Lessons from the Great Recession

The recession that began in December of 2007 and, arguably, ended in June of 2009, has been dubbed the “Great Recession” — the deepest recession on record since the Great Depression. Now, more than two years later and according to a few signs I’ve seen, as many as 99% of us are still living with the impact of this economic downturn. The events of these past years have left plenty for us to chew on; have we learned anything from them? Here are a few lessons that I hope we have learned personally and as a nation.

Debt Matters.  During the long periods of economic growth leading up to the Great Recession, our individual and national levels of debt increased dramatically. We relied on it as a tool to enhance our standard of living — an appropriate utilization of debt. However, to be sustainable, debt should primarily be used to indirectly increase our standard of living — by using debt as a means to enhance our productivity and income. The increase in productivity and income on a personal level, or GDP on a national level, serves not only to increase our standard of living, but also provides the means to carry and ultimately repay the debt.

Prior to the Great Recession, we used debt extensively to directly increase our standard of living without the necessary productivity gains. Personally, we borrowed money against our houses to build nicer bathrooms, buy cars, and obtain bigger TVs. Nationally, much of our debt is significantly premised on controlling oil prices and maintaining easy access to other global resources. Both of these examples increased our perceived standard of living, but provided no means to repay the debt.

Productivity is the nail that holds economic growth together, and debt can be one hammer that drives it. If a hammer is pounded against wood with no nail, you’ll get the same noise, but it won’t hold together. Debt without corresponding productivity gains will never create sustained growth.

Counter-party Risk Matters.  The trigger that finally brought down our debt-laden house of cards was the compounding of leveraged risk through derivatives such as credit-default swaps. As the name implies, a derivative does not represent a direct investment holding, but rather a fabricated security that is derived from another security — there are even derivatives of derivatives.  According to the Bank for International Settlements (BIS), the derivatives market reached a notional size of $585 Trillion in December 2007, more than 10 times the size of the total world economy. If anything went wrong, literally all the money in the world could not cover the liability.

When you enter into a derivative contract to remove some component of risk from a particular investment, the counter-party is taking on that risk for you in exchange for a risk premium, and betting that the risk won’t materialize. If the counter-party bet heavily and is wrong, they will not be able pay you. For example, Bear Stearns’ total market capitalization was around $20 Billion in 2007. Yet they held over $13 Trillion in derivatives when they failed and were unable to pay up.

Have we learned that counter-party risk matters? As of December 2010, the derivatives market has further increased to $601 Trillion, and investors continue to purchase hedged products assuming their counter-party will be able to pay.

Diversification Matters.  Diversification was a casualty of the Great Recession. At first glance, diversification failed investors in 2008-2009 and its merits are in question. According to Lipper, as of March 2009 the average US stock fund had a 1-year decline of nearly 38% and international funds fell 46% — we expect this in a recession. But prominent bond funds, which were suppose to protect us, fell anywhere from 5% to 20%. Of course our hedges didn’t work either because our counter-parties couldn’t pay.

In reality, what failed investors wasn’t diversification; it was ignoring risk. Most core bond funds had sold off US Treasuries in favor of higher-yielding, higher-risk holdings. Yet during the same 1-year period, US Treasuries returned over 7% and would have significantly helped investors who were appropriately diversified. Furthermore, even if you missed the protection of Treasuries, the following 12 months saw dramatic reversals of these declines in all types of assets. Investors who simply adhered to their diversification and rebalancing plans where made whole and then some long before the media announced that the Dow and S&P 500 had finally recovered.

Diversification — not the neat and tidy version of Modern Portfolio Theory sold to us by Wall Street, but a more attentive and nuanced dance with asset valuations, with the goal of avoiding unnecessary risks — works.

Family and Community Matters.  Recessions are touted as a national economic phenomenon. In reality they are a deeply personal tragedy for many, while others are largely unaffected. Perhaps the most important lesson we can learn from the Great Recession is that in some form it is our individual responsibility to help those affected within our family, community, nation, and globally. For many reasons, this responsibility is best fulfilled by each one of us directly, with a collective system (government, community, charity) in place to catch those who are not reached personally. The alternative is to entirely defer these obligations to our government and watch as our resources are inefficiently utilized amid bureaucracy, rampant fraud, and further debt.

When we take the time to invest in our family, and participate in and contribute to our community, life becomes more fulfilling and rewarding, and significantly less painful for those experiencing personal recessions or tragedy. Simultaneously, we are establishing a personal hedge against future recessions that cannot be matched by any individual investment portfolio.

We would do well to learn and apply the specific financial lessons of the Great Recession — they will serve us well in the future. The next “Great” economic cycle will bring more lessons, some of which we won’t foresee, and some that we know we should have already learned.

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