A 2010 equity portfolio: the current “exogenous” event

Exogenous shocks

Economists explain the depth of the recessions of 1973-74 and 1980-1982 by pointing to extraordinary shocks to the world economic system that occurred during these periods.  In both cases, the shock involved was a sudden two-or threefold rise in the price of oil in economies very dependent on petroleum.

The current case

In the case of the current financial crisis, the “shock” was the sudden collapse in 2008 of major international banking firms in the US and the EU.  The reason?  –the realization that trillions of dollars of exotic securities that commercial and investment banks created, owned in very large size (and therefore counted as an integral part of their capital) and traded with one another were pretty much worthless.  As a result, many of these financial institutions were essentially bankrupt.

The housing problem

What triggered the crisis?  Many of these “toxic” securities were based on home mortgages taken out by “sub-prime” borrowers, who by and large didn’t have the income to make their mortgage payments.  These borrowers began to default.

What separates the current housing bubble from previous ones is the duration, and consequently, the size of the lending to unqualified borrowers.  Fed money policy in the US was unusually loose (see my June 3, 2009 post in Odds and Ends reviewing  John Taylor’s book on the crisis, Getting Off Track) for several years at the start of the decade. Government and trade groups estimate that:

–over 10% of outstanding mortgages were given to unqualified buyers,

–one in four residential housing commitments were made to speculators, vs. one in ten during a “normal” boom, and

–for a quarter of current mortgage holders, their home is worth less than the mortgage amount they owe.

Other, related, problems

Bad credit and weak banks aren’t the only problem.  the booming housing market signaled continuing economic prosperity.  So housing and commercial construction companies expanded and hired more workers, as did materials suppliers, retailers, hoteliers, airlines–and just about every other economic entity in the US.  When the bubble burst, we found ourselves with an economic infrastructure that is 5%-10% too big for what we can use.

The crisis also underlined the poor state of government finances in Washington, weakened by the Bush administration’s policies of increased social spending and tax cuts, while also waging an expensive war in the Middle East.

Derivatives allowed US problem loans to be exported to Europe and infect the banks there.  France was a hotbed of “financial engineering” expertise, which helped the process along.  The fact that most transactions originated in London, where laws differ from those in the US and where regulatory supervision was lax, poured gasoline on the fire.

Two low points

1.  In September 2008, Secretary of the Treasury Paulson decided to allow the investment bank Lehman Brothers to go into bankruptcy.

This had two immediate unintended effects, which both spread the financial crisis far beyond the housing market.  International trade finance, and therefore the lion’s share of international trade, immediately dried up on intensified concerns over counterparty risk (if Lehman could fail, who was safe?).  Also, worries about counterparty risk spread to money market funds, some of whom had bought Lehman short-term debt to try to raise their yields.  As investors shifted to federally-insured bank deposits instead, they all but eliminated an important source of working capital finance for American industry.

During this time, industrial layoffs intensified.  Armed with sophisticated supply chain management tools, companies could see the full extent of the economic contraction that the crisis was bringing.  Many also realized they had made a mistake during the 2000-2002 downturn by not cutting production–and workforces–quickly enough.  So they cut very sharply this time around.

2.  In March 2009, sentiment reached its lowest ebb when Congress initially refused to appropriate funds for a bailout of the financial system.  For a while, the world feared that the global financial system would collapse, bringing on a new version of the Great Depression of the 1930s–not because the problem, although large, was not understood or was too big to handle, but because of cognitive/intellectual deficiencies among myopic US legislators.

The repair process

A lot of positive things have happened since the darkest days of nine months ago.  The repair process will be the subject of my next post.

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