How did we get here?

Over the last 10 years, legislative changes transformed the fi nancial services industry. The Gramm-Leach-Bliley Act of 1999 effectively repealed the Glass-Steagall Act of 1933. This Great Depression era act had separated lending (the extension of credit) and investing (the use of credit). Combining both activities in the same fi nancial services entity had led to abuses that threatened the safety of deposits. The repeal in 1999 allowed for consolidation between commercial banks, investment banks, and insurance companies, blurring the distinctions between lines of business and regulatory oversight. As a result, the traditional roles of financial institutions changed:

One outcome of this transformation was an explosion in the volume of mortgage originations. At the same time, relatively low interest rates set by the Federal Reserve Bank and other Central Banks following the 2001 recession triggered a boom in housing activity. The typical home price rose from about 3.5 times household income to 5.0 times income by mid-2006. Financing from the investment banks was abundant, mortgage rates were low, home prices were rising, and volume was the key driver of profi ts. So, the lending extended to less credit-worthy borrowers than traditional mortgage lending, as innovations in structured fi nance broadened the appetite for mortgage debt in a yield-hungry marketplace.

Each day the credit markets are frozen, the consequences for the economy and markets become more severe, deepening the recession and bear market.

Tight credit spreads forced the investment banks to use high amounts of leverage through debt issuance in order to increase the profi t on investments. To illustrate the problem, consider that a homeowner would be leveraged 5-to-1 with a purchase of a home with 20% down payment and an 80% mortgage. With a 5-to-1 ratio, when the price of the homedeclines 10%, the value of the homeowners’ equity would be cut by 50%. Some investment banks were leveraged 20-to-1 or even 30-to-1 on their housing-related investments. With 94% of mortgage holders still paying on time, mortgages debt is not suddenly worthless now that home prices have declined 10-20% from the peak, but even a modest decline in the value of the mortgage debt can have devastating consequences on a fi nancial institution when they are magnifi ed 20–to-1. The investment banks relied on quantitative tools that used historical inputs to measure risk on these new types of investments, which resulted in an underrepresentation of the actual potential losses to those inside and outside these institutions.

The changes among fi nancial institutions also meant funding for investment became more dependent upon investment banks borrowing from other banks, whereas in the past funding relied more upon commercial bank deposits. As prices began to slide, investment banks became unable to raise funds from other banks and were forced to sell their investments. With the investment banks having made up a large portion of the demand for these securities in recent years, there were few buyers to absorb the supply. This process accelerated the decline in the value in the securities and the prices entered freefall causing interbank lending to seize up in September.

This seizing up in the credit markets has made it much harder for nonfi nancial businesses to borrow to fund their businesses. Each day the credit markets are frozen, the consequences for the economy and markets become more severe, deepening the recession and bear market.

How will we get out?

Policy makers have introduced enormous and unprecedented policy actions to thaw the fi nancial markets and restore funding to troubled fi nancial institutions:

We expect that there are likely even more dramatic announcements on the way, including direct equity injections and guaranteed bank lending in order to restore confi dence in the interbank lending market. Last week, UK Prime Minister Gordon Brown allocated $87 billion to recapitalize UK banks in exchange for shares. The British rescue package also would provide a guarantee of about $430 billion to help banks refi nance debt. Other countries, led by Germany and France, pledged to take equity stakes in distressed banks and vowed to guarantee bank lending. In the United States, Treasury secretary Paulson said such action by the Treasury would be in nonvoting stock to avoid the appearance of nationalization and a governmental role in decision making. This effectively would leave U.S. fi nancial institutions with suffi cient capital, while leaving the government with a recently enhanced regulatory backstop to protect taxpayers.

 

The trillions of dollars being marshaled to stabilize the global financial markets are likely to prove to be successful, with signs of progress evident in the coming weeks. Bear markets of this magnitude nearly always pull back after an initial rally. This “retest” is often the result of lingering uncertainty over the potentially negative unintended consequences of policy actions, in addition to the reassessment of the depth and likely duration of the recession.

