In the third quarter of 2008, the markets experienced the most serious challenge to world financial stability since the depression of the 1930s. What began in early 2007 with a sharp upturn in subprime mortgage delinquencies spread into commercial banks, insurance companies, and investment banking firms. By quarter’s end, the world’s credit markets were in a state of seizure. Investors and borrowers began to lose confidence in our leading financial institutions and volatility reached extremely high levels. In particular, equity prices fell sharply, reacting to seemingly unbelievable developments in the individual financial institutions.

As the quarter came to a close, some of our nation’s largest institutions had either ceased to exist or were in the process of radically changing their business models. Goldman Sachs and Morgan Stanley experienced 40% declines in stock values, in just three days, victims of short-sellers and hedge funds. By the week ended September 19th, Morgan and Goldman announced plans to reorganize as bank holding companies. In a single six-month period, all five of America’s major investment banking firms (Bear Stearns, Merrill Lynch, Lehman Brothers, Goldman Sachs, and Morgan Stanley) either merged with a bank, reorganized, or filed for bankruptcy. The end of America’s leadership in investment banking would have been unthinkable at the start of the third quarter of 2008.

Commercial banks were also swept into the maelstrom. Wachovia Bank’s stock fell from 60 in early 2007, to as low as 10 on September 26, 2008. As deposits fled, Wachovia was forced into a merger with Citigroup, which was announced on September 29th. This followed the merger of Washington Mutual, our nation’s largest thrift, into J. P. Morgan, which had occurred earlier in the same week. As the leading originator of many of the subprime mortgages, Washington Mutual was taken over by the Office of Thrift Supervision and forced to accept merger terms very favorable to J. P. Morgan. Even the old-line banks such as Fifth Third Bank of Cincinnati, National City and KeyCorp (both Cleveland-based banks), and Regions Financial of Birmingham experienced share price declines of 70% or more, frightening investors and depositors.

The world’s largest insurance company, American International Group, and a member of the Dow Jones Industrial Average, fell from $20 to $2 during the third quarter. Again, short-sellers and hedge funds drove the share price down without mercy. Only an eleventh hour rescue by the Federal Reserve saved AIG from declaring bankruptcy. If AIG had failed, the fallout would have affected every major financial institution in the world, as AIG conducts business in every important economic center across the globe. The Federal Reserve’s rescue came just hours before the company was prepared to declare bankruptcy, sparing the world’s financial system from certain collapse that would have plunged the economies of the world into an abyss deeper than anything witnessed in the 1930’s.

The White House response team, consisting of Treasury Secretary Henry Paulson, Federal Reserve Chairman Ben Bernanke, and Christopher Cox, Chairman of the Securities Exchange Commission, mounted a series of stop-gap measures to confront the unfolding series of crises which led to the erosion of investor confidence in the equity and credit markets. In reviewing this team’s actions, which have enjoyed some success, they have failed to stem the unwinding of institution after institution. The spread of investor confusion and concern, which has destabilized world markets, continues. The administration’s prompt response to save Bear Stearns was perhaps the most successful effort. By swiftly merging Bear Stearns with J. P. Morgan on March 17, 2008, the Federal Reserve indicated that it was prepared to maintain order in the financial markets.

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The spread of investor confusion and concern, which has destabilized world markets, continues.
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In stark contrast, the successful effort in rescuing Bear Stearns was followed by a complete failure of the U.S Government to throw a lifeline to Lehman Brothers, which was literally dying on September 12th, yet another victim of short-sellers and hedge funds. By allowing Lehman Brothers to fail over the weekend of September 13th and 14th, the Administration’s rescue team unleashed a string of counterparty defaults, which spread throughout the financial markets of the world and resulted in a series of unexpected consequences. The most notable of these was the collapse of the Fortis Bank, a large European bank, and the failure of the Reserve Fund, our nation’s first, and one of the largest, money market funds. Unable to maintain $1 of unit value, the Reserve Fund was caught holding large quantities of defaulted Lehman paper. Because of the lost value in their Lehman holdings, the Fund was forced to mark its value down by 3% from $1 per share to $.97 per share, effectively eliminating almost $3 billion of investor wealth and creating a panic in all money market funds. In yet another reaction to events, Bernanke and Paulson were quickly forced to pledge the United States’ full faith and credit to the maintenance of $1 per share of unit value for all money market funds.

In another bungled response, the government’s efforts to rescue Freddie Mac and Fannie Mae probably did more harm than good. On July 15th, the government announced its verbal guarantee to fully back all outstanding paper of Freddie Mac and Fannie Mae, the nation’s two largest mortgage holders. This was required because these two institutions were having difficulty rolling their maturing issues into new bonds. With a federal verbal guarantee, liquidity was restored temporarily to these two organizations. Concerns intensified again in late August, and at that point, the Federal Reserve decided to formally nationalize and assume control of Freddie Mac and Fannie Mae, thereby providing a full guarantee of the $5.5 trillion of mortgage paper these Government Sponsored Entities (GSE’s) issued.

The truly unfortunate aspect of this rescue was that earlier in the spring—at the urging of the Federal Reserve and the U. S. Treasury—Freddie Mac and Fannie Mae raised over $8 billion in the sale of new preference equity capital to investors around the globe. This paper was not covered in the rescue effort and became worthless within six months of its issuance in April, 2008. The resulting furor of investors—who witnessed 100% losses on the Freddie Mac and Fannie Mae preference stock—effectively closed the capital markets to other financial institutions, who were desperately seeking to raise capital. This was the direct result of the Federal Government’s policy, on the one hand urging Freddie Mac and Fannie Mae to raise capital in the spring, and then denying to back that capital raising in the fall when the two companies failed. This is a stain on the U. S. Treasury’s reputation that will take years to erase.

