Weathering the storm - financial climate change

Oct, 2008

Dr Peter Phillips is an independent market analyst specialising in capital markets and superannuation, particularly self-managed superannuation funds. He lectures in economics and finance at the University of Southern Queensland.

OVER the past year, as the world debated the various actions that should be taken to avert the gradual warming of the planet, financial markets, which had been running hot for most of the decade, were beginning to freeze over. The short-term funding supporting the day-to-day operation of the financial system was no longer available, at least not on anything but the most unfavourable of terms. Without it, the markets ceased to function effectively and the financial climate changed with a swiftness that stood in marked contrast to the steady retreat of the glacial shelves.

Relaxed lending standards had allowed large numbers of high risk borrowers into the mortgage market. As house prices in the United States began to fall, these borrowers faced the prospect of owning real estate worth less than the amount they had borrowed. Along with rising interest rates, this was enough to dramatically increase the defaults on home loans.

The problem is that home loans are not just agreements between a bank and a borrower anymore. Banks group the loans they have made into categories depending on the risk the borrower will default and sell them to investors. The higher risk loans have a higher interest rate that is supposed to compensate for the higher probability the borrower will not be able to pay. The banks use the money from the sale of the loans — called mortgage backed securities — to make more loans and so on…

Even this would not be so bad if it were not for one thing: derivatives. These are securities whose value depends on (is derived from) the price movements in some other asset. It is possible to take a variety of bets on the direction of prices and interest rates, including the interest rates on mortgage backed securities.

Because no one foresaw any trouble, there were, to put it simply, a lot of bets whose value depended on there being no trouble in the housing market. When it became clear there was, in fact, a lot of trouble, everyone began scrambling for the exits.

As prices fell and losses began to mount, a variety of financial institutions including some banks, brokers and dealers, investment banks and hedge funds suffered severe erosion in their asset base. The assets they used to post as collateral for the short-term loans that are essential to the operation of their businesses were no longer accepted or were accepted on very unfavourable terms.

Suddenly, no-one wanted to lend to anyone else. With their balance sheets severely damaged and without access to the short-term loans to keep their businesses going, some financial institutions began to fail.

Central banks and treasury departments in many of the world’s major economies have been trying desperately to relieve the situation. The US Treasury Department has taken unprecedented steps, even going so far as to effectively nationalise some of the most troubled financial institutions.

The objective is to remove enough of the risk so that financial institutions will begin to lend to one another and the system can return to a reasonably normal level of functionality. The key question is whether the financial system will be able to recover any time soon. I do not think it can.

Despite all of the interventions, some of which have been greeted with a partial recovery in share prices, the interest rates at which banks are willing to lend to each other still reflect a very high level of risk, real or imagined. It is still very unclear which financial institutions are in good shape and which are merely treading water in a struggle to survive. In such a climate of uncertainty, there does not appear to be any grounds for declaring the crisis to be at an end.

For many investors, the crisis of 2008 is the first time they have experienced a prolonged period of market turmoil. In such times, investors are well advised to maintain a high level of discipline in adhering to their long-term investment strategy. If the strategy is weak, now is a chance to revise it.

For most investors in or nearing retirement, a portfolio generating sufficient income will usually have a relatively light exposure—around 40 per cent—to shares. The rest of the portfolio is invested in cash assets and bonds. Such a portfolio may have lost only 10 per cent or less of its value, despite the 30 per cent decline experienced by the broader Australian share market.

It is possible, therefore, to construct a portfolio that does not leave the investor completely exposed to share market volatility.

For much of the last two decades, market slumps have usually been followed by rallies to new highs.

This time, investors should not expect a sustainable and prolonged rebound. The landscape of the financial system has been altered considerably and the effectiveness—and effects—of government intervention is yet to be determined.

The financial climate has changed permanently and irreversibly. It will take some time for the system to adjust. Investors who focus on the creation of real economic value and invest in firms who create this value rather than the rents that had been extracted from the system by financial engineers and investment banks will, more likely than not, experience favourable outcomes over the long term.

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Weathering the storm - financial climate change

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