“When the music stops, in terms of liquidity, things will be complicated. But as long as the music is playing you’ve got to get up and dance. We’re still dancing.” (Charles Prince, CEO, Citibank – Financial Times, July 10, 2007)

In 2008, the music came to an abrupt halt and things became very complicated indeed. By mid- year, events had moved with terrifying speed from sub-prime fallout to a worldwide credit crunch turned full blown financial crisis. We saw the entire US investment banking industry transformed. In addition, Fannie Mae and Freddie Mac, two of the largest residential mortgage lenders in the US were nationalized, along with AIG the country’s biggest life insurance company. Stock markets plunged 40% on average, and in anticipation of a worldwide recession, the cost of oil dropped from a high of $147 per barrel to just $40 per barrel, taking the Canadian dollar down with it. In sum, it was a nightmare of a year that we all would sooner forget.

Inside the crisis:

So how did we get into such a mess? In my last year-end letter, I looked at how the collapse of the US housing market and the resulting sub-prime mortgage crisis infected the whole of the financial sector world-wide. This was thanks to a financial innovation known as “securitization”, the packaging up of various kinds of loans, mortgages in particular, and selling them to investors as debt securities. (see www.sarafinance.com/en/articles/200801/)

At the outset of 2008, no one had any real idea just how extensive the fall out from sub prime would be. Today, we are coming to realize that the sub-prime contagion was just a symptom of a much bigger malady. Many market observers now believe the root cause of the financial crisis of 2008 stems all the way back to 1980 under President Reagan in the United States and Prime Minister Thatcher in the United Kingdom. At the time, market fundamentalism was back in vogue. It was the beginning of an extended period of deregulation that completely transformed the banking sector, not to mention the overall financial culture.

A casino society:

The National Post recently ran a series of articles featuring interviews with veterans of Canada’s business community. Called the “Wisdom series”, these interviews revealed a wide array of observations on the financial crisis. In response to the question of how we got here, there were some common themes such as greed, lax regulations, and a banking sector operating beyond its reach. But there was one interview which I found particularly telling. This one was with Seymour Schulich, a business man, author, philanthropist and recipient of the Order of Canada. In his words: “We have gotten away from the things that the capital markets are all about. They should be about raising money to build infrastructure, real estate, oil fields, power plants, employ people. Instead of that, we and the banks have evolved into a giant casino society…” (National Post, January 3, 2009)

Schulich is not the first to comment on this trend. Warren Buffet, another wise man of the investment world has long cautioned against the effects of such a casino mentality. “ We need the intelligent commitment of investment capital, not leveraged market wagers. The propensity to operate in the intelligent , pro-social sectors of capital markets is deterred, not enhanced, by an active and exciting casino operating in somewhat the same area, utilizing somewhat similar language, and serviced by the same work force.” (Warren Buffet Speaks, Janet Lowe, Wiles & Sons 1997)

Warren Buffet has also cautioned against excessive use of derivative instruments, famously referring to them as “financial weapons of mass destruction”.(Berkshire Hathaway Letter to Shareholders, 2003).

Derivatives are another financial innovation like securitization which started out as a way of mitigating risk. This kind of investing tool, known as hedging, serves a useful purpose. Fund managers of US and foreign equities can use derivatives, for example, to eliminate the risk associated with currency fluctuations. Businesses that require access to certain commodities can buy forward contracts, another kind of derivative, to secure a stable price and supply for the future needs of the business. But, with the pervasive casino mentality, hedging has become an investing strategy onto itself- although it might more aptly be called anti-investing! The hedge fund market has ballooned in size over the past several years so that, as Seymour Schulich puts it: “You have 1.5 trillion running around wrecking havoc in the world.” And this is no exaggeration. In 1998, the failure of Long Term Capital Management, a huge, highly leveraged hedge fund almost brought down the world financial system all on its own. The Federal Reserve under Alan Greenspan had to intervene to save the day -a scenario that has become all too familiar of late.

Despite the Long Term Capital misadventure, the hedge fund market remains largely unregulated, as is the trading of securitized debt instruments that caused the sub-prime crisis. I am confident that will now change, but it had to take a crisis of the proportions of 2008 to show just how perilous the casino society can be. Apparently, “ as long as the music is playing, you’ve got to get up and dance.”

A new era

Now that the music has stopped, monetary authorities and policy makers have their work cut out for them. And they are scrambling! No doubt once we have a new administration in Washington, there will be a greater sense of leadership and direction. That will be a relief. Having said that, we cannot expect a quick fix. The systemic problems this crisis has revealed will take time to work out. Not the least of these is a hang-over of trillions of dollars of excess debt – something which we will be hearing a lot more about.

Ultimately, this is not just another cyclical downturn. This is the end of an era, one that we can all be thankful is now behind us. Although the transition to the new will take time as these things always do, we have before us all the potential that renewal offers.

There is an old Chinese proverb that says, “when the wind changes direction, there are those who build walls and those who build windmills.” What do you prefer to build? Perhaps, as a society, we can start by building a strong, vibrant economy with the intelligent commitment of investment capital, or good old-fashioned investing, as it is now called !