Past and Present

Past and Present
The credit crisis looks a lot like 1907

By Kenneth Barker, partner, Baillie Gifford & Co.

Baillie Gifford began investing 100 years ago and while age is sadly no indicator of future success, it does allow one some perspective on current events. In looking back I am struck by the remarkable parallels between the events of the ”Bank Panic of 1907” and today. As a reminder, an investment boom led by commodities preceded the 1907 crisis. Banking trusts brought in new risk capital and also permitted greater gearing of this capital than before. The collapse from unrealistic optimism to blind panic was precipitous. Investors lost confidence in banks’ balance sheets, liquidity dried up and stock markets floundered. J. P. Morgan organized a recapitalization of some banks and brought in emergency funding from the U.S. Treasury. Nevertheless the U.S. and Canada suffered economic recessions the following year. ‘Plus ça change’ indeed!

In supportive markets, the process of financial innovation is driven by the belief that new financial instruments and broader geographical exposure both diversify our portfolios and give managers more tools with which to generate excess returns. This has been the main message that investment managers have taken to Canadian fixed income investors in recent years. We have to accept, however, that innovation can be seen as ‘widening the circumference of uncertainty’ and that in weaker markets this pessimistic view can stifle both good and bad evolution. A more discriminating view is that one should differentiate between helpful innovation and products and strategies that simply gear up the risk premium inherent in risky assets. The latter approach has been found out in the past year, particularly in structured products.

Beyond the benchmark

The template I suggest is that innovation should be based around clients’ needs, be sustainable through an investment cycle, and have active investment management as its foundation. Where derivatives are employed it should be done judiciously—my view is that derivatives make a better steering wheel than a gas pedal. With this framework, I remain convinced that Canadian investors can find genuinely diversifying and return enhancing investments in global fixed income. The guiding principle is that your fixed income benchmark should not be your opportunity set. The most interesting investment opportunities currently lie in credit. Corporate bond markets currently reflect an unrealistically dire economic prospect. This is most apparent in banking bonds, which, in March 2008, saw subordinated bonds’ prices (on a buy and hold basis) suggesting that almost half would default in the next 10 years.

The centrality of the banking system to the wider economic health of nations will lead the authorities to stop at nothing to prevent financial meltdown. In return for the provision of liquidity, banks will be expected to reduce financial gearing and take less risk in their business models. Both elements directly benefit investors in bank bonds.

Central banks have innovated in their support mechanisms for banks. In particular, the range of securities accepted as collateral has been greatly widened. However the principal approach—as in 1907—is to pump liquidity into the banking system. While credit derivatives have been to blame for many of the market’s problems, they might also provide another useful means to restore financial stability. The world’s central banks, perhaps through the International Monetary Fund, could sell protection in broad-based credit indices through credit default swaps. This would serve to set a ceiling on credit spreads and provide new risk capital to banks. Clearing the blockage in this way would encourage banks to convert their liquidity with more confidence into loans for worthy borrowers. If central banks will intervene in foreign exchange markets then why not in credit markets, which are arguably far more strategically important?

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