Stocks - October 2008

A Seismic Financial Tsunami

They’re dropping like flies. Bear Sterns. Indie Mac, Fannie Mae, Freddie Mac, Merrill Lynch (saved by a Bank of America buyout) and finally Lehman Brothers. All gone as we knew them. What is going on?

In a nutshell, we are witnessing the unfolding of a seismic financial tsunami. It is nothing less than the forced and rapid deleveraging of the world’s entire global financial system. Too much debt concentrated in too-few major players has bitten and bitten hard. And it’s not over.

The financial carnage is occurring on an almost daily basis, but it may be hard to believe that what we are witnessing — on a most fundamental level — is nothing new. It has happened time and time again over the long course of economic history. And in spite of whatever ultimately happens now (trust me on this) sooner or later it will happen again. Because behind the morning headlines — the collapse of many of our financial titans — the real story is this: human nature is constant. It never changes. The recurring cycles of fear and greed reign. And they reign supreme. No matter how globally interconnected we may think we are, no matter how sophisticated the mathematical risk management models created by Wall Street, there is one absolute constant you can depend on, which in and of itself virtually guaranteed this outcome. And that would be the ability of folly and greed on occasion to completely eradicate any and all common sense.

This is nothing new. In the 1841 classic, Extraordinary Delusions and the Madness of Crowds, Charles Mackey described the famous Tulip bulb frenzy (generally considered the first recorded speculative bubble) that took place in Holland in the early 1600s. At the peak of that manic mania, tulip contracts sold for more than 20 times the annual income of say, a skilled craftsman. At one point as much as 12 acres of land were being offered for tulip bulbs. The Dutch just went nuts for tulips! But of course, it didn’t last. Manic bubbles never do. They all end. Badly.

We’ve experienced such madness before. Remember the dot-coms? It was that frenzy and irrational madness (greed) for all-things-tech that drove the NASDAQ stock market index to planet Pluto-like heights (yes, to me Pluto was, and always will be, a planet), peaking in the spring of 2000, ultimately setting the stage for the eventual collapse of the NASDAQ stock market index. You see, once a bubble mentality develops in a market, it’s impossible to know how high is high. But I can say this with confidence: We do know how low is low. You see, without exception, all bubbles eventually pop. All financial manias have eventually ended, and the aftermath has never been pretty. And when the financial dust finally settled, prices have always retreated to ground zero from which they began.

The current incarnation of this phenomena is the manic bubble that developed over the last few years in real estate and credit. Ultra low rates resulting from policy decisions following the 9/11 attacks made financing a house affordable to many first-time buyers. As surge of demand was met by a surge of supply (the homebuilding industry was only too happy to accommodate), the mortgage and banking industry was quick to join the party by creating any number of exotic mortgages and loan packages for any Joe-Blow Donald Trump wannabe. And why not. Mortgage companies and banks were making a killing creating and brokering loans. Never mind that lending standards ultimately became nonexistent. That was not a problem because real estate loans were no longer kept under roof. Nope. They were sold to the investment braniacs on Wall Street who made big bucks creating billions of dollars worth of mortgage-backed bonds (bonds collateralized by large numbers of real estate mortgages) that were then sold to willing institutional buyers such as pension funds, insurance companies and various banks — the very folks now in trouble. You see, at no point was there any risk to the originating parties taking fees on all of these transactions. The risk instead was being transferred ultimately to the end-purchasers of these weapons of financial destruction (can you say “patsy”?).

Now there is nothing inherently wrong with any of what is described above, just as there was nothing wrong with any given dot-com company going public to raise money. The problem comes in when people take a reasonable idea to ridiculous ends, meaning greed. In the case of real estate, so long as housing prices were climbing, everyone was happy and everyone was making money — just like the dot-coms. But no asset class will climb in price above its underlying intrinsic value forever. As Herb Stein famously once quipped, “If something can’t go on forever, it won’t.” Everyone knew that sooner or later the party would end. Most of the smart folks on Wall Street just thought that they would get out ahead of the crowd. But they didn’t.

Why didn’t these presumably smart bankers see this coming? Why didn’t they leave the party before midnight? Well, some did, but most didn’t. You see, the psychology and aphrodisiastic characteristic of a greed-driven investment bubble are deeply powerful. Never underestimate the ability of crowd psychology to rationalize and justify madness (there has been an enormous amount of study on “groupthink,” how otherwise rational people can be brainwashed to do, believe and accept otherwise incomprehensible outcomes — the holocaust comes to mind). In spite of the fact that all of these very smart market players knew that the party would end, they were apparently unable to separate themselves from the magic of the moment. Warren Buffett once put it this way: it’s as if everyone at Cinderella’s ball knew that at midnight they would turn into pumpkins and mice so they were watching the clock. But in this case, unfortunately, the clock had no hands.

Bo Billeaud has been president and chief investment officer of a Lafayette-based money management firm for the past 18 years. Contact him at [email protected].