How Close Did We Come? A Look Back at an Unprecedented Week

We have never been alarmists but what just happened last week was more alarming than 1987. The failure of Lehman Brothers and the near-collapse of AIG on the heels of the government takeover of Fannie and Freddie Mac were stunning. Merrill Lynch’s sudden decision to sell itself to Bank of America at a price that was unthinkable not long ago reflected its fear that the alternative was to follow Lehman’s fate. The dominoes falling are the result of a toxic brew of 1) hundreds of billions of dollars of bad loans; 2) financial institutions’ leverage (debt); and 3) highly complex securities that, at least to some extent, interlink many players in the financial system.

We would mostly all agree that greed and poor judgment got us to this point, but we should also understand that the world needs a financial system that facilitates the workings of the economy. Businesses and banks rely on their ability to borrow so they can invest and grow and create new jobs, so they can bridge seasonal fluctuations in their revenues and so they can support their day to day operations, including making payroll. And, Main Street relies on its ability to borrow as well. Demand for a home, a car or other long-term assets, is dependent on borrowing ability. Without that, consumer demand and thus the global economy would be much smaller. A sudden and significant reduction in the availability of credit would result in drastically reduced demand for goods and services and a simultaneous loss of confidence on the part of businesses that would lead to waves of layoffs and less capital investment. This could create a significant shrinkage in the economy, which would have major negative fallout to businesses and individuals. Too much debt is bad, but some debt is a requirement to a well-functioning economy.

As we have written on several occasions this year, the problems at major financial institutions were harming the credit (debt) markets, as banks’ weakened financial state left them less able and willing to lend. This situation suddenly and dramatically worsened last week. Throughout the week our research team talked to their high level contacts at major bond firms getting real-time reports about what was happening. What they heard was stunning. Despite the Fed pumping hundreds of billions of dollars into the system in the first part of the week, the money markets—where businesses, including banks and financial institutions, conduct their short-term lending and borrowing transactions—appeared on their way to freezing up. The Lehman failure, AIG’s fall, Merrill’s sale and news that Morgan Stanley was discussing a merger with Wachovia— itself a severely weakened financial institution—shook traders and investors. Then news that a major money market fund had “broken the buck” triggered what began to look like a run on diversified money market funds in favor of Treasury-only money funds. Putnam, a longstanding mutual fund firm, announced that it was going to liquidate one of its money funds (without losses to investors) because it was overwhelmed with redemptions. In all, according to AMG Data Services, investors withdrew $145 billion from money funds last week, compared to $7 billion the week before. This all created massive demand for short-term U.S. Treasury securities—the only asset believed to be truly safe. At one point these securities traded at a negative yield—meaning that investors were willing to accept the certainty of a small loss on their investment rather than risk a larger loss somewhere else. The system-wide fear at this point was not merely that some funds might break the buck because they held Lehman or some bankrupt firm’s paper. Instead it was fear of a “run on the bank” that was developing, which would result in the inability of funds to sell the securities they owned (because there would be no buyers) to come up with the cash to meet investors’ redemption requests. This was a far more serious problem. 

What was going through our minds as we observed these events? A lot:

• We had serious worries about the market for commercial paper and short-term bank loans, which are essential to business operations. Last week, with capital leaving the money markets in favor of treasuries and government guaranteed securities, there were not many buyers for these instruments and trades that occurred were at very high interest rates. This meant companies and banks that had previously relied on some short-term borrowing to run their businesses (by allowing them to make higher-returning, longer-term investments with their capital), wouldn’t have that option. For decades as part of a normally functioning market they had been able to roll over these loans—now this was rapidly coming to a halt as money funds lost capital and consequently were afraid to invest in anything but the most liquid securities—treasury and government money markets. If allowed to continue this could be difficult to reverse and would have quickly resulted in financial hardship for many businesses, likely leading to layoffs, a general retrenchment in corporate spending, and in some (perhaps many) cases, bankruptcy. This had the potential to be a devastating blow to the economy.
• Even beyond the immediate and potential economic impact, the most alarming aspect of the crisis was the rapidly collapsing confidence in the basic workings of our financial system. Without unquestioned confidence in the system there is no system. That confidence was rapidly going away as money markets and the bond markets moved closer toward freezing up (because of a lack of buyers). Without assumption of a stable financial system, it was not possible to make long-term investment decisions in a normal framework.
• Our basic decision-making framework is always short-term risk versus long-term return potential. The sudden increase in risks—risks that had been unthinkable for the entire careers of just about everyone in the investment business—resulted in a necessary and rapid adjustment in our thinking.

