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By James J. Green and Melanie Waddell
Lo, how the mighty have fallen, and who knows where it will end? This year is turning out to be one of a kind for the financial services industry worldwide, with banks, brokerage houses, insurance companies, asset management, and investment banking all turned on their respective heads. A subprime mortgage crisis that morphed into a strangulating liquidity crisis which in turn has devastated the stock and bond markets has led to Lehman Brothers' bankruptcy, the nationalization of AIG, money market funds breaking the buck, the forced marriage of Merrill Lynch to Bank of America, the conversion of Goldman Sachs and Morgan Stanley into commercial banks, and a $700 billion bailout plan led by Treasury Secretary Henry Paulson--or King Henry, as Time magazine dubbed him on a September cover--under which the lender, and now buyer, of last resorts, the federal government, will buy up the "toxic" mortgage assets that started the whole cycle. At press time on October 13, the worldwide crisis has led the leaders of the 15 euro zone countries to announce partial nationalizations, I mean, infusions of capital, into the many major banks on the continent who have been weakened by their mortgage exposure. Those banks without that exposure are on the acquisition trail, buying up other banks and institutions like Neuberger Berman at firesale prices. Investors are fleeing stocks, bonds, even money market funds for the only safe investments around--Treasuries.
So what's an advisor to do? Where can you invest? Who should you partner with? How did we get into this mess? How bad is it really, and is this crisis as unprecedented as the TV talking heads keep telling us? What will the regulators and the legislators do in response that will affect you and your clients? What will this mean for the value of your clients' portfolios long term, and the value of your practice when you go to sell it? What should you tell your clients right now?
Conversations with leading observers and regulators, and the insights of the panelists in a series of Webinars that Investment Advisor sponsored from September into October, provide some wisdom and context that advisors can use to calm their clients and prepare for a post-crisis financial and economic landscape.
For instance, in the first of the Webinars, held September 22, Harold Evensky, president and CEO of Evensky & Katz Wealth Management in Coral Gables, Florida, counseled other advisors to do what he's doing: Calling all clients to check in. "They want to hear from you," he said.
Investors Are Shaken
Indeed, calming clients' jittery nerves is precisely what advisors should be doing now, agreed business consultant and money psychologist Olivia Mellan. "People are afraid of these cataclysmic changes, and we're in the midst of this Presidential election campaign that's scaring everybody," she said. "When people panic they tend to revert to their primitive survival mode, which is never rational." She encouraged advisors to share how they've stayed calm during the ups and downs of their own financial journeys. "In the midst of panic, any decision is the wrong decision. It won't be done in the right way."
During a Webinar held October 8, just days after the markets saw a tremendous drop and the $700 billion rescue package--the Troubled Asset Relief Program (TARP)--was signed into law, industry officials were confident that the package would provide a remedy to the nation's financial crisis. However, they believed a more difficult task would be restoring investor confidence. David Kelly, chief market strategist of JPMorgan Funds, said during the October 8 Webinar that the bailout "package is quite capable of dealing with the financial problem--the root of the financial problem, which is these hard to value subprime mortgages." Once those mortgages are bought up, he said "that should encourage banks to lend, and they will lend." On top of that, however, he said, "we have the psychological problem" of investor uncertainty.
The U.S. Treasury Department did recently set the ball rolling in appointing an investment advisor to implement TARP, authorized under the Emergency Economic Stabilization Act. Treasury announced October 13 that it had hired Chicago-based EnnisKnupp and Associates to serve as its investment advisor. In announcing the hire, Treasury said "the firm began work immediately to help the Department administer the complex portfolio of troubled assets the Department will purchase." Also, Treasury said it hired the investment consultant "for assistance as it evaluates potential asset managers and other vendors. The firms' duties also will include developing and maintaining investment policies and guidelines and assisting with the oversight of the portfolio's multiple asset managers."
Ben Warwick, CIO of Sovereign Wealth Management in Denver, wrote in his most recent Searching for Alpha e-newsletter (which is delivered to Investment Advisor readers) that the history of government interventions is a profitable one. "In the last six completed bailouts dating from the rescue of the Penn Central Railroad in 1970, the Treasury ultimately garnered a slight profit," he wrote. "The situation we face today is certainly more grim than the crisis in 2002 (WorldCom debacle), 1998 (Long Term Capital Management/Russian debt default), or the recession of 1990. However, valuations--especially in the credit markets--have never been more attractive. Those companies able to survive will reap enormous benefits from this market dislocation."
