‘If you didn’t see that train coming, you weren’t paying attention’

By the final quarter of 2006, Mark Canavan could tell disaster was looming in the US real estate sector and the wider financial markets.

Banks were leveraged 30 to 1 or loaded with illiquid assets. Balance sheets were stacked with asset-backed commercial paper, and a lack of transparency left nearly everyone in the dark. As Canavan now puts it, “everything was insane”. 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 was buying billions of dollars of the asset-backed commercial paper financing the country’s out-of-control real estate boom. By the start of 2007, Canavan had seen enough to sense 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. Had it continued on its previous course, Canavan estimates the treasury would have lost around $300 million during the crisis.

“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, who were not paying attention.”

 

Déjà vu

Although there had been nothing like the 2008 crash in his lifetime, Canavan had seen many of its symptoms during a much smaller crisis more than two decades prior.

Canavan’s formative experience came during the 1994 bond market crisis. As the economy crawled out of the 1991 recession, the Federal Reserve began raising interest rates. Thirty-year Treasury rates crept from 6.2 percent to 7.75 percent over a nine-month period, leading to a sharp and sudden sell-off in the bond market. The crash did not derail the economy, but it did precipitate the bankruptcy of Orange County, California and helped trigger an economic crisis in Mexico.

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.

For one, he learnt not to put too much faith in the ratings agencies. Both Moody’s and Standard & Poor’s had rated the county’s bonds AA. That proved meaningless when the Fed’s interest rate hike hit.

“They were AA on Friday and bankrupt by Monday afternoon,” Canavan says.

That experience stayed with him in the run-up to the global financial crisis, as the ‘Big Three’ ratings agencies began slapping triple-A ratings on complex, opaque securities backing doomed subprime mortgages. Each time he heard a colleague insist that a collateralised debt obligation must be trustworthy because it had received an investment-grade rating, Canavan would cringe.

“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.”

The 2008 crash was preceded by a yield-curve inversion, which occurs when short-term borrowing rates rise above long-term rates. This had also preceded the bond crisis, as lenders had been borrowing money short-term at a low rate and lending it long-term at a higher rate.

“Products had been put together with ‘borrow short, lend long’, and you just saw them get annihilated,” he says.

When the yield curve inverted in the closing days of 2005, many financial experts were unfazed. Canavan saw the system blinking red.

 

The crash

In 2007, Canavan was hired by the $12 billion New Mexico Educational Retirement Board, beginning his tenure the day before the new year. When he applied for the position, the job description asked for applicants who could buy real estate for the board. When he took the position, Canavan recommended the agency steer clear of these investments and instead put its money into infrastructure.

“I deemed infrastructure to be way more defensive than real estate,” he says.

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 – and staying away from real estate investments, Canavan says, was the best call he made during the crisis.

Canavan took several lessons from the crisis. For one, he says, he will never do another bank-sponsored infrastructure fund.

“In a time of crisis, the bank will show you that they are not loyal to you,” he adds.

The reasonably satisfactory performance of his infrastructure portfolio confirmed his view of the asset class.

“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.

 

Danger ahead?

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. I had seen a yield curve invert before. I had seen people have lots of leverage borrowing short and lending long,” he explains. “I have never seen the environment we are in.”

The difference today is the centrality of government policy. After the crash, the Federal Reserve looked to prevent another depression by loading trillions of dollars on its balance sheet. Before the crash, the Fed’s balance sheet was below $1 trillion. Today it stands close to $4.5 trillion.

“This is a policy-driven market,” he says. “A lot of where we are economically is based on Fed policy and the people’s belief that if things go bad again, the Fed will just flood the market with money to support it.”

This means that predicting government policy is arguably more important than correctly reading market forces.

“I live one foot in, ‘Well what happens when inflation hits?’, Canavan notes. “And I have my other foot in, ‘Well what happens if we get hit with a recession again?’.”

Canavan concludes: “You have a market where somebody changed the rules of the game.”