Current Issues in Financial Markets

CURRENT ISSUES IN FINANCIAL MARKETS
I. The Current Crisis—Causes and Consequences
The house of cards built on easy credit has finally come tumbling down, triggered
by the failure of one of the most flimsy of the cards, subprime mortgages. We’ll look
at the causes—it’s important to understand causes if one has any reasonable
chance of analyzing the present and assessing the outlook—and weigh the likely
outcome of the government’s actions.
Not to keep you in suspense any longer, we believe the bailout and associated
actions, adding yet more credit to an economy already over-ripe with easy credit, far
from solving the problem (i.e., getting banks to lend again), will make matters
ultimately worse, by postponing the necessary adjustments, building up inflation, and
destroying the dollar and its purchasing power, devastating savers and undermining
the foundations of the economy.
This will be a protracted slowdown as corporations and households de-lever and
attempt to restore some health to broken balance sheets. Nevertheless—to jump
ahead to the critical conclusion for investors we’ll discuss next time—we are far
beyond the time for wholesale liquidation, if it means selling quality companies well
below their intrinsic values. It may be too early for aggressive across-the-board
buying, but remember the words of the late, great John Templeton, who advised us
to “buy at the point of maximum pessimism.”

The root cause of our current problems is clear: excess credit creation over these
many years. Too much money and artificially low interest rates always and inevitably
lead to speculation and mal-investment
II. IMPACT ON:
A. THE ECONOMY (LOCAL AND GLOBAL)
Critical to understand is that this is not a normal cyclical downturn. Such is
triggered by tightening money and higher rates in a deliberate attempt to cool an
“overheated” economy and restrain inflation. The resulting recession can be sharp
but is typically short. Similarly, it is relatively easy to get out of a cyclical recession:
do the opposite of what triggered it, that is, ease money and lower rates. But this is
not a cyclical downturn; it is, rather, a secular de-leveraging contraction. Tighter
money and higher rates did not trigger it, and easing money and lowering rates will
not get us out of it. We currently have easy money and low rates, rates that are
actually negative at the short end. And easier money and even lower rates, such as
we’ve seen over the past year, have not helped. (Indeed, despite the Fed slashing
the overnight loan rate from 5¼% to 2% in the seven months to April, rates in the
real market mortgage rates, credit card rates, etc. actually increased and, of course,
available credit contracted.) This is important to recognize. To the global economic
downturn, national banking and securities regulatory authorities all over the world
have been examining and re-evaluating regulations for financial markets. Regulatory
focus around the world brings closer attention to increased transparency, improved
monitoring of risk exposures and better definition of accountability, with the aim of
preventing a recurrence of the banking and capital market crisis that impacted the
world economy.
B. ENVIRONMENT
The economic slowdown began with a decline in business capital
spending and investment. With the burst of
the dot.com bubble, businesses took a more pessimistic view of the
economic future and curtailed spending on
equipment, software, real estate, inventories, and other investments. One of
the first sectors to suffer the effects
of the reduction in capital spending was the high-tech industry, where
earnings and share prices nose-dived.
As the effects of cutbacks in corporate spending rippled through the
economy, temporarily soaring energy
prices took money out of consumers’ pockets and ate into corporate
revenues. Earnings sank, borrowing
This document has been prepared and distributed by the five largest
accounting firms (Andersen, Deloitte & Touche,
Ernst & Young, KPMG, and PricewaterhouseCoopers) and the American
Institute of Certified Public Accountants. The
five firms and the AICPA recognize the responsibility of our profession to
work toward enhanced financial reporting and
audit effectiveness and have made significant commitments toward those
ends. Preparing and distributing this document is

