Martin Gilbert can claim bragging rights as one of the people who called the 2008 financial crisis — or at least an important part of it.
In a 2007 conference in Monaco, he warned about Wall Street’s affinity to collateralized debt obligations, or CDOs, the complex financial instruments that went down with the mortgage market.
Ten years after the financial crisis, the co-CEO of Standard Life Aberdeen, a $736 billion asset manager and one of Europe’s largest, is flagging another debt instrument.
It’s covenant-lite loans, which lenders are increasingly issuing out to companies that seek less-restrictive financing terms. In these arrangements, lenders waive or water down certain so-called covenants, such as whether a company can pay dividends. Breaching these would normally give lenders the option to redeem the loan early.
Gilbert shared with Business Insider, via email, why he’s wary of these loans, and other reflections on the anniversary of the collapse of Lehman Brothers.
Business Insider: You steered Aberdeen clear of the market for collateralized debt obligations ahead of the crisis. What similar instruments are you wary of now?
Martin Gilbert: Yes, we steered clear of CDOs. I was pretty vocal about the risk they posed when speaking at a conference in Monaco in 2007. I viewed them as financially engineered vehicles that enabled misallocation of capital. We avoided getting involved with them.
Currently, I’m wary of covenant-lite debt paper for a variety of reasons, a good example of which are certain weaker covenants, which allow borrowers to essentially strip assets away from the restricted group. This has found its way into some high-yield documentation recently and became topical during the J.Crew restructuring in the US. The market has, however, managed to get this language removed in a number of cases but it’s nevertheless indicative of a wider trend.
The following week was a maelstrom in markets.
BI: Where were you and what you were doing during that weekend in September, and when you heard Lehman Brothers had finally filed for bankruptcy on Monday?
Gilbert: I was in London that weekend and the following week. There was a lot of panic that weekend because many people had assumed the US Treasury simply would not let an institution as big as Lehman go. The bank’s problems were no mystery at the time, but it was the fact that they were allowed to fail that was a watershed moment. It was when investors realized there was a limit to what the US authorities would bear.
The following week was a maelstrom in markets and I spent the entire week working with colleagues to analyze how the event would impact us as the dominoes kept on falling. I have to say though, the atmosphere in the office was not one of panic. Everyone had a clear sense of purpose and was trying to find practical solutions to the issues that markets were throwing up. It was stressful and intense, but it was all about keeping a cool head in those days and weeks in the immediate aftermath.
BI: What are some of the biggest lessons from the crisis and ensuing market crash, especially for younger investors who want to learn from history?
Gilbert: Don’t sell at the point of maximum pain. The scale of the great financial crisis was really something else but there are common threads running through all crises. Markets have a habit of bouncing back and you have to do whatever you can to take a step back.
Another lesson is to stick to the basics. Invest in what you understand, spread your risk and know that if something looks too good to be true, it almost certainly is. The products that the banks were churning out in the run-up to the crisis were ever more complex and built on even shakier fundamentals.
Don’t sell at the point of maximum pain.
This relates to another lesson, and that is that the nature of a globalized economy makes neatly apportioning blame very hard.
Banks have rightly taken a lot of the blame for the crisis, but it was a failing at all levels by governments, regulators, investors, rating agencies, and the banks. When the crisis hit, each party spent quite some time pointing the finger at everyone else. No one party was to blame, but they were all culpable.
BI: What could regulators have done differently post-crisis?
Gilbert: Regulators did a pretty decent job in their immediate response to the crisis.
One of the problems with financial markets is that they act a bit like water running down a hill. If something, like regulation, tries to block a certain route, the market tends to find a way around it sooner or later. This unfortunately means that we might not understand the shortcomings of the post-crisis regulation until it is really tested in the next crisis.
It could be desirable to see more support for securitization. Regulators rightly came down on securitization hard after the crisis because it played a big part in what happened. Securitization is a brilliant tool to match risk and return profiles to appropriate investors. When it is misused to create or obscure unnecessary layers of leverage, though, the crisis shows that it can be extremely harmful.
What I find encouraging is that, on the whole, regulation has been pragmatic. I’m a big believer in working with regulators. They have a tough job and the task of avoiding a repeat of 2008 is not solely theirs.
BI: If there’s another 2008-style crunch, what should the balance between government and private-sector intervention be, given that bailouts to Wall Street remain a grievance?
Gilbert: It’s inevitable that in periods of major crisis governments get involved. The degree to which their responses will be coordinated globally is an open question.
The political environment has changed significantly since 2008, so governments may not unite and work together. In many countries, the “too big to fail” mindset is history and governments feel less inclined to intervene and individual companies will be left to sink, swim, or be rescued (acquired) by a competitor.
That said, governments are very sensitive to public opinion so may well act in situations if the private sector doesn’t. They also recognize that the financial sector oils the wheels of the economy to get growth going again.
Leverage and illiquidity are also the normal ingredients for more systemic-style crises.
BI: What might the next 2008-style crisis be?
Gilbert: That’s the $1 billion question, or the $650 billion question given by how much the US economy shrank from September 2008 to the end of 2009. Unfortunately, as Nassim Nicholas Taleb has argued, black swan events that trigger financial crises come from left field and are difficult to predict.
As we experienced 10 years ago, the global financial system is so interconnected that even a relatively small part, such as sub-prime mortgages, can cause a domino-like effect.
BI: What risks should investors be watching to avert another crisis like that?
Gilbert: I’m not sure investors can avert a future crisis if seeds have been sown and problems have grown. What investors can watch for are signs of complacency, greed, and overt risk-taking within the financial system. Leverage and illiquidity are also the normal ingredients for more systemic-style crises.
If investors see signs of these emerging then they should perhaps prepare for the worst and hope for the best, in terms of diversifying their portfolios.