By the final quarter of 2006, Mark Canavan could tell disaster was looming in the US real estate sector and the wider financial markets. As Canavan now puts it, “everything was insane”.
What he was seeing in the markets – banks leveraged 30 to 1 or loaded up with illiquid assets – had become increasingly terrifying. But Canavan didn’t need any window into the financial world to see how badly things were amiss.
“My wife and I qualified for a loan in 2005 that would have left us with a mortgage payment that was 60 percent of our after-tax income,” he recalls. “People were getting loans with 540 credit ratings, with nothing down, at 105 percent of the value of the house.” For those not familiar with the US’s FICO scoring system, a 540 credit rating is very poor.
Canavan was working at the time for the New Mexico state treasurer’s office, which had been buying billions of dollars of the asset-backed commercial paper that was financing the country’s out-of-control real estate boom.
“In a time of crisis, the bank will show you that they are not loyal to you”
By the start of 2007, Canavan had seen enough to know disaster was on the horizon. That March, he fired off an email to Joelle Mevi, the treasury’s chief investment officer.
“I highly recommend not purchasing any more asset-backed [commercial paper] for the moment,” he wrote. “The credit default swap market will be generating some big losses for providers and until we can better assess exposure to [home equity] assets in our [commercial paper] programmes we should keep to direct obligations of top-rated corporations.”
The treasury stopped buying the doomed mortgage-backed securities and let its existing exposure roll off the books. By the time the Federal Reserve began cutting interest rates in response to a global credit crunch that autumn, the treasury’s portfolio was insulated from the fallout.
“If you sat in the seat I was sitting in at the state treasurer’s office and you didn’t see that train coming, then you weren’t paying attention,” Canavan says. “And I know a lot of people, frankly, that were not paying attention.”
Keep an eye on yield-curve inversions
Canavan’s formative experience came during the 1994 bond market crisis. After an ill-timed interest rate hike, the bond market experienced a sharp and sudden sell-off that triggered, among other things, the bankruptcy of Orange County, California.
At the time, Canavan was working at Merrill Lynch as a financial advisor. Though he did not lose money, and the crisis barely registered on a global scale, living through it left an impression. He learnt not to put too much faith in the ratings agencies. In the run-up to the global financial crisis, he remembers hearing others in the industry insist that any collateralised debt obligation with an investment-grade rating must be trustworthy.
“I kept telling my peers: ‘You’ve got to do your own homework. You can never trust these ratings’,” he says. “That kind of naïveté was widespread then, and it’s still widespread.”
Canavan also learnt to watch out for yield-curve inversions, which occur when short-term borrowing rates rise above long-term rates. This was one precursor to the bond crisis, and when the yield curve inverted in the closing days of 2005, Canavan saw the system blinking red.
In 2007, Canavan was hired by the $12 billion New Mexico Educational Retirement Board, where he serves as senior portfolio manager for real estate, infrastructure and real assets, beginning his tenure the day before the new year. Though the job description sought someone to buy real estate, Canavan recommended the agency steer clear of these investments and instead put its money into infrastructure.
“Infrastructure, when it is done right and conservatively levered, is a defensive asset class relative to real estate, energy, the other real assets and the market in general,” Canavan says.
“I have never seen the environment we are in. You have a market where somebody changed the rules of the game”
Canavan’s infrastructure portfolio “didn’t knock the cover off the ball”. One bank-sponsored fund took a beating, posting a -3.8 net IRR. But, overall, the portfolio weathered the storm.
Canavan took several lessons from the crisis. For one, he will never do another bank-sponsored infrastructure fund, he says.
“In a time of crisis, the bank will show you that they are not loyal to you,” he adds.
When the train hit in 2008, Canavan had been prescient enough not to be caught on the tracks. But he is not counting on the same foresight in the next crisis, whenever it arrives.
“I saw the last one coming because it was familiar terrain,” he explains. “I had seen a yield curve invert before. I had seen people have lots of leverage borrowing short and lending long.”
He cannot say the same today. “I have never seen the environment we are in,” he adds.
The difference today is the centrality of government policy, namely the Federal Reserve, which loaded trillions of dollars on to its balance sheet to stave off a depression. Now, predicting government policy is arguably more important than correctly reading market forces.
“You have a market where somebody changed the rules of the game,” Canavan concludes.
This story is part of a series of cross-asset class interviews with LPs on how they look back on the impact of the global financial crisis a decade later. Watch out for more of these soon.