Finally, one of the most extraordinary weeks in stock market history is
coming to an end. The week began with Lehman Brothers (LEH) filing for
bankruptcy, followed by an $85 billion dollar government bailout of insurance
giant American International Group (AIG), and concluded with the federal
government announcing plans to take bad loans off of private company's balance
sheets as well as halting short selling in financial stocks for 10 days (with a
possible extension). The market reaction was deep depression followed by
euphoria, with 2 days of 4% drops mixed in with 2 days of similar gains. With
such massive federal intervention, did we just witness a failure of capitalism,
or can we not afford to let it work? Who's to blame for this mess and are these
the right steps to prevent a redux? What does all this mean for investors,
particularly Magic Formula investors?
A Quick Synopsis of the Problem
First, a quick synopsis. As we know, banks got lax on lending standards, and
for some reason believed that a below-prime borrower that could barely afford an
introductory rate on an adjustible rate mortgage (ARM) was magically going to be
able to afford rates 5-6% higher in 3 or 5 years. Now that those loans are
resetting at higher rates, foreclosures are rising leading to increased loan
defaults. When 15% of a bank's loans default, and the bank had only provisioned
for 3% of them, that's bad news.
Exacerbating the problem is the incredible amount of financial "innovation"
that occurred this decade. Investment banks greedily bought up these mortgages
from lenders, and then went to financial culinary school, slicing, dicing, and
combining them into alphabet soup derivative securities like MBSs (mortgage
backed securities), CDOs (collateralized debt obligations), and so on. These
securities were then bought by all sorts of companies, from banks to insurance
companies to electric utlities. In effect, the mortgage crisis is putting all of
those buyers at risk now. It's clear why Warren Buffett referred to these
securities as "financial weapons of mass destruction" back in 2003.
The daisy chain doesn't end there. AIG got into trouble because it sells
credit default swaps. In effect, this is insurance against another company going
bankrupt. You can see where this is going. With so many firms exposed to this
mortgage mess, bankruptcies may skyrocket, leaving the insurers like AIG with a
tidal wave of claims to cover. If it can't meet those obligations, bankruptcy is
Why Not Let the Market Solve It?
So that's the synopsis. It's disturbing how fragile the financial pillars of
the economic system really are. Is this a failure of capitalism? I don't think
so. In a pure capitalistic system, the banks holding the mortgages would
certainly fail, and some of the insurers and other firms exposed to them would
also go belly-up.