Financial retreat and panic

The Wall Street Journal Editorial:

In his book "Manias, Panics and Crashes," the economic historian Charles Kindleberger describes the stages of financial boom and bust. Students of the good professor will recognize where we now are in the current credit crisis: the panic stage. It isn't a pretty sight, but a crash is far from inevitable if political and economic leaders keep their wits about them and focus on the proper remedies.

Amid the daily market turmoil, and to help prevent a crash, it helps to step back and remember how we got here. With the benefit of hindsight, everyone can see that the U.S. economy built up an enormous credit bubble that has now popped. Our own view -- which we warned about going back to 2003 -- is that this bubble was created principally by a Federal Reserve that kept real interest rates too low for too long.

In doing so the Fed created a subsidy for debt and a commodity price spike. The price spike contributed to "excess savings" in countries with a low propensity to consume and which channeled that money back to the U.S. That capital flow and debt subsidy, in turn, became fuel for smart people in mortgage companies, investment banks and elsewhere to exploit. In a sense they created a new financial system -- subprime loans, SIVs, CDOs, etc. -- that is enormously efficient and brought capital to new places. But thanks to low interest rates and human enthusiasm, this debt spree also got carried away. This was the mania phase.

Thus we were told that rising housing prices were no problem, even as they climbed by 20% or more a year in some markets. Demographics and immigration could explain the boom. Credit spreads narrowed to unheard-of levels, but neither lenders nor investors seemed to mind. The rating agencies added their AAA blessing, and financial CEOs basked in rising earnings from investments they little understood.

The political class now attributes this to greed and fraud, and there is some of that in any mania. But most was the product of creative Americans responding to the incentives for debt that the Fed created. The politicians also enjoyed the boom while it lasted, spending the tax revenues, feasting off Fannie Mae campaign dollars, and celebrating the spread of home ownership. No one wanted it to end, which is why there was so much caterwauling once the Fed did begin to remove the debt-subsidy punch.

...

Enter the panic stage. The desire for debt has turned into a stampede to quality, especially Treasury bills. The same folks who never predicted the economy would recover in 2003 are now cheerleading recession. Any bank writedown or deal to raise capital -- no matter that it is part of the healing process -- is taken as a sign that there is more bad news to come.

...

There is much more.

I think the biggest cause of the non performing loans was the removal of lenders from the lending decision. Putting loan brokers and other intermediaries between the borrower and the lender changed the dynamic and the incentives in the lending decision. Loan brokers made money by finding borrowers, and took no responsibility for the losses when the loan did not perform. In the past lenders had certain guidelines for borrowers and rules of thumb that protected the lender and the borrower from a bad decision. As the new financial instruments came into place these guidelines were discarded in the belief that creating greater liquidity with the debt would cover the risk. It had the opposite effect and now those who created the instruments are suffering the consequences, big time.

It should also be noted that to really lose big money in the market you need leverage. In the case of these instruments there were multiple layers of leverage beginning with borrowers who put up little to nothing so they consequently had little to lose when they were unable to pay. Add to that the way the instruments that were used to finance the borrowing were sliced and diced and the potential for big losses is magnified.

In order to avoid panic investors need to look at other investments in businesses that are producing products and services that are still in demand and that are still making money. There are many of them out there with great potential as well as good current earnings.