How did it happen? The financial crisis has been developing all year, but it seems to have only gotten worse despite the bailouts, the new government oversight, and even the election. The stock market started the year poorly, but only grew worse. Bond and commodity markets also fell, especially if there was any credit or counterparty risk involved. Even cash does not seem safe.
What does this foretell for investors? Are stocks still a good investment? What about bonds, real estate and other alternatives? Before answering these bottom-line questions, let's give our analysis some content and context. When we are done, we will see that our situation is precarious, but will still have substantial potential rewards for investors.
The Subprime Crisis
What did happen, and who are the culprits? It all started as a subprime mortgage crisis that had been building for a while. Real estate prices have been rising for years, even during the recession earlier this millennium. Congress and the President had been encouraging home ownership, and Fannie Mae and Freddie Mac went along with the program. So did the private banking sector. It became so easy to get a mortgage that many of us received mortgage refinancing calls almost weekly. Lenders required little or no down payment with delayed resets to market rates. Mortgage brokers were paid on commission and naturally connected the willing borrowers and lenders.
Why would lenders be willing to make such low-quality subprime loans? Well, they did not plan to keep them, but instead to resell them. Who would buy them? Investment bankers invented innovative structured products which packaged the payouts into tranches, so that the safest tranche would get the first payments. Insurers were willing to insure these tranches because they thought they were a relatively safe way to earn current income. Rating agencies often gave them their highest ratings. High-grade investments are scarce, so investors gobbled up the mortgage pools.
When the mortgage resets started--typically about three years after the original mortgages--the defaults began. And the default rate was much higher than anticipated because apparently, homeowners and lenders thought that rising real estate prices would allow for more favorable refinancings. But real estate had finally begun to fall. After credit markets started to dry up, real estate fell some more. Suddenly, even the safest tranches seemed suspect. They may not have actually been about to default, but who knew? The mortgage pools became less liquid and difficult to price.
Spreading to the Financial Sector
How did a subprime real estate mortgage crisis become a full-blown financial crisis? The reason is the financial firms held not only the safest mortgage tranches, but also the less safe tranches. These tranches had nice high yields. The financial firms levered up the yield spread between their borrowing rates and their investing (lending) rates. Many of the firms had over 20-times leverage, while some had more than 30-times. When these investments became illiquid, the financial firms quickly found themselves in trouble.
It would not have been so bad if a few financial firms failed, except that these firms traded in derivatives--especially swaps. In a credit default swap (CDS) market, when one firm wanted to close out a position, it typically traded in an offsetting swap. But these offsetting swaps did not completely close out the positions, because there remained counterparty risk. Thus, Bear Stearns was too big to fail and so was AIG as a swap insurer. Lehman Brothers was let go since the government felt it could not bail out everybody. Because the contracts and swaps were all interconnected, the market began to melt down.
So who is responsible? We have met the enemy and it is us. Excess risks, leverage, complexity, lack of transparency and lack of oversight exist throughout our financial system. The problem is no longer just mortgage defaults, but all types of debt. As the credit structure deteriorated, so did the financial firms.
Treasury Secretary Paulson and Federal Reserve Chairman Bernanke have taken drastic action, whether it meant cutting the discount rates, restricting short sales, providing risk capital, arranging bank mergers or guaranteeing deposits. After some hesitation, Congress finally approved the bailout package with demands that the government keep some upside, executive compensation be restricted, and home-owners reap some of the benefits.
The Loss in Confidence
As debt securities started to default and become illiquid, trust quickly evaporated. Given the lack of transparency in the debt markets, who knew where the problems were? It has been likened to an e.coli scare over lettuce. Most of the product (or produce) might be okay, but where were the bad securities? Lenders and investors began to hoard cash--not making new loans or refinancings. The curtailing of loans quickly spread outside the financial economy to the real economy. Hence the recession--or even worse?
The loss of confidence hit the equity markets as well. The stock market, which had performed poorly all year, became especially erratic in September and October. Daily returns of plus or minus 2%, 3%, 4%, 5%, even 10% started to occur. Historically the annual standard deviation is only about 20%, or just a little more than 1% daily--meaning we usually expect about two-thirds of daily price movements to be less than 1%. The recent implied annual volatility of markets (the VIX) reached over 80%.
Although the crisis started in the U.S. mortgage market, the financial crisis is global. This year, most world stock markets are down even more than U.S. markets. The whole world has come to depend on the U.S. financial sector, whether it's Japan and emerging countries taking advantage of our trade deficits and reinvesting in our debt markets, or Europe developing their financial sector to be more like ours. The U.S. had triple deficits building for years: the trade deficits, the government deficits and the household deficits. Only the corporate sector has refused to lever up, but this did not include the financial sector, which is the most levered sector of all.
Has the crisis spilled over into the real economy? The answer is a clear "yes." For some time there was doubt that we were in a recession, but those doubts have been resolved by now. This will be a global recession because the American consumer can no longer drive the world economy. The U.S. debt will no longer be regarded as a safe harbor, and the U.S. financial sector will not be our comparative advantage--at least not in the short run.
Although all the world economies will be hurt, those that have to rely less on the financial sector and hold less of the toxic debt will fare the best. The emerging markets can keep on growing, provided they can shift their production away from exports and toward their own consumers. The developed countries that can rebuild their economies in broad ways will benefit. The U.S. will be forced to take on a diminished role in the world economy and thus a reduced role in military and world affairs. The fall of our finance sector will have long-term consequences.
