8/9/2007 – When the Music Stopped but the Bankers Were Still Dancing

Benjamin M. Lavine, CFA, CAIA


“When the Music Stops, in terms of liquidity, things will be complicated.  But as long as the music is playing, you’ve got to get up and dance.  We’re still dancing.” – Then Citigroup CEO Chuck Prince in a Financial Times interview circa July 2017 (via Time Business).

Much has been written about the 2008 Great Recession and Financial Crisis, and much more will be written as we approach the 10-year anniversary of the Lehman Brothers failure.  Now, 10 years may seem like the Cretaceous period for many young investors who grew up on today’s ubiquitous technology like smartphones, tablets, social media, the sharing economy, etc., that didn’t exist 10 years ago.  But, we encourage readers to search out 10-year anniversary retrospective periods of one of the most tumultuous market epochs that almost sank the entire global financial system, a prospect that much of the everyday world outside of Wall Street and coastal housing bubble regions, seemed oblivious to. 

In contemplating our own retrospective piece covering infamous 10-year markers culminating in the enormous January-February 2009 market sell-off, we first thought about reminding readers that we are approaching the 10-year anniversary of Fannie Mae’s and Freddie Mac’s placements into conservatorship.  In this event, on September 6, 2008 the market finally acknowledged that investment losses tied to weakness in U.S. home prices had reached ‘enterprise’ proportions.

By 1Q2007, both agencies had accumulated a total book of business of $4.5 trillion consisting of mortgage-backed securities (MBS) and retained mortgage portfolios. $170 billion of of this book was comprised of the AAA-rated tranche of subprime mortgage pools.  As mortgage guarantors, both Fannie Mae and Freddie Mac felt the initial impact of the weakness in U.S. housing, that started in 2007, when both agencies began to experience large losses on their retained portfolios, particularly the Alt-A and subprime investments.   

In early September 2008 these government sponsored enterprises’ (GSE) regulator, the Federal Housing Financial Authority (FHFA), concluded that the GSEs would soon be insolvent due to the accumulated losses in their retained portfolios and mortgage guarantees.  In bailing out the GSEs, the U.S. government left taxpayers on the hook for future losses beyond the GSEs’ capital cushions, which were shrinking by the day.  A week later, Lehman Brothers filed for bankruptcy as the U.S. government refused to bail them out – a seminal event that helped contribute to the loss of $10 trillion in global equity market value the following month. 

The Fannie/Freddie debacle aside, we actually stumbled upon an 11-year anniversary marker (courtesy of an August 7, 2017 blog article published by that, when viewed in hindsight, one could argue, represented the day that the dancing stopped (however Chuck Prince and the other global bankers didn’t realize it and kept on dancing).  That day was August 9, 2007, when the Asset-backed Commercial Paper (ABCP) market peaked at just over $1.2 trillion before experiencing a precipitous decline to $800 billion by the end of 2008 (Figure 1).  This peak in ABCP issuance also happens to coincide with a press release statement from French bank BNP announcing they were suspending redemptions from three mutual funds because “the fund managers could not value the assets.” 

Figure 1: United States: Asset-Backed Commercial Paper Outstanding (Weekly Wednesday, Billions of U.S. Dollars, 2001 through 7/26/2017 (courtesy of

It also just so happened that the great August 2007 Quant Meltdown coincided with the peak of ABCP issuance, but that was probably just coincidence (yes, there were several mini-market signs that indicated the volcano was about to erupt, but that is, of course, is pure hindsight except for those few who participated in the Big Short).  Indeed, global equity markets reached new highs in the fourth quarter of 2007 as the initial cracks that surfaced in U.S. housing (subprime loans not seasoning well) were initially dismissed as “contained.” 

You see, the peak in ABCP issuance figuratively represented the day the music stopped – music for investor confidence (suspension of fund redemptions) and music for wholesale lending (commercial paper).  Commercial paper issuance represented the lifeblood of financing most investments (and their derivatives, and the derivatives tied to those derivatives) that were linked to U.S. housing.  As long as the collateral (housing) held up, bankers and mortgage investors could keep on dancing – through financial alchemy, subprime borrowing can be transformed into AAA borrowing via collateralized leveraged vehicles.

