3 Big Lessons Learned From the Credit Crisis
I hope William Blake was correct when he said, ““The road to excess leads to the palace of wisdom.”” Over the past 30 years, Americans have lived a lifestyle of excess based on asset inflation and debt accumulation. As one bubble after another was inflated by the Federal Reserve, we spent more, saved less, and grew lazy and complacent.
In 1980, total credit market debt was 158% of gross domestic product (GDP). By 2008, total debt was 359% of GDP. In 1990, no state had greater than 15% of its population afflicted by obesity. By 2007, only one state had a prevalence of obesity below 20%, 30 states were greater than 25%, and three states had a prevalence of obesity equal to or greater than 30%. By spending more than we had and indulging in unhealthy lifestyles, Americans, both individuals and corporations, traveled down a road of excess with the false promise of perpetual prosperity.
Over the past 18 months, that myth has been shattered and we are left with a much different perception of the world. During 2008, Federal Reserve data shows that households lost $11.2 trillion of wealth. With housing and equity markets remaining under stress, the 2009 results will show additional declines.
Having clearly traveled down the road to excess, we must now ask what wisdom has been gained. After all, the only positive of the current deep recession is the awakening that our prior path was both unwise and unsustainable. While I cannot speak for everyone, most corporations and individuals should have learned these three lessons:
1. Credit does not equal liquidity – Everyone knows the wisdom of saving for a rainy day. Most financial planners say individuals should have three to six months of living expenses on hand. Corporate managers know the importance of not relying on fickle credit markets to fund their daily operations. However, in the past many mistakenly viewed credit as liquidity. Corporate treasurers felt they could tap the commercial paper market and homeowners looked to credit cards and home equity lines for quick cash. Over the last six months, many of those credit options have disappeared and entities who thought they were financially secure have been ruined. Credit does not equal cash. We should all remember that fact.
2. Prudence pays – Inherently we know we should live within our means and not spend more than we earn. In reality, few follow this advice. The personal savings rate has hovered near 2% since 2000. Banks have leveraged themselves to obscene levels. Asset appreciation was interpreted as savings and increasing stock and housing prices encouraged people to spend more and save less. The consequences were predictable. When using borrowed money, things implode at the worst possible time. Borrowers never get asked to meet margin calls when their wealth is increasing. Only when markets have fallen are you forced from positions. Going forward, a prudent approach to debt and savings will avoid these mistakes from recurring.
3. Crisis creates the unknown – Many of the actions taken over the past few years seemed reasonable at the time. Investors diversified their assets. Investment banks used sophisticated models to manage risk. However, when crisis strikes, all assumptions are rendered mute. As correlations move to one, all asset classes suffer and the unimaginable occurs. Witness the collapse of investment banks that had survived the Great Depression and the inherent nationalization of the world’s largest insurance company. In times of crisis, we should never be surprised by the depths to which markets may plunge.
We have traveled down a difficult period in history. Whether markets have bottomed and the recession is ending remains to be seen. All we know for certain is the pain has been widespread and the consequences severe. Going forward, I hope the lessons learned will have a profound impact on behavior. If we conduct ourselves in a more reasoned manner and abandon the need to acquire lifestyles beyond our reach, some good will have come from the past 18 months.
Sean Hannon, CFA, CFP is a professional fund manager and weekly contributor for StockTradingToGo.com. He runs EPIC Insights Weekly (subscribe) the free Sunday market newsletter, and is the founder of EPIC Advisors, LLC.