Most of the population has no idea how close we came last week to a catastrophe that would have gone far beyond simply losses in the stock market. And the coverage in local newspapers in many cases didn’t adequately communicate what we were facing last week.

For some clients we believed were overexposed to equities in such an environment, we moved early in the week to reduce our equity exposure and generally reduce some of the risk in our balanced portfolios. Time will tell whether this move will add or subtract value. But regardless of whether it adds value, I believe that our decision-making process during this time was well-reasoned and correct from a risk-management standpoint. Panic decisions are ones that are made out of fear without accompanying reason. In contrast we were able to amass relevant information by acquiring information quickly from out independent research team and processing and debating the developments. We digested the sudden spike in real risk and the potential consequences, we looked at the potential impact on long-term returns and the rewards needed to compensate for risk taking, we thought about the risk tolerances of our clients and the potential impact of potential steep losses (which we believed were highly possible as early as Tuesday). We also realized that we were experiencing something that challenged basic assumptions that are essential to our normal decision-making framework—namely that the functioning of the financial system is a given that we can count on. The new framework, at least for a few days, was that betting on everything working out was tantamount to crossing our fingers. Almost always we have been able to rely on the assumption that things work out in the end. In 1929 that thinking wouldn’t have worked. This past week was as close as our country and the world has come to a 1929 scenario since then. We had the information needed to understand the situation and the ramifications, and our decisions were based on a rational assessment of the very material risks that existed at that time.

We believe the government’s proposed actions to bring confidence back to the money markets and address the massive system-wide mortgage-market losses, which gravely weakened the financial sector that we rely on for credit (the life blood of the economy), have allowed us to dodge a bullet. Importantly, they represent more of a comprehensive solution than the piecemeal attempts that had occurred prior. However, the next few weeks could still be volatile and the credit markets are not going to return to normal quickly.

Regarding the government’s plan, the concern about the cost is understandable. It is not good for our country over the long run. But the alternative would be far worse. The debate about whether we are moving toward socialism, the criticism that this is a Wall Street bailout with Main Street being ignored, and ultimately the question about whether these actions are absolutely necessary reflect a complete lack of understanding about the grave risk to the entire economy. This is why highly credible and experienced people with a deep understanding of the economy and markets, like Warren Buffett and Peter Bernstein, have endorsed the plan. In the end, this is about Main Street. It is about containing this crisis so that something far worse than a normal recession doesn’t occur. That Republicans and Democrats appear to be coming together in an election year reflects the magnitude of the risks. That coming together is itself unbelievable in this age of partisan politics. There is no question in my mind that there is no other choice, and we hope that a lack of understanding of its importance by the broader Congress doesn’t jeopardize its timely passage.

Having likely dodged this bullet we will focus our attention in the coming days on two general areas.

• First, we will be revisiting our thinking about long-term earnings and return potential for equities and other assets and whether that has changed because of the immediate damage done to the economy, the significant deleveraging and bad debt losses still to come, the likelihood of higher taxes and more regulation, and the longer-term impact on potential inflation, the dollar, and interest rates. We will rely heavily on our contacts with firms that have particular expertise in these areas, but will apply our own analytical overlay. We are also evaluating the long-term return potential in some sectors of the bond markets, which are subject to near-term uncertainty but appear priced to generate returns in the high single digits.
• The second area of focus is the short-term risk. We need to assess whether or not we are out of the woods. We expect there will be significant losses (beyond additional mortgage losses) in other areas such as commercial mortgages and credit cards. The resulting deleveraging may now be worse because the economy was already on a downward path and has now suffered a shock. Moreover, the interrelationships between institutions because of complex financial derivatives (e.g. credit default swaps) are still a concern. And, in the near term, the economy will be harmed by the credit-market freeze up that has still not yet returned to normal.

We do this analysis with the intent of investing some of the cash that is currently sitting in client accounts as soon as we can do so with confidence. Beyond near-term risk control, we also have the objective of reassessing our long-term positions. Some who follow our advice may be ready to judge based on the near-term results of a risk-control move, but we believe that the benefits of our understanding and analysis will be realized longer term, as we potentially move into a completely new environment. As we analyze all of this and also tap into the thinking of our research team, we will also have to stay focused on being objective and not letting recent events cloud the clarity of our thinking.

We continue to believe that the one silver lining in all this is that as the investment markets adjust to these dramatic changes, it is quite likely that we will have some compelling investment opportunities present themselves.