Although many date the start of the current economic crisis to the July 2007 collapse of two Bear Stearns internal hedge funds that were heavily invested in fixed-income mortgage securities, to me, the first event that was a “snap out of it” moment came in late February 2007. On February 27 of that year, the Shanghai Composite Index fell 9% in one trading session. This would be followed shortly by the collapse of Irvine, California, based New Century Financial, the first major mortgage originator to fail.
In the wake of the events since, much has been written and said about what warning signs existed, if any, prior to the crash of the US housing market. Of the warning signs, most pundits have pointed to the overheated housing market and other symptoms of excess liquidity (i.e., banks lending for leveraged buyouts at 8-10 times cash flow, with relatively few covenants). From following and studying the precious metals market during the past few years, I have noticed that a few unusual correlations existed prior to the first signs of trouble in early 2007. I am seeking to take a look at what the big picture was, what available data indicated at the time, and what, if any, warning signs can be deduced.
By early 2007, everything from equities to real estate was up. This occurrence can be attributed to several things. First and foremost, the capital unleashed by Greenspan’s interest rate cuts needed to find a home somewhere. That alone contributed to all asset classes being pushed up. Second, China’s role in the global economy contributed to subdued US inflation, rather than the level of inflation that might have been expected due to then-historically low interest rates. Finally, the modern measure of volatility, the VIX, was at all-time lows. This did not allow for proper risk management, allowing dangerous levels of leverage to be built up. As such, all asset classes were held up, and this paved the way for a swift decline when it all ended.
A mass of liquidity was unleashed in the early 2000s by central banks around the world, led by Greenspan’s Fed. This was due to the economic slowdown in 2000-2002 and the shock of 9/11. This global flood of capital saturated everything from emerging markets to equities around the world, but especially the US housing market. By early 2007, while banks were still making lots of money, uncertainty was creeping into the economy from the stalled housing market. No one was really sure what the effects would be, and around this time economists increasingly found themselves at odds with each other with respect to their predictions. However, there was a feeling that at the very least, the Federal Reserve would be able to engineer a soft landing for the economy, as Greenspan had been credited with doing five years earlier. For the time being, an air of euphoria prevailed in late 2006 and into 2007.
This giddiness was not only caused by the billions that had been made in real estate, but across all markets. The correlations that existed in late 2006 were unlike any that had ever been seen before. Gold, equities, and bonds, government and corporate, were all up. Such an across-the-board correlation, particularly between US government debt and gold, is rare. Gold finished 2006 up at a then-eye-popping $637 per ounce, up more than 20% for the year. The S&P 500 was up 14% on the year, rising after two relatively tepid years in 2004 and 2005, when it was largely range-bound. Finally, US government bond futures finished the year up 6%. As such, yields between the 5, 10 and 30-year bonds had not only risen but converged as well.
While the full faith and credit of the United States government was alive and well, an increase in gold implies uncertainty in the monetary system and, more often, the perception that inflation is going to rise. After all, inflation was significantly up in 2006 and 2007. The rise of emerging markets, such as Brazil, China, and India, and the resulting increases in demand for oil and food staples had helped to steadily push inflation up during the 2000s. However, in that case fixed-income investments would not be expected to do as well. The inverse correlation between Uncle Sam’s debt and gold was mentioned by a few commentators at that time. Dennis Gartman, the Virginia-based economic commentator and author of The Gartman Letter, wrote in December 2006 that, “one would expect gold and the debt market to move in contravention, for strong gold means rising inflation which is, of course, an anathema to debt investments. The only reason we can ascertain to push both higher is weakening economic environs, deflation and serious economic dislocations” (refer to Charts 1 and 2).
Chart 1 – Price of Gold, January-December 2006
Chart 2 – US Government Debt Yields, 2000-2010
In addition to contributing to the increases in the price of commodities, China’s role in the global economy allowed interest rates to stay low without immediately generating inflation due to the lower prices for its goods. It also contributed to lower rates and the property boom by, as I have previously written about, a voracious appetite for US debt. By early 2007, as Greenspan was enjoying the close of his first year of retirement, he was the most celebrated central banker in history (in all reality his legacy will be as such, no matter how much we know that he made mistakes). What was the perhaps the first tremor of what would become the Great Recession arrived in late February while Greenspan was addressing a large European fixed income conference in London. There, he advised the attendees that there was a chance the US could fall into recession in late 2007. The next day, a tremor came out of China that reverberated around the world.
On February 27, it became known that the Chinese government was creating a task force to explore ways to curb speculation on the Shanghai Composite Index (SSE). Investors panicked at the prospect of the Chinese government suddenly curbing their access to its capital markets. The SSE, which had doubled in 2006, fell by 9% in one trading session, to 4000. Suddenly, the markets were on edge. Although the SSE recovered along with US and European markets to post all-time highs in October 2007, it served to illustrate the newfound importance of China, even at a time when its importance was not completely understood by those who had the most at stake.
