Zaks Investment Advisory Service

Financial Crisis of 2007: Mispricing the Risk

Last time, we talked about bonds and the risk to which they are exposed, primarily the credit risk and the risk of interest rate fluctuations. In this connection, I mentioned that if there were a likelihood of a rise in inflation and, accordingly, a greater risk of interest rates going up, stocks become a preferable class of investments. I had planned to talk about inflation, about why it affects stocks and bonds in different ways, and its effects our economy on the whole. However, the latest financial market events demand that we try to make sense of them all, and so we will leave inflation to our next program.

The financial market crisis began shortly after the Dow Jones Industrial Average set a record: on July 19, the index closed at the 14,000 level. Two days later, it started to fall. Since then, i.e. over the past three weeks, the Dow Jones average has been changing daily by at least 100 points. The other indexes, the S&5 500 and NASDAQ, were just as erratic: over the past three weeks, the Dow Jones at one point fell to 13,180 (i.e. almost six percent below the record high level), then rose to 13,660. On Friday, August 10 it closed at 13,240.

What caused this crisis? As we talked about in one of our previous programs, the main reason is the revaluation of the level of risk on certain securities. As everyone by now must have heard, it all started with the so-called subprime mortgages. What are they? Financial organizations that provide mortgages, i.e., which lend money for the purchase of real estate, often also issue bonds backed by these very mortgages. The financial organizations thus in effect turn into go-betweens: first they give money to people purchasing the real estate, and then they get it back from those who buy the bonds. So in reality, it turns out that the real estate money comes from the bondholders. In this process, mortgages play the role of a collateral underpinning the bonds. These bonds have varying degrees of risk: if the mortgages backing the bonds are themselves risky, i.e. there is a chance the mortgage holder will be unable to pay up (and here we are talking about those very subprime mortgages), then the bonds they back are also risky – the collateral on which they were issued is bad. If the mortgages are of a high quality, then the bonds turn less risky. In theory, from the financial point of view, this is a very useful process because it redistributes risk: instead of the entire risk of the mortgage not being paid falling on the bank issuing the mortgages, the risk is spread across the various bond purchasers. These bonds are bought by large financial organizations such as investment funds and the so-called hedge funds. They invest in risky securities, expecting to receive higher returns. And everything would have worked out nicely, if only the bond purchasers had remembered that they were buying risky financial instruments. Unfortunately, until the very last moment, the buyers of these risky bonds were living in a state of euphoria, ignoring the risks. Every company that issues mortgages knows that a certain percentage of people will be unable to meet the payments. It seems that the bond buyers were hoping that the low level of unemployment and growing economy would allow a predominant majority of mortgage holders to handle their payments without any problems. How do we know that the buyers of these bonds were, in fact, being fairly reckless?

We have one very telling indicator – it is the difference between the yield of the Treasury bond and that of risky corporate bonds, which are sometimes referred to as “junk bonds” (the riskier bonds such as those backed by subprime mortgages belong to this same category). Common sense would tell us that yields on Treasury bonds should be lower than those on junk bonds: they carry absolutely no credit risk, while junk bonds may end up in default. Clearly, we should be paying less for a junk bond with a coupon rate and maturity similar to that of a Treasury bond – i.e. we will demand higher yields. And, in fact, the yields on Treasury bonds have always been lower than those on junk bonds. The problem is that the spread between the two rates of return has been – until the very last moment – minimal. This means only one thing: investors believed (and, as it turned out, wrongly so) that the likelihood of a bond default was very low. At a certain point, that all changed: over the course of the past month, investors across the world re-examined their perceptions about risk. At the moment, the spread between the junk bond yield and that of a Treasure bond is about 4.5 percent. That difference may not seem terribly large, but the two figures represent completely different visions of the financial world – one, in which defaults are practically impossible, and another in which they very much are.

