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Is There a Doctor in the House?

October 2, 2008 By:
Michael L. Schwartz, JE Feature
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Illustration by Michael Osbun

What started as a trickle about two years ago, with a softening in the real estate market, has now turned into a full-blown watershed event with this week's congressional action or inaction -- rescue or surrender -- as evidence. Our world financial system has changed dramatically with credit markets freezing up, investment banks going belly up, the U.S. government bailing out financial institutions, and worldwide central banks flooding the system with hundreds of billions of dollars in an effort to improve liquidity.

"Historic" is not a word to be used lightly, but it seems appropriate to describe what's taken place in the financial markets recently.

In just the past few weeks, three major investment banks have either filed for bankruptcy or been sold in a distress sale; Fannie Mae and Freddie Mac have been thrown into receivership; and American International Group has been essentially taken over by the U.S. government. (And, now, Wachovia is facing severe problems.)

Clearly, we are wading into uncharted territory.

The root cause of the problems we face can basically be summarized in three words: greed, leverage and fear. Greedy Wall Street people plus greedy mortgage lenders, homeowners, speculators and even politicians helped spark an unsustainable rise in home prices. This rise was fueled by extremely high leverage (i.e., using lots of borrowed money).

When housing prices started dropping, the domino effect of leverage came back to haunt the system, and financial institutions had to take massive write-downs and seek outside capital.

Fear took over as the problems kept piling on top of one another, and people began to panic. That's an oversimplification of what's happened, but it describes, at a high level, how we got to where we are now.

When will we hit bottom? Nobody knows. The situation is very fluid. For example, on Thursday, Sept. 18, the Dow Jones Industrial Average rose more than 400 points on talk that the government is "considering a permanent solution to the credit crisis and as regulators looked to hinder bets against financial institutions," according to MarketWatch.

However, the day before, the Dow dropped 450 points. Intraday volatility is also very high.

In order to understand how we can get out of this mess, it's necessary to figure out how we got into it. The late 1990s is a good place to start.

No doubt you remember those "good old days." The Internet was changing the world; technology stocks were soaring, and the economy was humming along. It was a great time to be in the stock market, as the S&P 500 index rose 220 percent for the five years ending Dec. 31, 1999, according to data from Yahoo! Finance.

That's an average annualized return of 26 percent, excluding reinvested dividends, which is simply phenomenal.

 Of course, the good times didn't last. The bubble popped, and the S&P 500 declined by 49 percent between March 2000 and October 2002, according to data from Bespoke Investment Group. The Fed took the federal funds rate from 6.5 percent in May 2000 all the way down to 1 percent by June 2003, according to data from the Federal Reserve Bank of New York.

 This precipitous decline in interest rates set the stage for the next bubble -- real estate.

With interest rates super low and the stock market in a funk, investors turned their attention to the previously moribund real estate market. As the economy gradually improved, people started to buy homes again in a big way. And banks, mortgage companies and Wall Street wizards were more than happy to come up with newfangled ways of getting Americans into their homes.

Wall Street investment banks were thrilled with this new opportunity in real estate, because they weren't making much money on traditional businesses of investment banking and buying/selling securities. Unfortunately, many of these new securities, which provided capital to finance the real estate boom, were highly financed themselves. When the real estate bubble became unsustainable, just like the earlier technology bubble, it all came crashing down.

So, what can we do? First of all, we need to keep the situation in perspective. The world is not coming to an end, and it will be resolved at some point. Second, we need to remain very vigilant and monitor the situation closely.

Third, we need to be opportunistic and be ready to make changes, as we deem appropriate.

Michael L. Schwartz, RFC, CFS, CSA, is an investment advisory representative of First Allied Securities, Inc., and president of a Jenkintown-based wealth management firm.

 

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