just one of several actions taken to fulfil this commitment. 2
capacity dwindled, growth slowed, energy prices dropped, and the stock
market tumbled. Investor wealth
declined by trillions of dollars. Layoffs followed, and with the unemployment
rate rising (although still
historically low), the surprisingly hardy consumer spending finally started to
wane. Companies initiated
restructurings, inventory liquidations, and write-offs. The events of
September 11 and their aftermath only
worsened already deteriorating economic conditions.
These factors put downward pressure on earnings and other performance
measures that, for most of the previous
decade, had been on an upward trend. This change in direction has created
a growing sensitivity in the capital
mBecause of this crisis, everybody even banking system and corporate
sector adjust smoothly to the new environment, particularly as they are highly
leveraged and increasingly dependent on foreign borrowings.
C. BUSINESS
This de-leveraging process is likely to be a protracted process as banks,
other firms, and households restore health to their balance sheets. But such a
process feeds on itself, as we have all-too-painfully seen this year.
Companies sell assets to raise capital, which pushes down prices, which
forces others to raise capital, pushing prices down further, which causes
banks to contract credit. And as banks contract, small businesses have

difficulties, reducing purchases, and so on. So much of the selling in the
market has been forced (by financial companies needing to raise capital to
meet ratios; by investor receiving margin calls, and funds getting
redemptions). The waves of forced selling then cause panic among investors,
leading to the very worst kind of selling, blind liquidation of thinly traded
securities into down markets. This can, and has, driven prices down sharply
and suddenly.
III. CONCLUSION
Next time, we’ll look at the outlook for various markets, including, most
importantly, the dollar, and then discuss how investors should act in the current crisis.
Don’t dump quality companies below their intrinsic value into a declining market). Better
implementation of the rules and regulations governing the banking industry acts as a
brake to prevent banks from making excessive risky loans.

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CURRENT ISSUES IN FINANCIAL MARKETS

I. The Current Crisis—Causes and Consequences

at the causes—it’s important to understand causes if one has any reasonable

outcome of the government’s actions.

ultimately worse, by postponing the necessary adjustments, building up inflation, and

the foundations of the economy.

This will be a protracted slowdown as corporations and households de-lever and

attempt to restore some health to broken balance sheets. Nevertheless—to jump

to “buy at the point of maximum pessimism.”

lead to speculation and mal-investment

II. IMPACT ON:

A. THE ECONOMY (LOCAL AND GLOBAL)

Critical to understand is that this is not a normal cyclical downturn. Such is

triggered by tightening money and higher rates in a deliberate attempt to cool an

not a cyclical downturn; it is, rather, a secular de-leveraging contraction. Tighter

available credit contracted.) This is important to recognize. To the global economic

The economic slowdown began with a decline in business capital

spending and investment. With the burst of

the dot.com bubble, businesses took a more pessimistic view of the

economic future and curtailed spending on

equipment, software, real estate, inventories, and other investments. One of

the first sectors to suffer the effects

of the reduction in capital spending was the high-tech industry, where

earnings and share prices nose-dived.

As the effects of cutbacks in corporate spending rippled through the

economy, temporarily soaring energy

revenues. Earnings sank, borrowing

accounting firms (Andersen, Deloitte & Touche,

Ernst & Young, KPMG, and PricewaterhouseCoopers) and the American

Institute of Certified Public Accountants. The

work toward enhanced financial reporting and

audit effectiveness and have made significant commitments toward those

ends. Preparing and distributing this document is

market tumbled. Investor wealth

declined by trillions of dollars. Layoffs followed, and with the unemployment

rate rising (although still

historically low), the surprisingly hardy consumer spending finally started to

wane. Companies initiated

restructurings, inventory liquidations, and write-offs. The events of

September 11 and their aftermath only

worsened already deteriorating economic conditions.

These factors put downward pressure on earnings and other performance

measures that, for most of the previous

a growing sensitivity in the capital

mBecause of this crisis, everybody even banking system and corporate

leveraged and increasingly dependent on foreign borrowings.

This de-leveraging process is likely to be a protracted process as banks,

process feeds on itself, as we have all-too-painfully seen this year.

banks to contract credit. And as banks contract, small businesses have

meet ratios; by investor receiving margin calls, and funds getting

brake to prevent banks from making excessive risky loans.

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