China’s Evergrande saga is troubling, and it could definitely signal coming ruptures in China’s real estate and financial markets. But suggesting it’s a “Lehman moment” gets the magnitude wrong and distorts some important lessons form the financial crash of 2008. If anything, the giant property developer poised to default on billions in debt is a “Bear Stearns moment,” a distinction that clarifies what might be similar to the 2008 crash, and what might be different.
Here’s a very abbreviated synopsis of the 2008 crash. The housing bubble peaked in 2006, and as unsustainable prices began to fall, mounds of risky debt issued on the premise of ever-rising prices began to go bad. One of the first public signs of trouble was the collapse of two Bear Stearns hedge funds heavily invested in subprime mortgages. That happened in the summer of 2007. Many other totemic financial firms, including Merrill Lynch, Citigroup and Bank of America, began reporting giant losses related to subprime loans.
Bear Stearns was the first major financial firm to collapse, in March 2008. JPMorgan Chase (JPM) bought it for a fire-sale price, with backing from the U.S. government. Since JPMorgan honored Bear’s debts, that prevented a panic, for a while. Bank losses kept mounting, however, and they spread to Europe and elsewhere. California bank IndyMac failed in July 2008, becoming the largest thrift ever taken over by the U.S. government. Then in September, the mortgage giants Fannie Mae and Freddie Mac essentially ran out of money and the U.S. government took them over.
Residents pass near the headquarters for Evergrande in Shenzhen in southern China, Thursday, Sept. 23, 2021. The Chinese real estate developer whose struggle to avoid defaulting on billions of dollars of debt has rattled global markets says it will pay interest due Thursday to bondholders in China but gave no sign of plans to pay on a separate bond abroad. (AP Photo/Ng Han Guan) ·ASSOCIATED PRESS
Markets were in turmoil at this point, causing extreme pressure at Lehman, which also had gargantuan subprime bets going bad. Lehman executives thought the government would save the firm as it had saved others, but Lehman proved too big and damaged to bail out. The firm declared bankruptcy on Sept. 15, 2008, which meant it would not be able to honor up to $600 billion in debt on its books.
That was an epic development because if Lehman could default, any bank could fail, triggering a 1930s-style run on the financial system. But Lehman wasn’t the beginning of the financial crisis. In fact, the Lehman bankruptcy occurred years after the U.S. real-estate market got out of hand and some 15 months after the first tangible signs of trouble. By the time of the Lehman cataclysm, many other canaries had already croaked.
The direction of the stock market shows how the level of public concern mounted. The Bear Stearns hedge fund failures in mid-2007 were the first sign of a crash coming, but the market didn’t register concern. Stocks rose into October, when a 5-year bull market ended as the S&P 500 stock index topped out at 1,562. In January 2008, the S&P 500 entered a correction, down 10% from the peak. But when all of Bear Stearns failed two months later, stocks remained steady, buoyed by aggressive government action to contain the damage. By May, the S&P regained a few points.
The S&P 500 index for 2008 and 2009. Source: Yahoo Finance ·The S&P 500 index for 2008 and 2009. Source: Yahoo Finance
That summer, however, mounting financial losses finally started to spook investors. By July 2008, the S&P was down 20% from the prior peak—a bear market. Stocks zig-zagged for the next two months, but panic selling began after Lehman’s bankruptcy, leaving the S&P 500 down 40% from the peak nearly a year earlier. The index would ultimately lose 57% of its value by the time it bottomed out in March 2009.
The impact of a default
If Evergrande has an analog in the U.S. financial crisis, it’s Bear Stearns, not Lehman Brothers. The hedge fund failures at Bear were an early indicator of trouble that eventually swallowed the whole firm. Evergrande may be the same. There’s substantial evidence of debt bubbles in China, and if Evergrande defaults on some or all of the $300 billion it owes, as expected, that will send tremors well beyond China, to global portfolios holding debt directly or indirectly affected by Evergrande’s default.
The main questions in 2007 and 2008 were how vast the subprime problem was, how interconnected the money-losers were and how deeply any given default would reverberate. The answers turned out to be far worse that most analysts guessed at the time. Those are the same questions investors have about Evergrande now. If Evergrande’s debt holders can bear whatever losses are coming their way, the problem will remain contained. If those losses metastasize, it will become a far-flung crisis.
One lesson from the financial crash is that this could play out over months, and come in cycles. Investors might think the worst is over and try to cash in on a relief rally, only to find the skies darkening again. Global stock markets have begun to reflect this uncertainty, with selloffs followed by rallies as traders worry about China’s debt problem one day, then decide it’s overblown the next.
A man walks past a residential building developed by Evergrande in Pudong district in Shanghai on September 22, 2021. (Photo by Hector RETAMAL / AFP) (Photo by HECTOR RETAMAL/AFP via Getty Images) ·HECTOR RETAMAL via Getty Images
As in 2008, government response is key. Markets seem to think China’s leadership has the tools to defuse a full-blown meltdown, and the willingness to do it, if things get bad enough. China’s Communist party actually precipitated the Evergrande mess to some extent, by forcing developers to pare debt during the last few years as a way to cool an overheated property sector. If the Chinese government can tighten credit standards, it can loosen them in an emergency, right? Can’t China call the whole thing off when the pain has reined in the raucous borrowers and lenders China is really targeting?
In 2008, investors had too much faith in Washington’s ability to fight the fire. Quick government action helped JPMorgan assume Bear Stearns’ assets and liabilities, preventing Bear’s failure from causing a massive domino effect in financial markets. That restored shaken confidence and fueled hope that Bear’s failure was a one-off. But Lehman was much bigger than Bear. Its collapse six months later came at a more perilous time, when the feds couldn’t engineer a bailout. Lehman’s failure triggered the crash that had been years in the making.
China’s leadership has been clipping the wings of other high-flying firms in tech and other sectors. This appears to be a deliberate, massive restructuring of the economy by President Xi Jinping, who’s aiming to secure a political dynasty by deflating the billionaire class and fomenting “common prosperity.” Xi doesn’t mind causing billionaires some heartache, but he seems to think he can control the economy better than his counterparts in Washington could back in 2008. Place your bets based on whether you think he’s right.
