During the third quarter, the worst performing stock market sectors were those that are tied most closely to global economic growth.  For the quarter, the S&P Energy and Material sectors fell by 25.0% and 22.9%, respectively, as the prospects for slower economic growth produced a major drop in commodity prices.  Interestingly, the performance of the already depressed S&P Financial sector was essentially flat, as higher stock prices for the apparent survivors offset the weak performance of failing firms.

The problems of the financial sector were front page news for most of the third quarter.  During the quarter, Fannie Mae and Freddie Mac, who collectively hold or guarantee about half of all mortgages in the U.S., were taken over by the Federal government.  The remaining major investment banks disappeared during the quarter: Lehman Brothers file for bankruptcy, Merrill Lynch agreed to be acquired, and Goldman Sachs and Morgan Stanley transformed from investment banks to bank holding companies in order to borrow from the Federal Reserve.  Insurance giant, American International Group gave an 80% stake to the U.S. government in return for an $85 billion loan. Two of the largest U.S. banks, Washington Mutual and Wachovia, virtually collapsed.  Washington Mutual was seized by federal regulators and most of its operations were sold off.  Wachovia accepted a takeover offer from Citibank that included an FDIC provision to cover losses over $42 billion, but left very little value for shareholders.  (Wells Fargo followed with a better offer.)  In addition, there were numerous other financial service firms that teetered near the brink of collapse or suffered from rumors of financial distress.  The crisis spread to Europe and the U.S. municipal market as well.

In an effort to head off a complete meltdown of the financial system, the Treasury Department and Federal Reserve proposed a $700 billion rescue plan.  The proposal received the support of the President, both Presidential candidates and Congressional leaders of both parties.  The three page plan grew to 451 pages by the time it was finally signed into law as the Emergency Economic Stabilization Act of 2008 (“EESA”).  The major provision is for the U.S. government to purchase up to $700 billion worth of “toxic” securities that are currently sitting on the books of financial service firms.  Currently, much of the credit markets are frozen, because financial institutions are fearful of lending to each other, due to concerns that the other party might become insolvent.  According to the plan, the government will begin to purchase these illiquid assets, allowing financial institutions to cleanse themselves of the risk associated with these securities.  Once their balance sheets are repaired, firms are expected to begin lending to each other again.  In addition, it is hoped that this program will establish a market for these distressed securities.  Currently, many of these securities are unable to be traded or even valued since a functioning market does not exist.  If the U.S. government purchases these securities at a reasonable price, there is a chance that the rescue plan will not cost taxpayers anything, or might even be profitable.  There is also a likelihood that a reestablished market for securitized debt will encourage private investors to reenter the market, adding further stability to the financial system.

So how did this crisis come about?  On the surface it appears as if the problems of one small part of the U.S. housing market – the subprime sector – have brought the global financial system to the brink of collapse.  Indeed, the U.S. has been through a number of housing downturns in the past 50 years, without experiencing a similar crisis.  In addition, while past housing downturns have often dragged the U.S. economy into recession, the current situation so far has been more of a financial crisis than an economic one.  While, growth is likely to slow, the U.S. has until now avoided a recession.   The great urgency to pass a rescue bill was predicated by the necessity to fix the financial system before it pulls the economy into a deep recession.

It seems that the current financial crisis has been caused by a perfect storm of separate but related problems.  For many years, liberal lending standards were encouraged by government policy makers to promote home ownership.  Securitization of mortgages provided a source of funding beyond bank deposits and spread risk beyond the local bank and geographic market.  Homebuyers overextended themselves, accepting risky mortgage payments terms and overpaying for houses. 

Perhaps, the biggest mistake was that financial institutions did not anticipate and were unprepared for a significant drop in the value of homes.  From the first quarter of 2006 when home prices peaked, to the end of the most recent quarter, the median home value in the U.S. fell by 18.2%. Since 1975, the second largest decline in value was a drop of just 2.8%, which occurred in the early 1990’s.

As banks began to report problems related to troubled loans and higher default rates, other more complex factors came into play.  A new “mark-to-market” accounting standard implemented in November 2007, liberalization of short selling rules, and the use of unregulated risk management products called credit default swaps contributed to a further weakening of already struggling financial firms.

While the success of the rescue plan is not a certainty, it should gradually add stability to the financial markets.  However, much damage has already been done to the global economy.  The restoration of consumer and business confidence will be essential in order to avoid a prolonged economic downturn.

Most fixed income investments, with the exception of Treasury securities, declined during the third quarter.  Investors pulled their money from corporate bonds, municipal securities, and bank accounts as they feared that even their safest investments were at risk.  Indeed, the withdrawal of money from bank deposits help to hasten the collapse of Washington Mutual and Wachovia.  To halt the run on money market funds and bank deposits, the U.S. government offered to guarantee money market accounts and increase FDIC insurance to $250,000 per account.

While near-term market and economic uncertainty is extremely high, and the financial crisis still must be contained, the return potential for patient long-term investors is significant.  Although, it is quite possible that the economy will deteriorate further before things begin to improve, stock prices might already reflect a worse case scenario.  Hopefully, signs of stability will return to the financial system soon, which should provide confidence to consumers, businesses and the financial markets.

John D. Frankola, CFA, CPA

The author is the president of Vista Investment Management, LLC, a Registered Investment Advisory firm. Under no circumstances does this article represent a recommendation to buy or sell stocks. This article is intended to provide information and analysis regarding investments and is not a solicitation of any kind. References to historical market data is intended for informational purposes, past performance cannot be considered a guarantee of future performance.   Neither the author nor Vista Investment Management, LLC has undertaken any responsibility to update any portion of this article in response to events which may transpire subsequent to its original publication date.

Vista Investment Management, LLC --- Phone: 412-824-5940 / 800-301-3204  --- E-mail: frankola@vista-im.com

Vista Investment Management, LLC