We should not be feeling terribly sorry for hedge fund investors. These are wealthy people (by law, you must have a certain level of income and assets in order to invest money in hedge funds). They understand that these funds are, by their very nature, immensely risky proposition on which they could either make a great deal of money or lose a lot. The problem now is that, having taken a look at what is happening to subprime mortgages, investors have reexamined their view of all risky securities. At the moment, investors are trying to figure out if the problem is limited only to subprime loans, or if the same thing could happen to other sectors of our economy. In the meantime, the prices on all securities, from stocks to corporate bonds, have dropped. No one, unfortunately, currently knows for sure if the subprime mortgage problem has spread to other sectors of the economy – and this uncertainty is one of the reasons behind the market instability. Most economists believe that the problem has been contained. But before the market can calm down, it must check whether this is actually true, and this may require some time.

As I have mentioned earlier, the process of revaluing the risk level, in and of itself, is a healthy thing. The problem is that this process started late, and then quickly snowballed. I suspect that if the whole process developed gradually, we might not have even noticed that much: after all, financial markets are a terribly complicated mechanism and some sort of processes occur there all the time about which the average investor has only the vaguest of notions. But the speed with which the risk levels were reassessed produced lots of unexpected results. For example, the problem for the market was compounded by banks, which started to fear lending money to clients with risky debts – and even to each other. The financial markets have an enormous amount of players, and almost all of them hold risky securities. If the parties performing a transaction understand the level of risk involved in a given security, this and of itself does not pose a problem. The problem arises when it turns out that the two sides are not sure if they are properly assessing the transaction’s risk. Then, just in case and as a measure of self-preservation, they start setting prices that are too high. For example, over the past several days, the interest rates on the short-term capital market (the so-called money market – a market on which banks, for example, lend money to each other for one or two days) have risen sharply. We know that interests rates are the price of capital. A danger has arisen of a so-called “credit crunch,” i.e. a shortage of credits – a situation in which banks, fearing the financial risks, are not lending money to even their credit-worthy clients. Such a situation could have had a grave effect on the country’s economy. Trying to avert this type of development, almost all central banks across the world – including our Federal Reserve – released a huge amount of cash into the money market. It seems their actions were successful, and the temporarily soaring short-term interests rates have come back down.

By the way, the latest round of the financial market crisis began in France. The spike in short-term rates happened after it turned out that the French bank BNP Paribas temporarily halted payments on three funds. These funds invested in bonds of the subprime mortgage variety (in our day, the financial world really has indeed seen globalization and knows no borders). And even though these funds were small – they held $1.6 billion compared to $600 billion managed by the bank – the bank’s stock fell by five percent, while the interest rates soared in panic on the inter-bank market. The European Central Bank, frightened that the markets might stop functioning normally, immediately became involved and poured nearly $130 billion into the European monetary system – twice as much as was added to the monetary system on September 12, 2001, a day after the catastrophe in New York. Investors, for their part, decided that if the European Central Bank thought it essential to infuse such a gigantic sum into the system, it must know something that investors themselves so far do not. So, just in case, they started selling a part of their assets, and as a result world markets fell Thursday by nearly four percent. But Friday was considerably calmer, and despite Thursday’s fall, the Dow Jones average finished up for the week.

What conclusions could we, investors, draw from all this? On the one hand, the problems with the real estate market are absolutely real. We know that property prices are falling and that the market is unlikely to bounce back for some time to come. We also know that the risk on many securities had been undervalued. On the other hand, our country’s economy is growing: according to a poll of economists conducted by The Wall Street Journal, this year’s fourth quarter growth will stand at about 2.5 percent, and in 2008 – at 2.8 percent. Take a look at our site, www.zaksinvest.com: despite three turbulent weeks, over the past three years the overall market grew at an annual rate of more than 12 percent, and our basic portfolio – by more than 14 percent a year. Yes, we could assume that the market will remain turbulent over the coming few weeks. But for those who invest money in the long-term, these are only temporary difficulties, not fundamental problems. Meanwhile those who will need their money back in a matter of months should be investing in CDs and not the stock market. And with that, we close for the day. This was Sergey Zaks. Thank you for your attention and until next time.