Making sense of market turmoil

The Baltimore Sun

T. Rowe Price, the Baltimore-based global investment management company, offered its view on the financial market crisis in a perspective issued last week. Here is an excerpt:

Investors have been rattled by the extraordinarily rapid chain of events rocking U.S. financial markets and reverberating through world markets. This financial crisis mirrors familiar elements of past crises in which credit stopped flowing. At the same time, U.S. government intervention in financial markets is at its highest since the 1930s. And all this is taking place against the backdrop of an already slowing global economy.

This is a liquidity crisis that quickly became a crisis of confidence. It began with the bursting of the technology and telecom stock market bubble in 2000 and the ensuing period of unusually low interest rates, lax lending standards for home mortgages, speculation, various forms of loan syndication, and ultimately the excessive use of derivatives and borrowing to fuel investment returns.

With that heightened leverage, small downward movements in asset prices translate to big losses. So many large financial institutions have been simultaneously trying to rid their balance sheets of a large number of complex financial instruments that the result has been a sudden constriction in credit markets. It is a harsh but useful reminder that leverage is always the enemy of investors.

This turmoil comes as the United States has been losing 75,000 jobs a month this year, and the housing downturn has been cutting into gross domestic product growth. Consumer spending already was constrained by credit conditions.

It is not certain how Wall Street events will translate to Main Street. While the economy is not forever bulletproof, the excesses in the real economy did not reach the extent of the excesses in financial activity. Expect little economic growth until spring 2009, and then a gradual recovery into 2010 - reflecting prolonged adjustments in the financial sector.

The history of financial turmoil, meanwhile, suggests that some of the best investment opportunities become available in bear markets and that markets tend to recover in advance of economic upturns. One of the reasons: Market fears and indiscriminate selling due to forced liquidations can lead to situations in which market prices become disconnected from securities' fundamentals.

In markets like this, it is critical to remain focused on the fundamentals, so as not to get swayed by the daily volatility and swings in emotions.

As of Friday, there was political movement toward the long-term solution to this crisis: coordinated actions by global financial authorities; mergers and acquisitions to provide shelters for troubled financial firms; possible regulatory changes that contribute to market stability; and the creation and efficient operation of a U.S. government-owned asset-management company similar to the Resolution Trust Corporation that was set up in the early 1990s in response to the savings-and-loan crisis.

So far, the actions by the U.S. Federal Reserve and Department of Treasury have been generally reassuring. The Fed essentially has been expanding its balance sheet, giving it more flexibility to end the downward spiral. It is trying to do the right things to avoid a misstep similar to the Bank of Japan's failure in the 1990s to acknowledge its banking sector's huge losses. The key will be whether the government's rescue directly addresses the root cause of the crisis - falling home prices and rising mortgage delinquencies.

Wall Street is experiencing radical changes. In coming years, the U.S. financial system will likely return to a more traditional model: banks taking in deposits and making well-underwritten loans; financial shops offering sound advice to clients; and investment banks returning to the role of representing clients instead of focusing on proprietary trading.

Still, this downturn may be protracted. There were financial innovations that created very complex securities that are both difficult to value and to untangle to get at the underlying collateral in order to fix the problems.

However, as we get into 2009 and some economic news improves, markets will begin to recover - as they did in 1990 and 1991. Indeed, markets may begin to react positively before investors feel better.

A full text can be found at www.troweprice.com.

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