Many commentators will tell you that they warned everyone about the depth and duration of last decade’s financial crisis, but no one listened. Some of those commentators had been predicting a financial crisis since the early 1980s, even before, and fought the tape all the way up; and some are probably taking a few liberties with the record and may not have been quite as prescient as they’d like you to think. But a few folks did recognize that this time was not different, that we were experiencing a generational financial bubble, and that the consequences would be systemic, lasting and painful.
I will admit that I was not one of those farsighted few who understood what was happening and what the consequences could be. Sure, I recognized that some regional housing markets had gone way beyond what former Fed Chairman Alan Greenspan dismissively called “frothy,” but I underestimated the damage to the overall economy that a sharp decline in housing prices and a concomitant collapse of the credit markets that both supported and depended on inflated house prices could cause. I underestimated the ability of specific problems to create systematic ones. So while I’m willing to ’fess up to my error, I can hardly have been alone given the extent of market dislocations that occurred once the systemic problem was undeniable.
Why the guilty plea today? Just like the generals who fight the last war or the second-year medical students who read the chapter about some rare but terrifying disease and then diagnose themselves as the latest victims, we investors tend to see the last problem where we should be looking for the next one. In this case, we risk missing valuable opportunities because we tend to see real but limited problems as systemic ones.
Two examples come to mind. The first is one that my colleague, Director of Equities George Evans, has written about in this space. It is the flawed leap from recognizing major European sovereign debt problems to dismissing all investments that sound European. Spain’s government bonds may need a bailout, so the logic goes, so I’d better stay away from Spanish stocks. But as George has reminded us, some great companies in businesses that range from medical equipment to fast fashion happen to get their mail delivered to a Spanish address, but their businesses are global and profitable, and their stock might be attractive to own. The important, but particular, risk of Spanish sovereign debt doesn’t necessarily create systemic risk that threatens strong Spanish businesses.
A second occurred to me when I recently appeared on an industry panel discussing the municipal bond market. Though our topic was the macro economy, we discussed the “systemic” nature of credit problems in the muni market, especially with respect to California. For decades the Golden State has seemed to follow the Tea Party line for taxes and Mother Jones for spending, and a handful of California cities have reached the limit of that approach and declared bankruptcy. Does that mean that all California bonds are going the way of the subprime mortgage derivative? Highly unlikely in my opinion. Flat and declining property valuations and over-optimistic budget commitments will probably stress more cities’ credit, in California and elsewhere, but, unlike the highly interconnected mortgage market of the past decade, these muni problems remain distinct. Your mortgage foreclosure may have degraded the market for my house, but your town’s budget woes don’t necessarily drag down my town’s bonds. Investors who look closely at the purpose (essential, please) and support for municipal debt will, I believe, continue to find good value in the market.
I and others misjudged the impact of the late-2000s housing bust because we failed to realize how big a house of cards we’d built on a base of interconnected, highly leveraged debt instruments. Financial bubbles require lots of leverage to become truly dangerous. Investors who infer that one overpriced or overly risky security necessarily means that a whole class of investments must be avoided are likely to miss the opportunities that a careful study of everything from European stocks to California munis can provide.