A Message from the Chief Investment Officer: How Did the World Financial Crisis Happen?

Last week, we discussed how the current crisis in the financial markets has affected investments supporting retirement programs administered by the General Board of Pension and Health Benefits (General Board). Today, we will address the origin and evolution of the crisis.

For several years prior to the summer of 2007, the supply of money available for investing was abundant. Interest rates declined, and many investors, both financial institutions and individuals, looked for ways to increase rates of return. In response, financial institutions created investment products to meet this demand.

Trust was plentiful, and those who loaned funds believed that their money would be returned, along with suitable interest and earnings. Many chose to invest without conducting sufficient research, so they did not fully understand the risks involved. In addition, many investors, especially financial institutions, combined borrowed funds (known as leverage) with their own capital to make larger amounts of risky investments in order to further boost returns.

During the summer of 2007, the term subprime mortgage loan became widely known when financial institutions began reporting losses from their lending activity. Housing foreclosures soon followed, along with changes in lending standards that made it more difficult to finance the purchase of a home, and housing prices fell.

Beginning in the spring of 2008, some large and well-respected financial institutions began to fail. Losses resulting from these failures were widespread and impacted U.S. and world stock and bond markets. Investors soon lost confidence in the credit markets.

The current investment and credit climate can best be described as one gripped with fear. Investors—from individuals to large institutions—are paralyzed and reluctant to accept any investment risk. The trust that existed has evaporated. Even the most creditworthy borrowers are having a difficult time accessing the credit markets. A massive “deleveraging” is taking place.

Investors who borrowed money are being forced to sell their investments to return the funds they borrowed. Even some investors who held money market funds, which are considered low-risk investments, have seen losses in the value of their accounts. Indeed, with few exceptions, all investments except U.S. government securities and securities guaranteed by the U.S. government, considered the safest ones in the world, have experienced significant declines in value.

Until some semblance of normalcy returns to the credit markets, the economy cannot operate effectively. Last week, I wrote that we at the General Board are confident that policies will ultimately be implemented that will allow credit to begin flowing again. Although the current market crisis has tested the patience and endurance of even the most experienced investors, I also wrote that we do not believe that it is prudent to abandon our consistent, long-term and disciplined strategy for managing a diversified investment program. This strategy has stood the test of time during up and down markets, and we believe that it remains the best strategy for our participants.

Dave Zellner
Chief Investment Officer
General Board of Pension and Health Benefits