The Markets: Fear and Greed - Are We Done Yet?

The current financial problems in the US are of great concern to people all over the world. Even seasoned market professionals are watching in awe as the various regulatory agencies in the US attempt to contain the collateral damage from the failure of Lehman Brothers, until recently the fourth largest investment bank in the US and a 158 year survivor of many prior market convulsions, the near failures of Merrill Lynch and AIG and the conversion of J.P. Morgan and Goldman Sachs into bank holding companies. Will the bail out announced last week work or this just one more step toward the eventual collapse of the US financial sector as we know it?

To answer the question, we first have to look at the root causes of the problem and then assess whether those causes have been rectified. Only when the root causes have been rectified will the US financial sector start working its way back to good health.

There are three basic causes of the financial market meltdown in the US. The first was a misguided belief that real estate prices could continue to rise quickly for some infinite period of time without any negative consequences. The second problem was a banking sector that totally ignored risk in their lending practices. The third problem was an increasing reliance on debt financing. Lets look at each of these in turn.

US residential housing prices have risen slowly for many years. For example, according to the Fidelity Research Institute, the returns on a dollar invested in US real estate since 1963 have been only slightly better than the returns on low-risk Treasury bills, the returns on which tend to approximately equal inflation. For example, one dollar invested in common stocks in 1963 would have appreciated to $12.63 by 2006. One dollar invested in real estate would have risen to just $1.79. Even in the highest-appreciating regions of the US, the NE & the West Coast respectively, an investor would have realized annual real returns of just 2.35% and 2.49% respectively, and underperformed the 2.74% real return on bonds. Nationally, real estate only became a hot investment vehicle in 2003, fed by ultra-low interest rates and a movement away from the stock market following the tech bust of the early 2000s.

Rising house prices and the investors/speculators who were driving them higher were aided and abetted by banks that ignored risk and ceased adhering to any form of prudent lending standards. Even the names of the various products conjure up images of what was transpiring.

Liar loans were mortgages for which the borrower did not have to provide any documentation to support their reported income or assets. Of course, many borrowers lied. One bank began promoting its NINJA mortgages. NINJA stood for ëno income, no job, no assets, no problem'.

The banks were only willing to do this because they had no intention of keeping this toxic waste on their own balance sheets. Instead, they would quickly bundle pools of assets and sell them off to other investors in the form of mortgage backed securities or MBS. Wall Street got into the game by slicing and dicing these pools of securitized mortgages into various tranches or risk pools. The highest quality tranches were often awarded a triple A rating, implying the probability of default was highly remote. Only the highest risk tranches were awarded low credit ratings. According to some published reports, by the time Wall Street was done with their financial alchemy, as much as 90% of these pools of low quality loans had been awarded a AAA rating.

The investment bankers turned what had been high risk, poorly documented mortgages into what seemed to be gold plated, triple A rated securities, which in turn were purchased by investors and central banks all over the globe. Even Moodys and S&P, the big credit rating agencies, got into the game, since they were the ones handing out the highly coveted triple A ratings that allowed the securitized mortgages to be sold with yields only slightly above that of risk-free Treasury bills.

This belief in forever rising real estate prices and the cessation of any form of prudential lending standards allowed many individuals to purchase much more house than they could afford, financed almost entirely with debt, based on the belief that rising prices would allow the buyer to sell the property for much more than they had paid, thereby preventing any repayment problems.

The use of extreme amounts of debt to finance a lifestyle that they really couldn't afford was not confined to individuals. Even the largest banks on Wall Street were gorging themselves on a seemingly infinite appetite for their debt securities, offered with low spreads over risk free rates of return and typically for periods of time much shorter than the assets which they were funding. Given a steeply upward sloping yield curve, the banks were able to make enormous profits from this mismatch in term, but they ignored the liquidity risks inherent in any funding scheme that has one's liabilities coming due before the assets that they support.

Of course, in Canada this same funding mismatch led to the total freezing of the ABCP (asset backed commercial paper) market in August of 2007, when investors refused to purchase paper issued by the SIVs due to concerns about the quality of the assets backing them.

The amount of leverage used by the large Wall Street investment banks far exceeded that available to commercial banks anywhere in the world, reaching levels of $40 of assets being funded by only $1 of equity. With this kind of leverage, even a 2.5% decline in the value of the firm's assets will totally wipe out the firm's equity, forcing the firm into either a forced merger, a bailout or bankruptcy. This is exactly what has happened to Bear Stearns, Lehman, Merrill Lynch, AIG and others yet to be discovered.

With the forgoing as the precursor to today's problems, it is clear that problems in the financial sector will remain until residential real estate prices stabilize. This is likely some distance off. For example, John Burns of John Burns Real Estate Consulting, one of the most knowledgeable real estate experts in the US, states that US house prices are likely to fall by approximately 22% in total, 12% of which has already occurred. ¹Using a different methodology and measuring sales only in the 20 largest metropolitan areas, Robert Shiller, founder of the Case-Shiller Real Estate Index, believes prices will fall by approximately 30%, 17% of which has already occurred².

If these experts are correct, and there is little reason to believe they are wrong, given the tendency of all markets to revert to their mean values over time, we are only just over half of the way through the eventual fall in US house prices.

Will the bail out of the financial sector announced last week stop the bleeding? In my opinion, it will not, unless some way is found to stabilize the value of US residential property. That remains to be seen.