August 19,2007

The Bubble Bursts and Mr. Bernanke Takes Action. A Good Thing, or Not?

Selling in the stock market has been very intense. Fine investment opportunities are before us. We have large cash reserves and expect to make good investments at favorable prices.

A text book case of the bursting of a financial bubble has unfolded in recent months. The extremely low interest rates set by the Federal Reserve in the aftermath of the dot-com bubble and September 11th caused housing prices to rise. Concurrently and contributing to the rising prices, came the combination of very easy credit and ‘innovative’ financial products. (The world of finance often coins colorful terms. The best in this cycle has been the ‘Ninja’ mortgage: No Income, No Job or Assets.) As housing prices rose, came the home buyers who never intended to live in the homes they bought, but to ‘flip’ them. Euphoria, visions of ever-rising home prices and wealth prevailed. The Cassandras who warned that things would not end well were ignored because their predictions of dire outcomes were not realized. Until recently.

For a time, the view was that the problem would be limited to ‘sub-prime’ mortgages. But the financial innovators who created Ninja mortgages also created packages of the sub-prime mortgage loans. Credit-rating companies—S&P and Moody’s and Fitch—granted Triple-A ratings to packages of slices of sub-prime mortgages. (Most of their fees were paid by the underwriters of these securities: Is it a coincidence that the agencies could give AAA ratings to pools of really dodgy stuff?) Credulous institutions—including some very well-known banks—bought these securities. When these banks and hedge funds and others, some of whom we know now, others of whom we will know, realized that the securities they had bought were impossible to value and to sell, they stopped buying more.

Because they could not sell what they wanted to sell, they sold what they could. Soon, everything was falling in price. Lenders stopped lending—even to the credit worthy—and buyers stopped buying. Investors happy to pay 120 (let us say) for the stock of a very good company while its price was rising became utterly uninterested in the stock when its price fell to 105.

Beginning on August 9, the important central banks, lead by the European Central Bank, began actively to provide cash to the financial system that seemed to be grinding to a halt. The ECB provided 200 billion euros to the markets by buying loans that other institutions did not wish to hold. The Fed acted in a similar fashion on a smaller scale. By Wednesday of this week, it became clear that those actions by the central banks were insufficient to keep the banks lending and the markets stable. After a climactic session on Thursday, the Fed took the novel step on Friday morning of cutting the discount rate for bank borrowing directly from the Fed. The timing was exquisite: the US market had recovered from a 350 point loss in the Dow by 1 pm on Thursday to close unchanged. Before the opening on Friday, the Fed made its announcement and a very satisfactory rally ensued.

The questions. As of Friday’s close, things looked reasonably favorable on Wall Street. But there is probably more selling ahead. The very dramatic decline is of the magnitude of the best of them in the last decade or two. If Thursday’s low was the bottom (a big if, of course), then we are still likely to have more bad news and more selling. Even if the stock market low happened at 1 pm on Thursday, can we imagine that all the credit problems have been resolved, as well? Probably not. It seems quite likely that more time will be needed before this round of selling will have run its course.

Walter Bagehot, the 19th century economist and journalist, foresaw the events of the last year: “At particular times, a great deal of stupid people have a great deal of stupid money …. At intervals . . . the money of these people . . . is particularly large and craving; it seeks for someone to devour it, and there is a ‘plethora’; it finds someone, and there is ‘speculation’; it is devoured and there is ‘panic’.

The other question, which does not bear directly on how Core invests your capital, involves what is called ‘moral hazard’. Since the early nineties, when financial crises have disturbed the markets and the banking system, the Fed has taken dramatic and decisive action to restore confidence. There was talk of the “Greenspan put”: Speculators could take risk freely on the notion that the Fed would put a floor under losses if things went really wrong. The idea that the Fed will bail out improvident investors encourages recklessness. Would it be a better thing for the financial system if the institutions that purchased flawed Triple A packages of sub-prime mortgages failed? Would it be better if the consequence of stupid investing were failure? Certainly the Fed does not want to encourage recklessness, but it must also concern itself with the greater social and systemic costs of reckless investing. It seems that the members of the Fed thought that there was risk to the broad economy and the functioning of the banking system during the last week. Its actions, providing liquidity to the system and lowering the discount rate, were designed to preserve the system, not to bail out stupid investors.

Core’s actions. At the end of July, we sold your positions in commodities; early this month, we sold investments in US small cap stocks. Last week, we sold investments in emerging markets. Before we made these recent sales, Core’s overall position in US and non-US money funds and in bonds was 30%. Our recent sales have increased these levels to above 42%. (These are aggregate numbers; individual accounts vary.) The intense selling has produced some very attractive investment opportunities. If and as the selling continues, more opportunities will arise.

What lies ahead? In the coming weeks, markets will surely be very volatile, with days of big gains and big losses. It is very possible that the Fed will take further actions to support the banking system and calm the markets. It seems likely to me that in coming weeks, the markets will regain firm footing, that the banking and credit systems will resume normal activity, and that world-wide economic growth will continue. We intend to take advantage of the appealing opportunities that are now and will be on offer. Your large money market positions provide shelter from the selling and the source of funds for new investments.