September 18, 2008--US financial crisis

Greetings!

My frequency of communication with you has picked up to try to keep up with the headlines. Recent coverage of events in the financial markets, of the US in particular, may create concern among some of you. I have had only three communications from concerned clients in the last couple of weeks, but my hope is that my newsletters will help all of you to make sense of what is going on.

Allow me to begin with conclusions first and address some of the more alarming headlines—

While there is confusion and concern about US financial companies as the impact of the sub-prime crisis works its way through the system, we are certainly not on the verge of a global financial collapse.

Question—since mid-May, which stock market has fallen further, Toronto or New York? Based on the panic headlines about the US, you would think it’s New York. In fact Toronto has fallen more, largely due to the sell-off in resource companies. I mention this because no one in the media is talking about the end of the oil industry; they’re too busy writing headlines about the US. Needless to say, we shouldn’t believe everything we read.

The value of a company as a business enterprise has little to do with the price of its stock today. Stock prices are falling across the board, yet Coca Cola still has a “license to print money.” The value investor is always thinking "I’ll buy Coke stock when it becomes cheap because other investors are distracted. Then I’ll sell the stock at a profit when other investors remember that Coke is a great enterprise."In spite of the sub-prime crisis, people will continue to drink Coke, visit Home Depot to plan a renovation, put gas in their cars and continue to invest for retirement.

Let me say more about the US financial crisis by looking at AIG Insurance, the most recent chapter in the story. This week, AIG Insurance was bailed-out by the US government. For $85 billion, the US government took an 80% ownership of AIG and prevented its collapse. AIG is the largest insurance company in the world. Perhaps surprisingly, AIG was and continues to be a strong enterprise with over 100 profitable divisions [lines of business] and 116,000 employees world-wide. Virtually every American owns some AIG insurance on their house, car, etc. Insurance is one of the most profitable enterprises you can find. AIG doesn’t sound like a prospect for bail-out, does it? So what happened?

A while back, AIG’s bosses decided to diversify into a new business line and insure mortgages investments, including investments derived from sub-prime mortgages. We’ve all read about sub-prime mortgages, but a quick review. Mortgage brokers were paid to write new mortgages with home-owners with poor credit ratings [thus the term-sub-prime]. In many cases, these people were unable to maintain their mortgage payments and defaults became widespread. Further, the mortgages were secured by houses with inflated values. The result of the defaults is whole neighborhoods as ghost towns filled with foreclosed housing that no one will buy. And written against these empty houses are worthless, sub-prime mortgages.

On top of this predatory lending practice, investment banks like Lehman Bros packaged and re-packaged these mortgages into investments [known as derivatives] and sold them as high-interest alternatives to savings accounts, at a time when consumers were fed-up with the low interest rate environment. You can see the picture now of this “house of cards.” [The whole episode is a disgraceful story of bankers’ greed, the failure of bond-rating services, the failure of government regulation….but that’s another story].

Back to AIG. In insuring mortgage investments derived from sub-prime mortgages, AIG had made a promise to compensate the investor should the mortgage investment turn bad. As the sub-prime mortgages were revealed as junk, AIG had to begin to pay up. At that point, AIG had a liquidity crisis, much like, to use a metaphor, the wealthy professional with the nice house, cars, cottage, who loses his job--lots of assets, great net-worth statement, but a cash-flow problem. That was AIG.

Just a few months ago, AIG had no problem raising cash by issuing shares which were gobbled up by investors. But in the last month, the sentiment has changed completely, driven by fear about just how big the sub-prime crisis might be. And, afraid, investors did not want AIG shares at any price. In the same way, banks that previously would have lined up to lend money to the world’s largest insurance company held onto their cash. Thus the US government became the lender of last resort.

So, here’s the point. AIG is a strong enterprise [the US government admits that their $85 billion investment will likely turn out to be a good one as the government sells off AIG’s profitable business lines]. AIG went under because fear prevented AIG from accessing solutions—issuing shares or borrowing money—that a strong company like AIG would normally have access to. The sub-prime crisis has created fear that has paralyzed the financial system. But the system is not a quadriplegic that will never walk, it’s just too scared to get out of bed.

Yes, it’s disturbing, but the fear will pass. This is reflected in the debate amongst most experts about HOW LONG the crisis will take to pass, not IF it will pass. As I’ve said before, markets in the short term are driven by fear and greed. Fear is having its day right now, and stock prices in both good companies and bad have fallen. But as the fear passes, more and more investors will turn their attention to good companies with cheap stock prices, and start to invest as the recovery begins. And so the cycle will continue as it always has.

Cheers!

Tom

I welcome your questions and comments.

copyright September 2008
Tom Buck, M. Ed. CFP
Certified Financial Planner
Assante Financial Management Ltd