But the 8/9/2007 BNP Paribas statement revealed that the collateral no longer held up, and the music stopped for the three mutual funds that held assets tied to that collateral.  And confidence was emblematic of the participation of the retail public, whether buying houses on spec with minimal credit or investing in high yielding securities tied to U.S. housing. 

Tainted Meat in 2018?

Since the great housing earthquake that shook financial markets in 2008, there have been notable aftershocks as other heavily levered entities faced their own music-stopping moments such as the Greek sovereign debt crisis in 2011-2012 and the commodity market collapse in 2014-2016 that was still banking on Chinese economic growth.  A crisis occurs when the financiers and lending institutions run for the exits because they don’t want to get caught with ‘tainted meat’ (see the Gorton analogy that helps explain how the repurchase agreement repo market seized up as lenders questioned the health of the underlying collateral tied to those repos). 

The 2007-2008 housing meltdown experience demonstrated how financial contagion occurs when the deteriorating fundamentals in one subcomponent of an asset class can quickly spill over into other areas as a combination of leverage and loss of confidence result in a broad brush being painted over everything.  Few have the time or wherewithal to determine what is good meat versus tainted meat.  Hence, why we saw the Federal Reserve and U.S. government step in with their bailouts in order to restore confidence into financial markets and give lending institutions time to sort out the good lending from the bad. 

As we write this, the ‘tainted meat’ concern of the moment is Turkey (no pun intended, seriously), which when viewed in isolation, is a small component of total market capitalization.  But the relative weakness in emerging markets that began around the time of Trump trade war rhetoric towards the end of the first quarter morphed into ‘contagion’ concerns when the Financial Times reported on ECB concerns over the European Union bank exposure to Turkey.  Among emerging market countries, Turkey has the highest external debt-to-GDP ratio at nearly 55%, and a deteriorating lira (down 66% against the U.S. dollar since August 2014 when Recep Tayyip Erdogan became president) adds to this high debt burden. 

So, a loss of confidence in Turkey’s ability to meet its debt obligations (or willingness – see Venezuela under Hugo Chavez) can turn into a contagion-driven sell-off where all emerging market investing is viewed as suspect, especially with a tariff-happy U.S. president and a Chinese government trying to manage its breakneck growth in a more sustainable manner.  The choices facing President Erdogan (rate hikes, IMF involvement) are not very palatable; hence, the ‘blame foreigner’ rhetoric reminiscent of Mahathir Mohamad, Malaysia Prime Minister during the 1997 Asian Currency Crisis and threatening capital controls.   

The saving grace (?) for emerging market investors is that equity market valuations are starting to look very attractive (Figure 2), especially if expected earnings can stabilize (much of the recent decline in estimates is due to currency weakness). 

Figure 2 – Emerging Market Valuation (Orange Line) Looks Attractive if Earnings Estimates (White Line) Can Stabilize

Source: Bloomberg (MSCI Emerging Markets Index).

This is not to dismiss the real threat of contagion spreading across emerging markets, as investors reassess the growth story in light of high external debt levels (South Africa, Latin America), trade tariffs, questions concerning China growth, and Russian sanctions.  But emerging markets are priced with higher risk, via lower valuations, which investors expect to be compensated with over the long run.

So, as we reflect on the 10-year anniversary of the 2008 Financial Crisis, investors should be cognizant of what kinds of investment risks they are willing to take and at what premium.  Did the music stop for emerging markets as investors are unwilling to debt-finance further growth?  Time will tell, but equity markets are starting to price in a binary outcome for the future of emerging market prospects. 


The above is the opinion of the author and should not be relied upon as investment advice or a forecast of the future.  It is not a recommendation, offer or solicitation to buy or sell any securities or implement any investment strategy.  It is for informational purposes only.  The above statistics, data, anecdotes and opinions of others are assumed to be true and accurate however 3D Asset Management does not warrant the accuracy of any of these.  There is also no assurance that any of the above are all inclusive or complete.

Past performance is no guarantee of future results.  None of the services offered by 3D Asset Management are insured by the FDIC and the reader is reminded that all investments contain risk.  The opinions offered above are as August 13, 2018 and are subject to change as influencing factors change.

More detail regarding 3D Asset Management, its products, services, personnel, fees and investment methodologies are available in the firm’s Form ADV Part 2 which is available upon request by calling (860) 291-1998, option 2 or emailing or visiting 3D’s website at

By: Benjamin Lavine