Compounding all of these difficulties has been the sudden increase in volatility in the share prices in the U. S. stock market. This can be traced to SEC Commissioner Christopher Cox, who on July 7, 2007, suspended two important trading rules that were established in 1934 by the first SEC Chairman, Joseph P. Kennedy. A practitioner of speculative tactics in the 1920’s, Kennedy was familiar with the “bear raid,” whereby speculators could drive down the price of a stock by relentless short-selling. Upon assuming SEC command, Kennedy instituted the “uptick rule”—i.e. requiring that a short sale only be followed by a higher priced transaction—effectively stabilizing share price movements and eliminating rampant speculation… this worked well until Mr. Cox’s unexplained suspension of the rule on July 7, 2007. In addition, short-sellers under the Kennedy SEC rules were required to physically produce shares as collateral for their short sales. Mr. Cox relaxed this collateral rule, creating “naked short-selling,” wherein the speculator can short stocks without having to borrow the shares first. This policy, in some cases, created situations where more than 100% of a company’s shares were sold short!

Throughout 2008, daily volatility of the U. S. stock market increased significantly partially due to the SEC’s rule changes of 2007. As cries to return to the old rules prior to July 2007 were not heard by Washington, markets became less stable, further upsetting investors. Following a 100% ban on short-selling imposed in Great Britain on September 16th, Mr. Cox suspended short-selling on just 799 financial stocks and reimposed the naked short-selling prohibitions on September 17th. This emergency order is scheduled to expire on October 7th, and the SEC said there will be no additional extensions. It is important to note that thousands of companies’ stocks are still exposed to short-selling as speculators were not affected by Mr. Cox’s September 16th actions.

On the morning of September 18th, with the markets in disarray, the Treasury and the Federal Reserve called an emergency meeting of congressional representatives to unveil a comprehensive rescue package for the troubled mortgage markets. This hastily prepared legislation was short on details and was not well-communicated to legislators or their constituents. Public resentment and poor communication by administration officials resulted in the failure of a vote by the House held on the afternoon of September 29th.

As this letter is written, congressional officials have made slight modifications to the bill and plan to bring it to a vote again by October 3rd. The actual bill is a $700 billion stand-by federal credit guarantee designed to give banks the ability to remove troubled assets from their balance sheets. A similar stand-by credit facility was created in 1990 to address lending failures in the non-residential real estate markets under legislation organizing the Resolution Trust Corporation. This credit facility successfully removed non-performing loans from the balance sheets of savings and loans, while they awaited improvement in real estate values. Ultimately, however, loans, on average, were liquidated at a profit and the government recovered its loan credit advances. The current confusion, with respect to the stand-by credit facility, lies in how much will actually be needed to be deployed before real estate values stabilize and begin a recovery. There is the possibility that the proposed rescue effort could yield a profit to the taxpayer, as did the Resolution Trust Corporation when it completed its usefulness in restoring order to the non-residential real estate markets in the early 1990’s.

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There is every reason to believe that today’s proposed legislation will be as successful as our prior experience.
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It is impossible to calculate the cost of the currently proposed stand-by credit facility. In the case of the 1990 Resolution Trust Company, $250 billion was made available at a time when our gross domestic product was $6 trillion. That credit facility represented just over 4% of our gross domestic product. The current legislation calls for extending as much as $700 billion in new credit for financial organizations holding troubled paper. This represents slightly over 4% of our projected gross domestic product of nearly $15 trillion. Therefore, the relative cost of the proposed legislation providing support for the banks is just about the same, on a relative scale, as was the Resolution Trust Corporation of eighteen years ago. Our economy survived the difficulties of that period, and the commercial real estate and non-residential construction markets recovered. The credit advances were repaid with a modest profit to the government. There is every reason to believe that today’s proposed legislation will be as successful as our prior experience.

What does all this mean for investors? As the economy slows, inflation and interest rates will likely fall. In 2009, inflation should not exceed 2%. Falling oil prices and a slowdown in economic growth should reverse the commodity price spike of 2007. Wage gains in the United States are under pressure as unemployment should jump to over 7% by the spring of 2009. The bright spot in our economy should be in the capital spending area, which accounts for roughly 17% of our economy. This sector should benefit from increased spending on defense and exports to Asian countries for infrastructure development. Interest rates of between 2.5 and 4% are likely on U. S. government securities during calendar year 2009. The highest quality corporate bonds should closely parallel the treasury yield curve, which is a huge departure from the current environment. “Junk bonds” and lower-rated paper will remain unstable until the economy indicates signs of recovery.

Equities are now down over 20% year-to-date as measured by the S&P 500. We believe this decline largely discounts our weak economic forecast. We do believe that equities can justifiably trade between 13,000 and 14,500, as measured by Dow, over the next 18 months. In the near term, the stock market will reflect the uncertainty in the financial world. However, many outstanding companies are currently valued at levels we see only once in a decade. Opportunities to acquire leading companies at very reasonable valuations do not come often, and one must take advantage when they present themselves. I would note that one of the savviest investors, Warren Buffett, has made large equity investments in Goldman Sachs, General Electric, and Constellation Energy in the midst of all this market turmoil. We would feel uncomfortable betting against the investment record of Warren Buffett. Therefore, although we are not sure of the exact timing of a recovery in our economy, the markets have always moved on to new highs. This cycle is unlikely to be any different.
—Jim Hardesty