As I thought about the events that marked 2007, I was reminded of the wise words of Sir John Templeton, an investor of great renown. He warns that one should never forget the lessons of history. According to Sir John, “This time is different” are among the most costly four words in market history.

Overview

Investors were treated to a pretty tumultuous year in 2007. After several consecutive years of strong stock market performance, it was a rude reminder that what goes up in financial markets can also come down.

The volatility we witnessed was largely related to the meltdown of the US sub-prime mortgage market and the ripple effect that had worldwide. As the year drew to a close, financial markets were still trying to assess the full extent of the fall-out.

Overall, stock markets around the world managed to eke out positive returns for the year. But, some sectors, particularly the banks and other financial stocks, suffered significant losses. Even bonds and fixed income investments, traditional safe havens for investors, were dragged down. Add to all that, the impact of a soaring loonie and you get a pretty disappointing year overall for investors.

The soaring loonie

In recent years, the Canadian dollar has seen significant gains in value. But, 2007 was truly exceptional.

At the outset, the loonie was worth about US$0.86; it gained steadily in value, over the course of the year, soaring to an all time high of US$1.10 in November. By the end of December, the Canadian dollar had retreated back to parity with the US greenback where it now continues to hover.

Such an incredibly rapid rise in our dollar is never good news for Canadian investors in foreign securities. That’s because the gains earned on these investments are reduced – and even turned to losses – when converted to Canadian currency. Of course, the opposite effect occurs, as we saw in 2006, when the loonie loses value. That is when Canadian investors get to reap tremendous windfall profits.

Some US and global equity funds are hedged to eliminate the effects of currency fluctuations. However, most managers do not use these strategies since they entail additional costs to the fund when the problem is usually only temporary.

Based on current economic measures, a value of US$0.85 is still considered to be a more appropriate level for the loonie. That is not so inconceivable if you consider where our dollar was at just a year ago. Any number of factors could trigger a sharp decline back to US$0.85, all of which are pretty impossible to predict. But, it will happen eventually. And if you are tempted to think, “this time is different” – be wary!

Sub-prime contagion

Of course, the other big story in 2007 was the implosion of the sub-prime mortgage market and the ensuing crisis in credit markets. The extent of the fallout was quite extraordinary. After all, the market for sub-prime mortgages is relatively small. Even more curious is the speed with which the “virus” spread beyond US borders creating an international credit crunch. Although not a very novel story, it is certainly an instructive one which I think worthwhile elaborating on.

Sub-prime mortgages started out as a way to allow borrowers with less than stellar credit records to fund the purchase of a new home. Lenders necessarily charge higher interest rates on these loans, since the risk of default is higher. Over time, sub-prime mortgages became more commonplace spurred on by the rapid rise in housing prices at a time of exceptionally low interest rates. Quite an intoxicating combo!

At the same time, given the very low interest rate environment, bond investors everywhere were looking for higher yields on their fixed income investments. So investment bankers got the idea to bring borrowers and investors together. They packaged up different forms of debt including mortgages, car loans, credit cards etc. and sold these bundles to investors as securities. In order to meet the demand for higher yields, sub-prime mortgages were added to the package. The result was a bond-like investment product that offered relatively high rates of income with little risk – or so it was thought.

Investors around the world lapped up these securitized debt instruments, as they are called, conveniently forgetting the one basic rule in bond investing: as yields increase so does the risk.

Soon demand grew and ever more exotic, complicated products were created. Some investors even started borrowing to buy these new-fangled investments. In the end, it was an accident waiting to happen. Once interest rates started to rise and the housing market started to decline, many a sub-prime mortgage went into default. From there you can imagine what happened to all those sub-prime-laced debt securities that were sold worldwide.

In investing as in life, there is always a return to balance, eventually. So when interest rates fall well below historical averages, one can expect they will start to rise, eventually. And if housing prices have tended to go up at rates well above the average, one can expect a correction along the way, eventually. It is always just a matter of time. As Sir John Templeton warns, to believe “This time is different” can be very costly indeed.

What to expect in 2008

For now, financial markets are still trying to tally the extent of the fallout from sub-prime. That may take several more weeks, even months and until then, we can expect more volatility in the markets.

We have been through other credit crunches like this. In 1997-98, we experienced the Asian flu, spawned by the devaluation of the Thai Baht. Although that was a very different set of circumstances, the effect on credit markets was the same – a retraction of liquidity that threatened to completely seize up the global economy. As I remember it, the situation was more dire in 1998 than it is today. It was one of the first real challenges posed by globalization and we still had a lot to learn.

In 1998, The US Federal reserve reduced interest rates as part of the global rescue plan, something which appears to have only laid the ground work for the current crisis. Today, Central banks from several countries are working cooperatively to come up with more creative, innovative solutions. History has shown that although we tend to fall prey to shortsightedness and good old-fashioned greed, when push comes to shove, we do get wise. And so we move forward.