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The GFC has been noted as the worst global financial crisis to hit since the great Depression. It resulted in lending between banks coming to an abrupt halt, market shares falling by 50% or more and numerous financial institutions had to be bailed out. Although far too many loans had been granted to US homebuyers, resulting in a crisis when supply surged and interest rates suddenly increased, this wasn’t the only contributor to the GFC.
Other GFC Contributors
- Approximately 40% of loans were granted to people who were in fact not able to repay them. Not only were some loans even provided to people with no income or assets; a large number of them were classified as non-recourse loans – in other words, borrowers were given the option of handing the home back if its value dropped to below the amount that was still owing on it, and they would not be liable for any further payments.
- This was all made possible by a significant lowering of lending standards that saw sub-prime loans being incorporated into securities which were given AAA ratings based on the fact that while a minor percentage of loans could default, that risk would in turn be offset by broad exposure. However, once these sub-prime loans were moved away from banks, there was no one to monitor them.
- This occurred as banks around the world were sourcing more and more of the funds they were lending from global money markets, which meant that they no longer had to rely on costly bank deposits from brick and mortar locations.
In 2006, an oversupply of properties, poor affordability and multiple interest rate increases over a two-year period resulted in property prices peaking and then dropping. This made it more difficult for sub-prime borrowers to obtain refinancing at lower rates, causing many of them to default – which in turn saw investors who had invested in sub-prime loans suffering tremendous losses.
This all ended in 2009 after major fiscal stimulus and monetary easing helped restore regular operation of money markets, growth and overall confidence. However, sub-par global growth and extremely low inflation rates were still experienced afterwards.
Lessons Learned from the GFC by Investors
- High returns always come with a higher level of risk. Although risk can remain dormant for years, it often returns aggressively.
- Always be wary of financial engineering or difficult-to-understand products. Investors during the GFC experienced the biggest losses with products that relied almost exclusively on financial engineering to convert junk to AAA investments.
- True diversification is crucial. Although hedge funds and listed property trusts were popular alternatives to government bonds before the GFC, they performed poorly (to the point where Australian REITs fell by an astounding 79% – while government bonds performed excellently.
- It can – and usually does – take time for the market to return to normal after a GFC because a lack of market confidence results in reduced consumer spending and investing.
- Correct asset allocation is essential, namely your allocation to cash, shares, property, bonds etc. Only then should exposure to individual shares be considered.
Will Another GFC Occur?
There will most certainly be another boom and bust at some point, as each generation fails to learn from the financial mistakes made by past generations. However, just because global debt has increased exponentially, it doesn’t mean that the market is heading for another crisis.
Inflation rates are currently low and lending requirements have not been relaxed to pre-GFC levels. Banks now also require higher capital ratios and need to source a higher percentage of money from depositors. This means that while another boom and bust cycle is likely, it will more than likely differ vastly to the last GFC – although numerous signs of excess that indicate towards a deep bear market are still very much absent.