A Game Changer
In an interview on October 10, Ken Fisher, the founder and CEO of Fisher Investments, recalled another October that shaped investors' attitudes toward investing. "Do you remember 1987?" he asks, referring to the October 19, 1987, crash, known as Black Monday, when the Dow fell 508 points in one day, losing 22.6% of its value. "Remember, for years after 1987 people still framed everything in relation to 1987," recalls Fisher. "It took the 1990 bear market and recession to get people thinking about anything else," he argues. Ironically, that was the recession that stemmed, at least in part, from the savings and loan industry collapse. "That's the way it's going to be with this; it's going to be a game changer," Fisher predicts. "Coming out of this, the weak are going to get killed, and the strong are going to pick up market share." Acquisitions of advisory firms will be on hold for a while, too, predicts Fisher, saying, "If I'm an investment bank or a Putnam Lovell, it's an ugly world in the short term." Firms like Berkshire Capital or Cambridge Partners that do smaller acquisitions of firms, says Fisher, "that well will run dry." Private equity firms, the banks, even firms like his own will pull back as well from the acquisition path. "We've told our people," he says of his M&A operation, "you've got to come up with a new structure--firms that we will look at will need to take a little bit of cash, a note that they'll carry, and swap some of their equity for some of ours. You can't do it on an all-cash basis or an all-note basis." (For more on Fisher's opinions about the crisis and the reaction in Washington, see page 24. For more on the M&A world, and how to build value in your firm prior to putting it up for sale, see page 50).
An Historical Perspective
To get the longer-term view of where these troubling weeks fits into the history of Wall St. and investing, we spoke to Ron Altman, who has logged 40 years in the investment research and money management business and currently runs the Aston/MB Enhanced Equity Income Fund.
"You look at all the bear markets we've gone through since World War II, and they all have the same characteristics. It always revolves around either a financial crisis or a significant overbuilding of some kind that results in a capacity utilization problem and pricing pressure, problems with profitability, and so on. Sixty-two was all about the beginning of the electronics era, a lot of money was thrown at it, and it was probably just as cuckoo as the late '90s, with the valuations that were out of proportion. What always seems to happen is that you either get an excess valuation in the marketplace like we did in the early '60s or the late '90s, or you get a financial crisis--one of the two--that tends to lead to a bear market.
"When you understand what the crisis is," says Altman, "it's over. We can read it about on the front pages of the newspapers, or listen to the talking heads on television, and learn about everything that went wrong, but the market is a discounting mechanism. It doesn't look backward; the commentators look backward, the market looks forward." Is there another issue, Altman wonders, that "we haven't read about or heard about that is going to hit us between the eyes and create another period of paranoia? I don't think so. It's always something that comes out of the blue, but now that you have the Fed, Congress, and everybody else addressing these issues, these things get solved."
For his part, Altman thinks the 1970s "were a lot worse than what we're going through now, because we had an inflationary problem that was circularly reinforcing. It started with commodities and ended up with wage inflation, and it took some really nasty medicine to fix. We ended up with interest rates going up to 18%; 13% on long governments." That was when Paul Volcker was brought into the Federal Reserve "and he said, 'We're going to break the back of inflation.'"
What Altman does worry about is the "other side of that problem, and that is the possibility of deflation, which is just as nasty as runaway inflation. Europe is sitting there worrying about the Weimar republic, and we're sitting here worrying about the '30s. Europe has come around to recognizing that it's not the Weimar republic, but it is the 1930s. They're talking about lowering rates, which I think is very good [The interview took place on October 3; European and other central banks, including the Fed, did cut rates in a coordinated move on October 6].
"In my opinion," says Altman, "deflation is really the big problem--that's when you get a collapse of credit, an implosion in the financial systems. You get to the point that no matter how much the Fed pumps liquidity, nobody uses it, because they're deferring consumption. I don't think we're going to go through that; I think we'll stop it before we go over the cliff. Bernanke did all his academic work on the Depression, so he understands that period as well as anybody."