Investing in Stocks and Bonds
Stocks have become more risky. We are still awaiting the numbers for the calendar 2008 return, but this year will compete with the worst. Returns in the negative 20s have occurred only in three years since 1926--1930, 1974 and 2002; returns in the negative 30s occurred only in 1937, and a return in the negative 40s, only in 1931. Daily volatility similar to this occurred in the 1930s and for a few days associated with the crash of 1987. But the volatile periods have both up and down days.
Because stocks have become so much riskier, some investors will want to reduce their allocations to stocks. Rebalancing will help them to maintain a constant level of risk. But be careful, because bonds--especially those with credit risk--have also become riskier. Also, since stocks have already fallen so much from their highs, much of this reallocation is automatic. If stocks had doubled their risk but have fallen in half, there may be little increase in stock risk for the portfolio.
There is cause for optimism in the longer run. Although stocks have become more of a risk, their future returns are likely to be higher. Of course it is difficult to call the bottom, but the potential payoffs can be substantial.
As one can see from the table on the next page, the highest return years are interspersed among the worst years--hence the high returns in 1933 and 1935. And typically, stocks start to rise at the bottom of the recession; they do not wait for the economy to recover. Both 1954 and 1958 were recession years.
The long-run outlook is that stocks will outperform bonds, and that bonds will outperform cash. The extra risk has a high probability of being rewarded. Since 1926, counting this year, stocks have had positive returns in 59 of 83 years (71%). There exists an equity-risk premium as well as a horizon-risk premium for bonds, and a default-risk premium for lower quality debt. But these premiums pay off in the long run and by their nature are subject to market risk.
Not everyone will want to take these risks, so that those who do have to have enough of an incentive to do so. This risk premium will first show up as a higher discount rate on expected cash flows, along with lower valuations. It's only in the long run that it will result in higher stock returns. I would stick with my 9% forecast, but with a lower riskless rate and a higher equity premium.
I wish I could tell you when stocks will reach their bottom. Maybe they have already? Or maybe we are in for another bad year? If you cannot accept the increased volatility of stocks, you should reduce their allocation to your portfolio. But if you want to maximize your expected return, do not wait. Rebalance your portfolio now, recognizing that in the long run, the greater the risk, the greater the expected return. Unless you have more knowledge than the market, the long run starts now.
Restructuring the Financial System
It is evident that the financial system will be restructured. President Obama, our new chief executive, and Congress will increasingly regulate this sector. Remember, most existing regulations were developed during the New Deal in the 1930s. They have generally served us well, but they have become outmoded.
I hope the [new] regulations will not be too severe or bureaucratic. We do need regulation to provide for sufficient capital, to limit leverage and to provide transparency--but ideally not to squelch innovation.
We also need tax legislation that provides fairness and adequate revenues for the government and reduces the deficit, but hopefully does not reduce incentives.
It is clear that banks will continue to be regulated as we protect depositors from risk. We need to develop more transparent clearing operations, especially in the derivative markets. We need to continue to align incentives so that those who take the risks get most of the rewards, rather than the "heads I win a share of the profits, tails you take all of the losses" culture that exists in too much of our corporate sector today.
How will alternatives fare? It is likely that they will do poorly over the short term as their securities become less liquid and leverage becomes harder to obtain. There will likely be substantial withdrawals from real estate partnerships, hedge funds and private equity. We are hearing daily reports that the hedge fund industry is shrinking, due to deleveraging, negative returns and withdrawals. Their returns have not been good this year, although usually, they have not done as poorly as stocks. As their name implies, most hedge funds are hedged. This year is illustrative of which funds were really taking systematic or market bets, instead of hedged positions.
One category of hedge funds that is not usually subject to market risk is the equity market neutral category. This category is actually up a little this year through September. At my firm, Zebra Capital, our two major funds are equity market neutral and were somewhat up, especially in October. Investors can use hedge funds to avoid market risks, but they have to pick their funds carefully.
But how will hedge funds do over the long run? In this regard I am not pessimistic. They are likely to be the least regulated entities because they get their capital primarily from institutions or sophisticated individuals. Although they may continue shrinking next year, I think eventually there will be an expanded role for these entities, whether they are private equity or hedge funds. The traditional banking sector will be too regulated to take the economy's risks. Hedge funds also will be the major providers of liquidity. The public should not despair if these hedge funds fail, so long as they do not entangle the financial system. The freedom to fail is also the freedom to succeed.
I hope this sector becomes only lightly regulated, perhaps to curtail manipulation, limit leverage and provide some transparency. It is this sector that will have the major role in making prices reflect their true values. This sector will help make markets efficient, which will be not only a global benefit but one that especially benefits the U.S. economy.
Real estate will also recover. There are likely to be many distress opportunities in the market so that astute investors can do particularly well.
There will be distress opportunities in the corporate sector as well. But beware the danger of investing in existing pools with stale prices that do not fully reflected the true drop in market prices that has already occurred. Wait a while, or invest only in new pools that reflect only the new downward prices that already exist, rather than in pools whose drops have not yet been totally measured.
The U.S. and world economies will eventually stabilize, and growth will begin anew. Risks have increased, but so have opportunities. As liquidity returns to the market, prices will again rise. The biggest gains will go to the sectors and stocks which will have the largest increases in liquidity. These are the sectors that have been hurt the most.
And it is still true that the greater the risk, the greater the return. The long-run outlook is still positive.
Roger G. Ibbotson, PhD, is Chairman & CIO, Zebra Capital. He is the founder and former Chairman of Ibbotson Associates, a Morningstar Company, and a Professor in the Practice of Finance at the Yale School of Management in New Haven, Conn.