On Monday, 15 September 2008, Lehman Brothers, the fourth largest investment bank in the world, filed for bankruptcy as a result of continued subprime and real estate losses. The bank's total debt amounts to more than US$600-billion. At the same time, Merrill Lynch announced that it was being taken over by the Bank of America in order to avoid the same fate as Lehman Brothers. These announcements, and the fact that many other global financial institutions remain on shaky ground, have sparked concerns throughout the financial world. This has resulted in severe volatility across all stock markets, including our own, over the last week.

In times of volatility and uncertainty, it is natural for investors to question how their investments will be affected. The purpose of this note is to provide some answers by looking at the background to the ongoing credit crisis and the potential global and local economic consequences.

Background

The subprime issue arose from a lending spree by banks in the United States. Essentially, banks granted loans to potential home owners without adequately checking their credit worthiness. In fact, loans were often granted to people who could not afford them. The conditions for these types of loans were that the initial repayments were low, with 'balloon' or significantly higher payments scheduled from the third year onwards. The rationale behind this structure was based on the belief that house prices and people's incomes would increase over the years, thus allowing them to afford the higher repayments at a later stage.

Banks then took all of the individual home loans and securitised them. This essentially entailed creating a product (a mortgage-backed security) that allowed investors to invest a lump sum and receive the income derived from the home loan repayments. In this way, mortgage-backed security investors actually became the lenders and assumed the risks. Many financial services entities such as hedge funds and investment banks used these mortgage-backed securities as both investments and collateral for other financial transactions.

But in August 2007, things started falling apart as the US housing market continued to weaken and interest rates started increasing. This, combined with the onset of the 'balloon' payments for the subprime home loans, resulted in many home owners being unable to meet their mortgage repayments. As a result, many of the mortgage-backed securities were unable to provide their investors with the expected returns.

What followed was a complex web of interrelated transactions where literally 'everybody owed everybody', and this, in turn, led to a domino effect. The complexity of the situation made it very difficult to determine where and when the crisis would eventually end. The US Federal Reserve responded by immediately cutting interest rates in an attempt to assist debt-stricken institutions. The Fed also assisted with JP Morgan's take-over of Bear Sterns, who acted as a prime broker to many large hedge funds.

In this way, the US subprime crisis evolved into a global credit crisis as financial institutions became reluctant to lend money to other institutions due to uncertainty around their creditworthiness. In addition, lenders feared that they would not receive their money and tried to force their borrowers to repay immediately. This resulted in the forced selling of investments, which has ultimately led to various financial institutions now facing possible bankruptcy.

Rescue plans

Although the Fed would not provide guarantees for Lehman Brothers, they have stepped in to rescue AIG by lending up to US$85-billion for two years in exchange for a 79.9 percent equity stake. The AIG rescue, combined with the Freddie Mac and Fannie Mae rescue, brings the total US efforts to stabilise the financial system to about US$700-billion. Barclays has now announced that it will be buying the assets of Lehman Brothers for approximately US$2-billion, while ten major banks have combined to create a US$70-billion fund to help provide liquidity to ailing institutions.

How have the markets reacted?

Investors in financial shares worldwide have all suffered significant declines as a result of increasing risk aversion and concerns surrounding the interdependency of the global financial system. These concerns have resulted in extremely volatile stock exchanges and currency markets across both developed and developing markets. While this volatility is likely to continue in the short term, it is creating stock picking opportunities that allow good investment managers to benefit. In the medium to long term, sound investments made now will have the potential to deliver very good returns.

While it is still quite early to try to accurately assess the impact of the Lehman bankruptcy, the markets, as can be expected, have reacted in a volatile fashion. All stock exchanges initially experienced large losses, with most US indices rebounding sharply the next day. For example, the S&P 500 was initially down 4.71 percent, but then returned 1.75 percent the very next day. In South Africa, the market was down 1.96 percent and 2.59 percent last Monday and Tuesday respectively, with resources bearing the brunt of the fall. This trend has continued into Wednesday with the All Share Index down 2.6 percent, and the S&P 500 down 4.7 percent.

Global impact

When one is absorbed in current events, it is often difficult to objectively determine their long-term impact. However, a few logical conclusions can be drawn. Firstly, a declining US housing market is likely to push the US towards recession. However, US government's takeover of Freddie Mac and Fannie Mae, the two largest home loan lenders in the US, may mitigate this risk to some extent. The rationale behind the takeover is to prevent defaults on home loans by lowering the interest due by home owners.

However, this is likely to slow economic growth globally and stock market returns can be expected to be lower over the next few years. In addition, more financial institutions are likely to be forced into bankruptcy and markets are expected to be extremely volatile over the next few months. As a result, investors will become increasingly risk averse and will want to move their money out of 'riskier' investments to those that appear 'safer'.

These difficult conditions will persist in the near term as companies with high levels of leverage continue to address their positions. However, the end result will be a more sober approach to risk taking. Over the longer term, the clean out of impaired balance sheets will promote higher quality investments and financial decision making. In this way, the financial institutions left standing will actually be better placed. For example, Bank of America is now a more diversified business with exposure to both retail banking and broking following its purchase of Merrill Lynch.

Local impact

From a South African perspective, the outlook is mixed. South African companies, with the possible exception of Investec and Old Mutual, do not generally have much direct exposure to subprime markets. Despite this, they are likely to be affected by changing global risk appetites. On the one hand, the increased risk aversion could lower foreign investment in our equities, which would then place additional pressure on our current account deficit. This would cause the rand to weaken, placing upward pressure on inflation. But on the other hand, the oil price has fallen significantly and this could reduce inflationary pressures to some extent.

It is important to remember that the South African economy will continue to be stimulated by a high level of development in local infrastructure. This should ensure that the economy remains reasonably resilient.

The bottom line

The current market volatility and uncertainty will undoubtedly test the mettle of many investors. As always, our trusted advice is that investors remain focused on their long-term objectives and avoid the temptation to react to short-term market movements. Any attempts to time the market now by moving from growth assets into cash could have negative long-term consequences. The key to successful investing lies in maintaining a consistent and sensible investment strategy over time, despite the volatility and potential short-term pain. In this way, investors will increase their chances of achieving their long-term goals.

Check out 'Run for cover? ' in our 'Ask the Experts' section where a nervous reader, freaked out by the bankruptcy of Lehman Brothers, asks if he should sell his shares and invest in something safer.

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