Sailing through rough waters

The market conditions which major world economies have been experiencing over the past 3 months have battered even the most experienced investor. The ‘perfect storm’ of mortgage-backed investments, falling real estate prices, failing retail and investments banks, and imploding equity markets, has once again reminded investors that markets can turn, and turn quickly.


Panic-induced selling, not really seen since Black Monday in 1987, has beaten down share prices of even the most stalwart of corporations; some even foolishly proclaim that we are seeing the end of capitalism as we know it.
This current financial crisis began like many do, based on good intentions, as those in the Clinton administration wished for increased home ownership amongst the economically challenged. This added to a housing bubble everyone has talked about for the past 7+ years which was fueling a credit balloon which politicians, investors, and news sources chose to ignore until it was too late. In the 2nd and 3rd quarter the sub-prime domino fell hard on the rest of the market, leaving very few sectors untouched. Where inflation was the word on everyone’s lips at the beginning of the year, it has quickly been replaced by the word recession today.
The ‘sub-prime crisis’ can trace its origins to the easing of banking regulations by the US congress in the late 90’s which sought to increase home ownership under the false assumption that housing values would continue to rise, making good investments for those who have been traditionally shut out of home ownership. Sub-prime loans refer to mortgages given to individuals with poor or no credit ratings, but also included those 2nd or multiple-home purchases with no, or little, money down. Prior to regulatory easing, banks would routinely deny mortgages due to considerable default risk of loan repayment. However after the easing, banks and loan facilities found additional profit through ballooning interest rates payments and recouped losses from defaults by selling foreclosed property in a rising market.

Securization
Since banks are in business to make money, primarily through the borrowing and lending of money, they sought for a way to spread their market risk on these loans with investors, by bundling these mortgages together into an investment product; the process is called securitization, which offers investors a stream of income from the loan repayment from the ‘mortgage backed securities’ (MBS). Although the property sector has historically been considered a lower risk investment because of the resiliency of property values, mutual funds, hedge funds, and individual investors, under the false assumption that housing prices would continue to rise, didn’t properly assess the risk.
The whole house of cards started to fall as interest rates climbed. As it became more expensive to borrow, the once-seemingly irreversible buying pressure on the housing market fell off. Loan holders defaulted as mortgages became greater than the value of the property, which when foreclosed, reverted into the hands of the bank. With properties being worth less, banks were not capable of recovering their full values, leaving them not only with the loss of the revenue stream, but also unable to unload the property which had decreased in value. Where does this leave the holders of mortgage-backed investments, when an anticipated stream of income from mortgages payments has ceased, coupled with rapidly falling property values?
A downward cycle has been created from these devaluations of property prices, defaults on mortgage payments, asset prices on securities issued from the mortgages, tightening of credit by banks that have less money to loan, restricting the ability for individuals and businesses to borrow, which is like throwing a wrench into the gear works, which leads us to our present situation.
This ‘perfect storm’ of previously uncorrelated risks have shifted together to create systemic risk which destabilized the entire financial market, emboldening politicians to act rashly or state they we have seen the end of market-driven capitalism. The truth is that words like these further pressure an already teetering market. Fortunately, through this adversity there can be seen some brightness. World leaders are coming together to work in concert to get the economic motor moving again, even those with deep historic grievances such as China, Japan and South Korea. We can only hope that through these trials, the market emerges on the other side healthier and stronger than it was before.

Liam Crow

17.12.2008