As of this writing, the stock market has moved up sharply since its lows of early March. Credit product spreads have improved since last fall. Both of these indicate that some appetite for risk has returned to investors. These “baby steps” are a part of an effort to bring about an orderly market, a definite improvement over the erratic market behavior since last fall. However, our system remains well over-leveraged and there is still much work to be done. There is no magic bullet to fix this and it is likely that it will take years to heal all the damage done and to work through all of the issues.

Much will be written over the coming decades of the current financial problems facing the globe. The causes, warning signals, reactions and resolutions will be debated among the next generation of economists, politicians and financial analysts, to name a few. For the present, the headlines are full of comparisons to prior economic downturns.

Traditional banks provided almost 60 percent of the total lending in the economy immediately after 1945. Now they provide only 20 percent of the total, approximately $14 trillion of the total credit provided by all financial intermediaries. The other lending activities arose from what many call the “shadow banking” system, implying something sinister and in the dark. Some of this lending was less than transparent, usually in the form of structured investment vehicles (SIVs) and other conduits. Most of the other sources are available for review and used by large segments of the population.

For our purposes it is important to understand that capital markets are fundamentally different than immediately after World War II. Money market funds had grown to $4 trillion in assets. These funds would lend directly to large corporations in the form of commercial paper, due to its short maturity. Bond funds had grown to $2 trillion in assets. These were direct purchasers of corporate credit and securitizations. Securitizations, whether in the form of collateral debt obligations (CDOs), collateralized loan obligations or commercial mortgage-backed securities, directly and indirectly purchased consumer and commercial loans. Asset securitizations were conduits by which the original lenders could pass the loans onto the ultimate buyers of a package of these loans.

This last point indicates that aggressive and lax underwriting standards contributed to our current problems. Poor underwriting standards (little or no verification of income and loan-to-value ratios as high as 100 percent) as well as inappropriate products (option ARMs) contributed to a housing bubble. Along the chain of securitizations, from originator to distributor, many ducked taking ultimate responsibility for the results. Poorly constructed tranches of securitizations that effectively converted a large portion of poorly underwritten loans into AAA-rated securities, added to this. The rating agencies played a key role in assigning ratings the individual loans would not support. Abnormal housing appreciation as a result of the above practices, no-money-down mortgages, real estate speculation and dishonest individuals all added fuel to the fire.

By 2006, 41 percent of U.S. corporate profits were attributable to brokers, mortgage companies, insurers, hedge funds, banks, and private equity firms. During the 1970s the financial sector's share of profits was in the 20 percent range and in the 25 percent range during most of the 1990s. There was money to be made in the new export industry, derivatives. Congress and the White House encouraged the boom in mortgage lending, promoting the “American Dream,” with homeownership increasing to almost 69 percent from previous highs of 64 percent. A policy of cheap interest rates further fanned the flames.

As a result, excessive leverage pervaded the system. Hedge funds used leverage to magnify returns, private equity firms increasingly leveraged up their buyouts, even pension funds and endowments added to their leverage. Consumers were caught up by taking out second mortgages and home equity loans to finance their spending spree, using their homes as their personal ATM machines.

A widely read and respected financial commentator has recently been speaking of a “New Normal” for investors, consumers and managers. Looking forward to when the current problems start to recede, he advances the idea that we will all assume less risk in our investing and spending patterns, lenders will be less willing to assume risk and regulators will be more critical of speculative practices. This long term adjustment to the reduction of risk as a result of the lessons we learn from this downturn will likely have important economic implications for the financial markets and spending habits for some years to come.



David Helscher is a senior vice president and trust officer with Clinton National Bank.

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