Time and faith are needed to weather the market crisis

by Ken Chernin

A colleague with 30 years of experience recently said to me, “I’m tired of living through history.” He was referring to the current state of the financial markets, shaken in a way the world has not seen since the Great Depression.  

As I write, the S&P/TSX Composite Index and the S&P 500 Index are down 35% and 38%, respectively. But we have been through bear markets and recessions in the past, and we all know they’re a natural part of the economic cycle. So why does the current state of the financial markets send chills down our spine? In addition to diminishing investor confidence, the credit crisis has severely damaged investor trust, which has resulted in virtually freezing the debt markets. It also will likely result in drastic changes in banking, and the remedies may require elevated taxes for years to come.   

The credit “crunch” or “crisis” was primarily driven by the deflating U.S. housing-market bubble and subprime mortgage defaults.  Over the last decade, banks flush with cash were overly eager to lend money at higher interest rates to borrowers with unfavourable credit ratings (subprime) to buy homes, automobiles, credit cards, and so on. The loan business basically became a volume game based on wholesale funding—borrow short and lend long.

In their quest to heighten profits such as mortgage-origination fees, and simultaneously attempt to reduce their risk, banks devised ways to restructure outstanding loans into securities that could be sold to investors and removed from the banks’ balance sheets, making room for more loans. The banks did this by putting mortgages into special-purpose entities and subdividing them into different pieces, or tranches. Mortgages of similar credit quality were grouped in the same tranche, then sold
to investors, often on a global scale, spreading the subprime risk far beyond U.S. borders. The better-quality tranches were paid back first, then the second best, and so on. The lowest-quality tranches containing the mortgages with the highest credit risk, which were hard to sell for obvious reasons, were put into another securitized asset called collateralized debt obligations.

There were blue skies everywhere until the American housing market began to show signs of weakness in late 2006. By mid-2007, rating agencies started to downgrade these debt instruments, which caused values to sharply decline. Banks, which are typically highly leveraged, faced a shrinking asset base as a result of the mark-to-market rule (the houses backing the mortgages were worth less), so had to sell their assets to cover their losses. But they were unable to turn these historically illiquid mortgages and loans into cash (which are now worth a fraction of their original value) and faced solvency challenges. As a result, banks reduced the amount of cash they lent to consumers, businesses, and other banks, because they were leery of the borrower’s capacity to repay
the loans.

Thanks to the creation of asset-backed securities, the subprime issue is no longer isolated to banks; it has now spread to other investors. Furthermore, some financial institutions sold bond insurance (credit-default swaps) on these debt instruments, where the underwriter must pay the counterparty in the event that the underlying security defaults (or a defined credit event), so exposure to the subprime fiasco spreads further. Now investors are faced with uncertainty as to who has exposure to what.

The result: Mistrust spreads through global debt markets, even into securities that have little or no exposure to tainted subprime. With investors trying desperately to offload debt securities and very few buyers for them in the market, prices crashed. The global credit markets froze, and we found ourselves in the midst of a credit crisis. With nations, states, provinces, municipalities, and companies dependent on the debt markets to raise funds to sustain growth, fears of an economic recession built and the equity markets spiralled downward.  

Governments across the globe are now working to restore trust in the debt markets and the flow of capital. On Oct. 3, U.S. Congress passed a $700-billion package primarily aimed at taking the toxic subprime debt off the balance sheets of U.S. banks, and on Oct. 7, the U.S. Fed said it would purchase three-month unsecured and asset-backed commercial paper directly from the issuers. Central banks around the world have made significant cuts in overnight lending rates and have injected money into the markets.

Even if these measures can curtail the equity markets from further declines and restart the debt markets, the credit crisis will have ramifications for years to come.  In the short term, equity markets will likely be slow to recover. This would make raising money via equity issues much more difficult than it has been over the past few years, and will likely have a greater impact on small resource firms given that a recession, if one should occur, will weaken commodity prices. Even firms with strong balance sheets and strong operating cash flow will probably face funding pension deficits resulting from the decline in the equity markets, which will be a strain on
cash flow.  

In the long term, the traditional banking model will likely be restored. The primary funding source will be deposits, and loans will stay on the balance sheets instead of being spun off in asset-backed securities. Banks would carry the risk of the loans, which would translate into more onerous screening processes and, in all likelihood, fewer loans. Fewer loans translate into less business, less consumer spending, and slower economic growth. But the highest costs of the remedies to correct the crisis, which was driven by our generation’s excessive consumption, will be borne by our children in the form of taxes for many years to come.

Ken Chernin is an equity research analyst with Acadian Securities Inc. in Halifax. He can be reached at ken.chernin@acadiansec.com.