’s partially caused by managers just trying to get to a yield target. The market is not pricing certain types of risk appropriately, and we are potentially setting up another bubble. We’re being prudent and focusing on fundamentals and on credits that we perceive the market have mispriced.

David Dewolf
David Dewolf, EMBA ('05)

Currently: Partner and CFO, Abacus Wealth

Position five years ago: Founder and Financial Advisor at Quantum Wealth Management

In 2005, David DeWolf (’05) graduated from UCLA Anderson, took out a second-mortgage on his home and founded Quantum Wealth Management with his classmate and partner, Darius Gagne (’05). The former CFO had a goal: to help people plan for their futures, instead of corporations. DeWolf and Gagne built their business, managing the assets of high net-worth clients; they would go on to merge with Abacus, financial advisement firm based in Santa Monica and Manhattan Beach. But in the fall of 2008, DeWolf and Gagne were still a two-man shop when the market crashed and the pair shifted from simply managing assets to managing the expectations – and the psyches – of their clients. “There was huge fear once Lehman Brothers collapsed and fear of the unknown struck many of our clients. The worst part was not knowing what would happen next,” DeWolf says, “a lot of retirees and near-retirees lost 30% of their portfolio and nobody knew how far things would go.”

Do you have any thoughts on what caused the recession and the subsequent economic collapse in the fall of 2008?
First of all, it’s important to remember that the stock market high was in October 2007, a full year before the crash. Was the housing market unsustainable? Yes. Oil prices passed through 120 dollars per barrel, it was the first predictor and we sold our clients out of oil. That said, from our point of view and our clients’ point of view, how it happened is irrelevant. What’s relevant is how we dealt with the situation.

So, how did you deal with it? You had clients who were already retired and those who were about to retire who had little chance to earn back what they lost.
We had to become psychologists. Our job was to remind our clients not to panic, don’t stock up on guns and food, and to reassure them that everything would be alright. The fear and uncertainty really intensified in January and February (of ’09), then the market low was in March. In early 2009, we were preaching you can’t panic, you can’t sell and you haven’t lost any money until you do sell. That message worked but after four or five months it was hard to endure, particularly because all the “advisors” online and on the TV news were saying, ‘Get out now.’

How did your clients react? Did many instruct you to “get out” of the market or did most ride it out?
We had a few sellers but anybody who rode it out was better off. In the first quarter of 2009 there was a 25 percent drop in the S&P, we called that “panic selling.”

It’s been five years more or less since the market crashed. What are the lessons from that time that still resonate today?
When we talk to people, we always talk about risk, but the conversation tends to be abstract. The crash of 2008 made people realize that risk was real. The memory fades over time, but it was a real reminder that risk is not an abstraction and a demonstration of what might happen if the market dropped 40% again. We tell clients that we will see another drop and when we do, we have a plan for it.

I’m sure many Assets reader would like to know how you plan for a 40% drop. What are you telling your clients?

We have our clients hold bonds as a safety net. If they need cash, we draw from bonds, not stocks. They don’t have to start firing their employees.

What happened in ’08 and ’09 solidified our beliefs at the 20,000-foot level. At the 5,000-foot level, we made adjustments. We constantly ask ourselves “where do the risks lie.” If interest rates go up, bonds will go down. In ’08, that was not a concern, but it might be now.

We also believe in promoting sustainability. Abacus has a fund with Dimensional Fund Advisors; the fund over-weights sustainability. We still buy oil, but if Exxon is doing things that are more sustainable than British Petroleum, then we buy Exxon because we believe that companies focused on sustainability will do better over time.

There are two things we deal with when it comes to our clients. The first is that two to three times per year we’ll experience the apocalypse du jour. It was the fiscal cliff last year and if you gave in (and sold stocks) you missed out on 30% returns. We try to discount that effect. Our clients understand that we will have a meaningful drop, so prepare yourself now.

The other thing we deal with is risk tolerance. It really changed for some. People have to continue to remember what happened (in the recession). It’s easy to forget, but it will happen again. X