Let me begin with this: this is not financial Armageddon, nor is it the end of the world. However, there are some serious problems that have come home to roost and it will probably take awhile for these problems to work out. In addition, working these problems out will be painful. While a complete meltdown is not in the cards, neither is a quick rebound from current events.
Since the beginning of 2001, the US consumer has accumulated a great deal of mortgage debt. According to the Federal Reserve, total mortgage debt outstanding increased from $4.9 trillion in the first quarter of 2001 to $9.8 trillion in the first quarter of 2007. To facilitate the creation of this debt, the US financial system has developed a system called "securitization", which I explained in this article. Central to this system is the willingness of certain financial parties such as investment banks, mutual funds and other large investment pools to buy and sell large pools of mortgage debt. This system has been around for about 20-25 years and has worked very well over that period.
However, over the last few years lending standards have deteriorated. In the past for example, a borrower had to put down 5% or more of the purchase price, the mortgage payment couldn't be more than x% of the borrowers income and the borrower had to have a decent credit history. These lending standards were lowered by a sub-section of the mortgage market called the "subprime market". "Subprime" simply means a person was not a prime risk, but instead was riskier to lend to.
The system of buying and selling mortgage securities and the mortgage underwriting business worked against themselves for the last few years. As the system of buying and selling mortgages wanted more mortgages to buy and sell, mortgage underwriters were happy to oblige by writing more mortgages. This was partially responsible for the lowering of lending standards. Because there were so many mortgage investors, it was thought the risk of the less credit-worthy borrowers was spread out among enough buyers that a default wouldn't seriously hurt anybody. However, we're learning that isn't exactly true:
"For years, people have taken the view that the strength of the modern financial system was that risks were widely spread, and so when something went wrong everybody had a small piece," says Lou Crandall of RH Wrightson & Assoc. "The problem now is, everybody's got a small piece, but those pieces are actually big enough to pull some players under, which means the fact that the risks are so diffused in the system means everybody is a suspect, and that's the flip side of what we saw as the strength."
Everything changed in late July. Bear Stearns announced that two hedge funds that invested in mortgage derivatives which had previously been worth about $6 billion were now worthless. I have publicly criticized the fund's manager before and I am doing so again. He was a fool. His fund was heavily leveraged and his investments were risky. So long as the market is going up, he was a genius. But the market turned against him, forcing margin calls and essentially bankrupting the fund in short time. He deserved to lose on his bet.
The Bear Stearns situation was the first in series of announcements from three continents (Australia, the US and Europe) where funds or investment managers announced their respective funds were losing value because of their investments in subprime mortgages. Since Bear made their announcement in late July a week has not gong by without another announcement of a problem at an investment fund, bank or financial company.
Because of these announcements, the system of buying and selling mortgage securities has ground to a halt. That means the financial system has gone from fourth gear to first gear in a very short time. This alone adds stress to the financial system. This creates a very large problem: the US economy depends on the fluid functioning of the credit markets. Every day large businesses need to issue short-term commercial paper for a variety of needs. If the credit market is not working, the overall economy will be hurt.
It is this series of events in the credit market that has caused the US stocks to drop in value since about mid-July. Traders are concerned about the tightening of the credit markets enough to sell stocks. There is overall concern about the quality of some financial firms. The financial markets don't like uncertainty and there is a lot of it right now. This has fed into the current market environment, leading to more selling.
So, where does that leave us?
First, I want to caution again that this is not financial Armageddon. The US financial system is a very resilient system and it has the tools and resources to deal with this problem. However, this is not gong to go away anytime soon. In a recent radio interview on the Young Turks I described this situation as a 15-round right where both fighters are going to get very bloody. The biggest problem we have is the unknown: we simply don't know when the next bout of bad news will occur or who will make what announcement. And so long as that situation is still with us we're going to have the volatility we've experienced over the last month or so. As the blog Blogging Stocks observed:
There are roughly 10,000 hedge funds managing $2.7 trillion. And not one of them is required to disclose its holdings to regulators. That's why we can expect the unexpected every day for the foreseeable future until every single hedge fund that's lost money for investors dribbles out its bad news -- in the form of a leaked letter to clients.
While I personally wouldn't take it that far, the point is definitely taken. There are a lot of financial institutions out there and we need a period of no news from any of them before this whole thing settles down. I have no estimate of how long this will take.
Secondly, this is not a good time to take on more risk. Before doing anything, I would ask myself, "would a stodgy old man do this?" This is a time to maintain a conservative financial lifestyle. I am not offering specific advice here regarding any investment - this is general advice about where to go for now.
Third, the whole financial system is not broken; a subset of the system is having large problems right now. The subprime market needs to be fixed, but not destroyed. In my opinion a return to common-sense lending standards will help. I also think disclosure documents that clearly explain risk and an investigation into predatory/aggressive lending practices are warranted. I would really like to see some type of disclosure requirements for hedge funds as well. As I mentioned above, if we knew where the big holdings were right how we could probably end this problem a whole lot sooner.
Fourth - and not like they listen to me anyway - but unless there is a serious slowdown in the economy, the Fed should not lower interest rates right now. That would simply bail-out a lot of people who got us into this mess. And frankly, they need for the market to hand them their hat (as it were). Sometimes the only way to learn a lesson is to swallow the bitter pill called "responsibility." Lowering rates just isn't the answer.