Andrew Bell explains how the global economy got into such a mess and suggests what investors should learn from the experience

We live in historic times. Barack Obama’s election to the White House has raised hopes for peace in the Middle East after eight years in which the ‘humble foreign policy’ promised by George W Bush has been noticeable by its absence.

And future generations will study the dramatic financial events of recent months as a once in a century case study, as well as – we hope – deriving lessons in how to prevent the end of a credit bubble from leading to a depression.

September 2008 will merit a chapter in the history books of financial markets as it marked the start of a massive programme of state intervention employed – in the home of capitalism itself – to stabilise the US financial system. The two state-sponsored entities responsible for underwriting most US mortgages (Fannie Mae and Freddie Mac) proved to have too little capital and had to be brought into a form of nationalised management. The major investment bank Lehman Brothers filed for bankruptcy and the giant insurer AIG was taken over by the Federal Reserve.

A domino effect
Bank mergers were announced on both sides of the Atlantic, as institutions sought combinations that would increase their financial strength and enable them to reduce costs. Bank of America took over Merrill Lynch, and Lloyds Bank performed a similar role with HBOS in the UK. Towards the end of the month, Bradford and Bingley was nationalised only days after the US suffered its largest ever bank failure when Washington Mutual was closed.

Emphasising the global nature of the problem, this was followed by the rescue of another major US bank (Wachovia), the refinancing of two Benelux banks with state equity injections, the supporting of a German property company in part with state-supported credit lines, the nationalisation of the Icelandic banking system and the undertaking by the Irish authorities to guarantee all deposits until 2010 to stop a run on its banking system.

This was followed by a rash of capital raising, underwritten by governments, keen to put a stop to the process whereby the failure of one institution immediately brought the perceived next most vulnerable into the market’s sights.

So where did it all go wrong?
The roots of these events lie in the unprecedented expansion of borrowing undertaken in the US, particularly the housing sector. Financial innovation enabled organisations to make loans, which were then bundled together and sold to other investors who sought higher returns than were available on bank deposits.

Lending standards deteriorated so that the loans did not earn enough in the good times to pay for the inevitable bad debts when the markets turned sour. On top of poor lending decisions and inadequate pricing of risk, many parts of the financial system employed high levels of leverage in an effort to gear up the returns on offer.

As the US housing market deteriorated, many of these loans began to default. This sparked off liquidity problems for markets in August 2007, when investors withdrew funding from these packaged loans, resulting in the banks having to finance them from internal funds.

A chain reaction ensued, resulting in increased stress in most parts of the financial system, which revealed that the borrowing excesses of recent years had been much greater than was realised at the time. Some institutions experienced liquidity problems – i.e. they needed more cash than they had available – while others had credit or solvency problems, as losses eroded their capital base.

A further consequence of the pressure on bank balance sheets was that their lending policies swung from being excessively liberal pre-2007 to highly restrictive by 2008. As the supply of mortgage finance dried up and companies found loans harder to obtain, what was initially a financial market problem spread out to the wider economy. Compounding this credit squeeze, a surge in oil and other commodity prices in mid 2008 put pressure on consumer incomes and corporate profits.

By summer 2008, the deterioration in the global economy was happening more rapidly than the rate at which the banks could recapitalise themselves. Despite hopes that the collapse of the US investment bank Bear Stearns in March would be an isolated event, doubts began to emerge about the solidity of a number of other banks.

Overtaken by events
A number of observations stand out. First, the crisis has now spread from financial markets to the broader economy. The banking system is likely to need yet more capital in order to absorb recessionary losses. Furthermore, investors no longer have confidence in the degree of financial leverage in the banking and investment world, which is prompting falls in most asset prices as organisations – willingly or under pressure – reduce their risk.

A number of financial structures devised for distributing loans have fallen into disfavour,
and the means used to hedge risk have also proved vulnerable, as confidence in dealing counterparties evaporated. The financial world has abandoned one system of ‘plumbing’ without yet having found a replacement, so central banks have had to intervene to fill the resulting gaps. Finally, corporations are building up a greater cushion of their own liquidity, in order to avoid being forced to go to the banks, cutting back on capital expenditure and employment – in short, resulting in reduced growth for the economy as a whole.

These unprecedented events have led to extraordinary volatility in financial markets, as economic forecasts were slashed in the wake of the ‘credit quake’. The problem facing policy-makers is how to re-instil confidence in the solvency and effectiveness of the global financial system.

Unprecedented actions
Unprecedented measures have been taken to reduce the cost of borrowing, open up liquidity to the banks and boost demand in economies by cutting taxes and raising government spending. However, investors, reeling from the recent shocks, are reluctant to believe that the more concerted easing policies adopted since September will succeed. These will need time to work, but appear to be properly focused on the problem in hand – how to mitigate the risk of a sharp recession morphing into a prolonged slump similar to the 1930s.

The immediate prospect is for further uncertainty, particularly while the interbank lending market remains disrupted, and while profit downgrades and income pressures work through the economy. This flow of poor news, together with restructuring in the bank sector, could mean that there is no early respite from recent financial market volatility.

There are, however, some more positive factors that are presently being overlooked. With the rating on equity markets historically low and with inflation and interest rates falling, there are investment opportunities as a result of the recent fear-induced selling. The yield on many equity markets exceeds that on bonds, a relative rating that has historically been followed by equity outperformance.

Rays of sunshine
In parallel with the banking denouement, the commodity inflation scare has reversed. The oil price has dropped even more rapidly than it rose, which will be positive for growth prospects in 2009. Although it therefore seems too late to be running for cover, a process which would be akin to driving using the rear view mirror, it is important to exercise care and patience in investment selection and to be diversified.

At times like this, it is well to recall that, in the view of some well-known investors, the best time to invest is when it feels least comfortable. The late Sir John Templeton said that the best opportunities occurred at the time of maximum pessimism, while the no-less-illustrious, but still current, Warren Buffett believes in being ‘fearful when others are greedy and greedy when others are fearful’.  The recent period of negative sentiment has been particularly acute, and often, though not always, such moods give way to periods of economic convalescence and recovery.

As we enter 2009, the risks do not all look to the downside, despite the current mood
of trepidation.

Andrew Bell is head of research at wealth manager Rensburg Sheppards Investment Management