Intervention by policy makers has consistently marked the turning point for bear markets and limited the duration of recessions, in the past. While this fi nancial crisis is more severe than most, the scope of the policy response is unprecedented. And while key policy actions are taking precious weeks to implement, the trillions of dollars being marshaled to stabilize the global fi nancial markets are likely to prove to be successful, with signs of progress evident in the coming weeks.

• Sweeping regulatory changes – A tremendous amount of uncertainty results from the likelihood of broad changes including consolidation of regulatory agencies, expanded oversight by the Federal Reserve, and new rules covering everything from predatory lending practices to short selling. This uncertainty may weigh on the markets.
• More political oversight – With all of Washington closely involved in the new regulatory framework, it is likely that more “politicized” overseers may be appointed, which may introduce a new philosophical dimension to enforcement.
• More conservative consumer fi nancing – Consumers will fi nd borrowing harder due to tighter lending standards combined with less capital and higher rates. It has been a long time since consumers have been without easy and abundant credit, and the degree that this tightening will impact spending is uncertain.
• Insurance regulation – The government’s loan to AIG raises the issue of whether the insurance industry should come under some type of federal regulation.
• Changes at rating agencies – The business model of the credit rating agencies may be forced to change to separate confl ict of interest between consulting with issuers and rating them.

What are the consequences

• The future of Fannie and Freddie – Congress must decide what to do about the future of the companies that help provide capital to 50% of the mortgage market. The potential for a breakup and re-introduction to the private markets has raised a lot of questions.
  
  
• Lower leverage for fi nancials – Further deleveraging and lower returns on capital are likely, for enhanced safety for the fi nancial system. We also expect higher borrowing costs and less risk-taking to result from policy actions.
  
  
• Global coordination – Effective regulatory and economic policy-making increasingly requires integration across borders, adding another complicated dimension to efforts to achieve fi nancial stability on an ongoing basis.
  
  
• Inflation fears – Market participants may fear that these policy actions pumping money into the fi nancial system may reignite infl ation pressures, as policy makers opted to address the risks to growth at the expense of potentially higher infl ation. Another fi scal stimulus plan to boost the economy is likely next year under the next administration and Congress, which may raise concerns that weak demand and more money supply could lead to higher prices. Rising infl ation would be bad news for fi nancial assets.
  
  
• Changes of legal form to avoid regulatory backlash – In response to the reforms stemming from the Sarbanes-Oxley Act of 2002, many companies opted out of the public markets. A drain of value from the public markets might result as healthy fi nancial fi rms choose a partnership structure or re-mutualization.

What should investors do?

First, do not panic and sell all of your investments. While the markets may continue to fall in the coming days, they are currently extremely oversold by those forced to sell. All the policy actions discussed are very likely to limit the duration and depth of the recession and turn the stock and credit markets around after a record-breaking plunge. The investments you do not need to use for living expenses in the coming year or two should remain invested.

Second, these interventions leave lingering uncertainties surrounding their unintended consequences, which are likely to foster a high volatility environment and may warrant a shift in your portfolio. The focus on whether markets will go up or down is misplaced—they will go up AND down. Rather than a period of rising or falling markets, we may be entering a bull market for volatility. From early 2003 to late 2007, the stock and bond markets exhibited unusually low volatility. While in general, stock and credit markets marched steadily upward, investments that benefi t from volatility languished. The market environment ahead is likely to differ. Rather than investing purely directionally for either a rising or a falling market, focusing on the types of alternative investments that benefi t from high market volatility, may be increasingly effective at helping manage risk and return.

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IMPORTANT DISCLOSURES Investing in international and emerging markets may entail additional risks such as currency fl uctuation and political instability. Investing in small-cap stocks includes specifi c risks such as greater volatility and potentially less liquidity.

Stock investing involves risk including loss of principal Past performance is not a guarantee of future results.

Bonds are subject to market and interest rate risk if sold prior to maturity. Bond values will decline as interest rate rise and are subject to availability and change in price.

The opinions voiced in this material are for general information only and are not intended to provide specifi c advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, consult your fi nancial advisor prior to investing. All performance reference is historical and is no guarantee of future results. All indices are unmanaged and cannot be invested into directly.

© LPL Financial

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