2008: A Hard Look at the Year’s Economic Events

Travis Goodman, CFA
February 2, 2009 | COMMENTS

It's been said that the collapse of Bear Stearns' hedge fund in July 2007 started the housing debacle. But it really began years ago, with shoddy lending practices and securitization of bad loans. Lenders passed risk down the line to trusting investors with little recourse to the actual loans. Looking back, several critical events led to what is now considered the worst financial crisis since the Great Depression.

After the housing bubble burst near year end 2007, most industry watchers thought we were headed for a soft-landing recession. The 2008 forecast predicted a slowdown in gross domestic product (GDP) with a modest correction in housing prices, but nothing that would cause major headaches. In hindsight, problems stemming from the housing bubble seem clear. Credit and liquidity are at the forefront of the economic crisis, and massive devaluation on all assets continues. As borrowing lines dry up, investors are selling all they can to amass as much cash as possible, amid declining stock prices and skyrocketing Treasury prices. Financial markets volatility is hitting all-time highs, with years of financial gains wiped out in days.

Run up to Crisis

As 2007 closed, the markets began feeling the effects of the bursting bubble. The Dow Jones Industrial Average (DJIA) was at 13,265, while the S&P 500 was 1,468—both some 6 percent off their all-time highs and both netting a 6 percent return for the year. The 10-year T-bill offered a 4.45 percent yield, while the two-year T-bill offered a 3.05 percent yield—healthy spreads of 140 bps. Financial institutions welcomed a return to an upward-sloping yield curve, which had been persistently flat for years, inhibiting normal spread transactions of borrowing short and lending long. Aside from an emerging credit and liquidity squeeze that didn't appear too threatening, the economy seemed to be holding up reasonably well.

Real GDP in third-quarter 2007 was revised to show a 4.9 percent gain; but employment weakened in the fourth quarter, decreasing from 115,000 new jobs in November to just 18,000 new jobs in December. While employment was softening, the main concern was inflation. By year end, the Federal Open Market Committee had cut the target lending rate from 5.25 percent to 4.25 percent, with no real sign inflation was moderating. Inflation hawks pounced on the Bernanke strategy, fearing an easing policy would mean higher long-term inflation. Oil prices spiked up a staggering 57 percent, causing massive disturbances for all goods and services as much of the economy is intertwined with energy prices. So, while 2007 ended on a sour note, 2008 didn't look any better.

The Lehman Effect

2008 can be broken into two categories: “before Lehman failed” and “after Lehman failed.” Before Lehman failed, economic news came fast and furious in the first quarter. By month-end January, the FOMC had cut the federal funds target rate from 4.25 percent to 3 percent. In March, it cut another 75 bps, and by quarter end, the rate was 2.25 percent.

First-quarter economic statistics also contributed to an overall somber mood. Non-farm payrolls accelerated job losses and, all told, 247,000 jobs were lost in the quarter, with unemployment increasing from 4.9 percent to 5.1 percent. By quarter end, the DJIA fell 7.55 percent, to 12,263, and the S&P 500 fell 11 percent to end at 1,314. Increasing the confusion, inflation and oil prices soared.

During second-quarter 2008, Treasury prices began falling and the so-called “flight to quality” waned. The Fed cut the target rate another 25 bps, to 2 percent, then held until an October inter-meeting cut. Congress passed a $63 billion economic stimulus package, and checks began arriving in the mail. Payrolls improved over the last quarter. As economic performance improved, investors focused back on inflation; consequently, the cost of oil per barrel soared, ending the quarter at $140, with the average cost of gasoline at the pump costing $4 per gallon. The end of March saw headline PPI and CPI on a year-over-year basis at 9.2 percent and 5 percent, respectively. Consumer confidence fell with worries about rising gas and food prices, and growing unemployment.

The third quarter brought a glimpse of the ”after Lehman failed” world: Lehman went belly up, Bank of America bought Merrill Lynch, JP Morgan bought Washington Mutual, Goldman Sachs and Morgan Stanley became bank-holding companies, and Fannie Mae and Freddie Mac went into conservatorship.

As if the news couldn't get worse, non-farm payrolls continued deteriorating in the third quarter and unemployment jumped to 6.1 percent. On a positive note, oil plummeted to below $50 a barrel in the fourth quarter, with gasoline at the pump dropping below $2 a gallon—a much-needed relief to consumers. However, by year end headline PPI was -0.9 percent and CPI was 0.1 percent.

What Lies Ahead

Into 2009, consumers' pain persists. Home prices continue falling nationwide while foreclosures climb. Along with a thaw in the liquidity and credit freeze, homeowners need supply to match demand before home prices will stabilize. But growing foreclosures make that difficult. Going forward, the industry faces unprecedented obstacles for credit unions to consider:

• How will increased competition from mega banks affect deposit balances? Can credit unions compete against too-big-to-fail institutions? Will newly formed mega banks tempt rate-shopping depositors with higher rates, or will higher service quality remind depositors why they prefer credit unions?
• How might credit unions fare under probable new regulations? Proposed solutions include establishing one regulator over all institutions, eliminating the SEC, NCUA and OTS.
• Where will credit unions find liquidity beyond attracting new deposits? Although credit unions historically have safer, less-risky balance sheets, they face liquidity problems just like their counterparts and must plan accordingly.
• What new government programs will affect credit unions? 2008 was peppered with unexpected government programs designed to help a new segment of the financial industry. It's safe to say more will come.

Looking ahead, we know this: Credit unions must remain flexible and ready to adapt. The “after Lehman failed” world is creating a new financial model.

Travis Goodman is a senior financial advisor with ALM First Financial Advisors, LLC in Dallas, Texas. Contact him at 800-752-4628.