The rise of China and its role as a factory for the world created economic conditions that served to mask the true situation. This had many ripple effects on the global economy, some more obvious than others. The “money loop” that was established enabled goods to be produced at lower prices, contributing to subdued inflation at the point of sale in the US and Europe. Another effect was that the resultant, ballooning trade deficit left the Chinese flush with cash. As was the case with the US, this capital had to find a home somewhere. The Chinese ramped up their buying of treasuries throughout the 2000s. Indeed, it was one reason that US government debt prices went up with the market in 2006. China’s purchases of US government debt increased from $72 billion in 2000 to $420 billion in 2007. China bought other, higher-yielding debt implicitly guaranteed by the US government (translation: Fannie Mae and Freddie Mac debt) in large numbers, further contributing to the property bubble. Of course, to political leaders in the US and Europe, this was a win-win situation. Subdued inflation was a key ingredient in maintaining economic stability despite low interest rates. The juiced housing market created construction and real estate jobs (these sectors created over 1/3 of the new jobs created from 2003-06, according to official Dept. of Labor data). In this manner, China’s role of helping to pay for the American Dream was crucial to keeping the American machine running, which in turn had to run in order to keep China’s factory machine running, and so on.
By early 2007, economists and central banks across the globe found themselves increasingly divided about the future prospects for the US economy. Residential real estate prices across the nation had stopped appreciating or were in swift decline, particularly on the coasts and across the Sun Belt. At the same time, as we know, there was still plenty to smile about. One month before the first signs of trouble, the mood was jovial at the 2007 World Economic Forum in Davos, Switzerland. As mentioned, prices for most assets were still at relative highs, and there was emerging talk of a secular “Great Moderation” among a growing cadre of academics. One central tenet of this theory was that modern banking systems and risk management had brought volatility to new, permanent lows. Thus, the implication was that we were in an age of lessened, if any, financial shocks. Since the early 1990s, the primary measure of volatility has been the VIX index. In late 2006, the VIX was at multi-decade lows.
The VIX is the ticker symbol for the Chicago Board Options Exchange Volatility Index. Briefly, it has been disseminated since 1993, and is constructed by formulas that measure the fluctuations of S&P 500 futures activity. Although there are now derivatives that trade based on its fluctuations, the VIX itself is not backed by anything. It is solely for the purpose of measuring volatility in the market. The VIX measured in the 40’s after the tech bubble burst, and fell steadily from the upper 20’s in 2001-02 before dropping below 10 for the first time in late 2006 (refer to Chart 3). The driving up of asset prices across the board had led to lower profits and returns on investment. However, this also served to drive down volatility. Although I have generally disagreed with Nouriel Roubini’s economic predictions since the beginning of 2009, his initial prediction about the US real estate market and the derivative-led shock waves across the banking system proved to be spot-on. While he was predicting the ripple effects of the real estate downturn, he was also noting that the excess of liquidity was resulting in diminished returns as well as less volatility. In turn, this caused rates of leverage to grow at alarming rates (after all, traders thrive on volatility, no matter which way the market goes). At Davos in January 2007, while part of a panel discussion, Roubini prophetically noted that, due to leverage more than anything, “the risk of something systemic happening is rising.”
Chart 3 VIX Index 1993-Present
By late 2006, nearly every widely-used measure of market risk did not point to heightened volatility in 2007, let alone a sharp downturn, and much less than what would eventually transpire. One of the reasons that I point to the SSE fall in February 2007 is that on that day, the VIX posted its largest one-day jump ever up to that point, and this sent global markets ineluctably on the path to heightened volatility that would define the next two years. Prior to that day, however, volatility was low across the global markets, and yields continued to flatten across the atlas of credit. Money managers found themselves needing to take on more risk to achieve the returns demanded by clients, or to merely replicate/exceed past performance.
Lower volatility, to a trader, meant it was theoretically safer to take risk. That directly translated into more leverage. In particular, a key driver of the hedge fund industry’s growth from 2000-2007 was the fact that many institutional investors had fallen behind when the tech bubble burst. This was particularly true within the realm of pension funds. To get back on track, more robust returns were sought. Hedge funds, ready to use leverage via the environment of readily available credit, were the perfect candidates to accept this assignment. Money managers would lose clients if returns were not high enough to meet or exceed investor expectations, so the vast majority of them used leverage. The first hedge fund tremor came five months before February 2007, in September 2006. A trader at Amaranth Advisors, one of the many hedge funds that opened up in Greenwich, CT, in the 2000s, had wagered with 9-1 leverage that the value of the March and April 2007 natural gas futures contracts would converge. When the spreads instead widened, Amaranth was forced to liquidate after losing more than $5 billion in one week.
According to Michael Lewis’s Bloomberg column from January 11, 2007, the Amaranth debacle was the most widely-read story on Bloomberg since 9/11 when it broke on Monday, September 18, 2006. Additionally, several of the follow-up stories were in that year’s Top 20. That speaks volumes about what Wall Street was concerned about in the months that led up to February 2007. Besides the obvious reasons (cutthroat competition, firms wanting to know who the winners in the trade were, wanting to know who would buy the portfolio, etc.) it is also indicative of what may have been shared concerns. What I mean is that other Wall Streeters appear to have been concerned about the use of leverage and risk. They could conceive of their own firms having the same problems. However, the conclusion by way of the prevailing market measurements at the time was that all was well. Indeed, in spite of Amaranth, the VIX continued to fall for several more months afterward.
In the end, this lack of preparedness for the events of 2007-2009 was an issue of unprecedented historical market correlations brought on by the excess of liquidity. Because it had never happened on a global scale, and therefore had no historical precedent, the effects and outcomes were nearly impossible to predict. Therefore, it should serve as a reminder that this was not completely a matter of the financial and political crème de la crème being asleep at the wheel, as countless pundits have asserted in the three years since.
Respectfully Yours,
Matthew R. Green
June 4, 2010
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