Zaks Investment Advisory Service

The end of the financial crisis of 2007: July 20 – September 18

Today I will again do a market review for the preceding week, but I suppose that this review may be the last for the foreseeable future. I believe that the market has pulled out of its crisis condition, and there is no real sense in commenting on trivial changes in market prices. But what was happening over the past week was no trivial matter at all. In the previous program, I said that all people with even the slightest relation to financial markets, from analysts and economists to individual investors, were waiting to see what the Federal Open Market Committee (FOMC) would finally do. The FOMC is a group of Federal Reserve chiefs that adopts decisions about interest rates. The market believed that the federal funds rate would be cut on September 18, but before the FOMC meeting, opinion was split almost in half: about half of the investors thought that the FOMC would reduce the rates by 25 points, while the other half anticipated a rates cut of 50 points. A fairly rare situation arose: whatever the FOMC decision, it would have come as a surprise to half the market – either coming as a pleasant surprise, or as a profound disappointment.

As we now know, the FOMC made a decision to lower rates by 50 points. At the same time, the Federal Reserve also cut the so-called discount window rate by 50 points. Just as a reminder to our listeners: the federal funds rate is the rate at which banks borrow money from each other over the short term. The Federal Reserve does not appoint this rate, but it may influence the amount of money in the system in such a manner that this rate reaches the desired level. Meanwhile, the Federal Reserve really does set the discount window rate. Banks use the discount window to borrow money directly from the Federal Reserve. They do this less often, preferring to borrow from their colleagues. And so, within minutes of FOMC meeting results announcement, the market gained 1.5 percent, and by the end of the trading day – nearly three percent; the Dow Jones index, for example, shot up by 335 points. The US market was not the only one to go up: all of the European markets also gained about three percent, while the Tokyo market – 3.7 percent.

The proposed interest rates reduction not only effected stocks. We talked about how the financial crisis broke out when investors realized that the risk on certain bonds and loan contracts was severely undervalued. One of the indicators of what was happening on the market is the spread between the yield of risky bonds and Treasury bonds with about the same term of maturity. This risk premium is the price that investors demand as compensation for the risk of buying corporate bonds. We once noted that prior to the crisis, the risk premium was incredibly low, by historical standards. In the heat of the crisis, it grew by about 50 percent. Over the past week, the risk premium fell in half.

This is not the only indicator: we have also mentioned the ABX index, which follows the risk of bonds that are created on the basis of securitized mortgages. As you all probably remember, this is where the crisis began. These bonds are subdivided into risk categories, from AAA (least risky) to BBB (most risky). During the crisis, the level of all these indexes fell. Indexes corresponding to the least risky bonds have regained about two-thirds of what they lost during the crisis. The riskier indexes, on the other hand, have recouped just 20 percent. There is an explanation for this: before the crisis, investors ignored the risk associated with these instruments, and now they price it more realistically.

What conclusion may we draw on the basis of all this information? The first is that with the Federal Reserve’s help, the financial crisis has been, for the large part, resolved. It is very rare when crises have particular starting and ending points, but in this case, we may say that the crisis erupted on July 20 and ended on September 18, i.e. it lasted for almost exactly two months. On the other hand, the real estate market crisis continues, and will continue for a fairly long time to come. The amount of unsold housing is high, and it will take long time to clear up this inventory. Plus, problems of the so-called subprime loans are real and unlikely to be resolved soon. The fact that the Federal Reserve lowered interest rates may help owners of adjustable mortgages to a certain extent. But the rate reductions are no panacea. And, as we see, bonds backed by riskier mortgages have not regained their pre-crisis values. There is actually sense in that: their risk was severely undervalued, and hedge funds and other financial organizations that at one stage bought them up, have lost a fairly large amount of money. But the fact that the market punishes such mistakes is its terrific disciplinary quality – and there is nothing wrong with that.

I am certain that my regular listeners know this already, but I will repeat myself just in case: the fact that the financial crisis is practically over does not mean that the market will now start marching into record territory. As always, price values will vary, sometimes going up, and sometimes going down. The fact that the crisis has ended means the following: the risk premium, which rose so steeply during the crisis, has fallen back, and this has lifted the prices on almost all securities. The market’s psychology has also changed: it has stopped panicking about every negative piece of news while ignoring the good ones.

And with this, we will draw today’s program to a close. Next time, we will finally talk about some very interesting financial instruments, which are called exchange-traded funds. This was Sergey Zaks. Thank you for your attention and until next time.