Commentaries

It is indeed a wonderful life, in so many ways. I have always marveled at the magic of capitalism and markets. The ability of capitalist economies to adapt, change, persevere, innovate and generate wealth is incredible. Stock markets are simply one of the more visible manifestations of capitalism at work. What makes it a wonderful life for investors is that stock markets give us a vehicle through which to share in the wealth created by entrepreneurs, inventors, innovators and the most productive members of society. Even those of us who never manage to come up with a billion dollar business idea can still participate in the wealth created by those who do.

I was having discussions along these lines with people a month or two ago, often in response to clients inquiring about China. With the rise of their economy and the newfound release of entrepreneurial energy there, some people worry about having to compete with them, while others want to know how to profit from their rise. I discussed the fact that free market capitalism leaves wise, long-term investors with little to fear. The rise of the United States (a feared, low-cost, emerging market) was once of great concern to the dominant economy of it’s time – Britain. That proved a very much misplaced fear, as the rise of a great trading partner benefited Britain as well as the United States, just as a prosperous China will benefit us as investors today.

But it was none of this that had me thinking of the title above. The recent “liquidity crisis” you may have been reading about has had me discussing the old movie classic It’s a Wonderful Life with Jimmy Stewart. Most people have seen it.

In the past month, stock markets around the world have dropped quickly, erasing most of the gains made during 2007 thus far. As you will have heard in the news, the primary reason cited is the concern over ‘subprime’ issues in the US. I want to put the market reaction and some of the media coverage into perspective. That’s where Jimmy Stewart comes in.

Remember the scene where the depositors to his little town bank all make a run on the bank (on the day of his wedding unfortunately)? Because of a rumour that there was a problem at his bank, everyone decides at once to cash out. He tries to explain to them that of course their money is safe, but that it isn’t all sitting here in the branch, it’s ‘in your house Mr. X, it’s in your farm, Mrs. Y’. Jimmy was experiencing a liquidity crisis. While his bank may have had more than sufficient assets to meet the demands of his depositors, he didn’t have it there in cash at that moment. Mortgages can’t be called in on a moment’s notice.

Mortgages can however be sold to other institutions for cash, or bundled and sold to investors as a security that generates a cash flow for investors, or many other creative incarnations. In all these many incarnations (broadly speaking: mortgage backed securities, or MBS) you have been reading about the effect of a little run on the bank. Due to a rising level of defaults on some of the higher risk mortgages in the US, a growing number of investors holding MBS decided they’d like their money back out. As they all tried to sell these securities at once, the value naturally fell. But that also pushed down the market value of the MBS for every other MBS holder. That resulted in some margin selling for investors who had borrowed against them to buy other securities. It meant that some financial companies would likely show lower profits to reflect the lower value of their MBS holdings. But mainly, it meant that the amount of money available to lend for all sorts of purposes (leveraged buyouts, or even perfectly sound mortgages) was reduced as lenders around the world sat back to assess the impact.

The value of all subprime mortgages in the US is less than one half of one percent of US financial assets. If 100% of them defaulted by 100%, the effect on the market and the economy as a whole would be manageable. But these are mortgages and therefore backed by assets. While there will be losses, particularly where they are most deserved (firms lending 110% of the value of a property to borrowers of dubious credit quality will suffer losses in this), the losses will never be 100%.

While the problem you keep reading about is mostly confined to the subprime mortgage sector, we have seen stock markets all over the world, and companies in all manner of business effected. Why? First, the liquidity crisis can affect other stocks in the short term. Margin calls may mean a stock like Coca Cola has to be sold to cover off a loan obligation. Coke shares may go down as a result for a short while but surely subprime mortgage defaults will have no effect on the number of Cokes sold each day, and the effect will be shortlived. Second, stock markets occasionally seize upon any convenient excuse to take a corrective downturn. This is normal, and quite frequent. Few now seem to remember that in 2006 the TSX dropped 12% in less than two months (the excuse then was the Israeli incursion into Lebanon) because it was brief and quickly reversed to make 2006 a year of double digit gain.

When good stocks drop in value for no reason, or for reasons that should not affect them, they must be better buys than they were at higher prices. I think we are seeing such opportunities now. This correction will pass. The purpose of central banks is to provide liquidity to the financial system at precisely such times as we have just experienced. Last week, calming statements to this effect from the Federal Reserve in the US may have already marked the end of this ‘crisis’. The stock market reaction, the panic of some investors, has been worse than the problem supposedly at its root.

My girlfriend is allergic to bee stings. I am not. If I get stung it is painful for an hour and it is annoying, but that’s the end of it. She carries an epinephrine shot with her at all times. For her, a bee sting could be fatal. But bee stings are all pretty much the same, and the difference between her and I is only in our reaction to them. There are no shots that will help investors survive an over-reaction to market corrections. Luckily, they can choose whether or not they want to be allergic and can manage their reaction to the sting of market corrections. Wonderful!

Alan Cameron

Commentaries

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