As the mainstream media gasps in horror at the mess Wall Street has made for itself, Bill Bonner says the writing has been on the wall for more than a decade. That’s because the idea that holding stocks for the long haul carried virtually no risk has been so ingrained in investors’ psyches that they have been willing to bid up stock prices to the point where they were all risk and no reward…

This from The Daily Reckoning:

One of the big revelations of the ’90s – or was it the ’80s? – was that stocks were traditionally, historically under-priced. Compared to bonds, said a popular financial author, stocks were a better deal. Stock buyers earned a premium over bonds for the risk they undertook, he said. But if you held stocks “for the long run,” the risk disappeared. Buying stocks seemed like a no-brainer.

Thus did the lumpen investoriat begin pumping money into stocks…cautiously in the beginning of the ’90s…and recklessly at the end of the decade. And by the year 2000, the stock market no longer reflected the “random” movement of prices as predicted by the previous hundred years of stock market history; instead, it reflected the recent and remarkable belief that stocks always went up…and that if an investor held long enough the risk disappeared.

From the peak of 2000 ’til today, stock market investors have earned nothing for their trouble. In nominal terms, stocks are about where they were 10 years ago. Adjusted for inflation, they are down 25%-80%, depending on how you measure it.

Wall Street made a fortune selling stocks to naïve investors. When the stock marked topped out, the financial industry might have gone back to sleep. Instead, it got a double dose of caffeine. The Greenspan Fed cut rates in 2001-2002 while the Bush administration boosted spending and cut taxes.

All of a sudden, every hand on Wall Street turned to pumping out credit – derivatives, SIVs, CDOs, MBS. They didn’t really have to invent any new theories, they merely recycled the same numbskull ideas that sank LTCM – basically, that you could eliminate risk by modeling historic price movements. If Lehman Bros. (NYSE:LEH), for example, had never failed in more than a century and a half – the odds that it would fail this year were so close to zero as to be not worth discussing.

But…

Now, it’s Lehman that is failing. And no consortium of Wall Street banks is willing, or able, to bail it out. Lehman has some $80 billion of dubious credits. These were the products of its own – and many other – whiz-kid financial engineers. Lehman hired some of the best talent on Wall Street. It has some of the world’s top financial mathematicians on its payroll. It could compute the risk of loss down to 3…4…heck…as many decimal places as you like. But it could do so based on past history.

As we explained, once investors came to consider stocks as a riskless way to get rich, they bid up prices to the point where they were all risk…and no reward. And when their models told them that they could make money by lending money to people who couldn’t pay it back, practically every loan they made took them closer to bankruptcy.

Source: It’s Lehman’s Turn