Not just the United States but the entire world is dealing with the implications of a near perfect storm which has created havoc on three fronts – falling asset prices, a weakening capital base amongst financial institutions and high inflation.

“If a loose monetary policy and rapid asset price inflation were the route to economic prosperity, Argentina would be the richest country in the world by now.”

Albert Edwards
Co-Head, Global Cross Asset Strategy
Societe Generale

August is my month off. Every year I go to Mallorca where my favourite pastime is the occasional glance at the sea whilst reading a good book. This year Peter Bernstein’s ‘Against the Gods’ was top of the pile. Not that I hadn’t read it before. But my last encounter goes back about ten years and I decided that it deserved a re-read. After all, the book is about risk management and few books deal with the subject of risk management better than this one.

I didn’t spend many days on the island before I realised that Mallorca was not in its usual ebullient mood. Clearly the credit crunch had started to bite here as well. My friends on the island, most of whom are in the property business, confirmed my casual observation. The banks are tightening they said. Loans which could easily be obtained only six months ago were no longer available.

A few days later I ran into an article in the Daily Telegraph which illustrates the magnitude of the problem (see chart 1 below). Although this chart is based on U.S. data, the behaviour of banks around the world is broadly similar. It is clear that tightening lending standards are no longer a phenomenon exclusively linked to property loans. Consumer loans in general, and credit card loans in particular, are now subject to much closer scrutiny.

Chart 1: U.S. Lending Standards

Source: The Daily Telegraph

From my vantage point in the Serra de Tramuntana, I started to philosophise about the roots of the current predicament. How could it possibly go so wrong? Is the end in sight yet? What can we learn from this mess? These are obviously big questions, although the answer to the first question is pretty straightforward, the way I look at things. It all went so terribly wrong because of hubris combined with excessive use of leverage. It is funny how we always think that this time it is different. This time we really figured it out, or so we thought. However, the ever present invisible hand had other ideas.

In short, not just the United States but the entire world is dealing with the implications of a near perfect storm which has created havoc on three fronts – falling asset prices, a weakening capital base amongst financial institutions and high inflation. It is the interaction of these dynamics which explains the mess we are currently in, but it is also here we are likely to find the answers to our questions, so let’s jump straight into things:

Observation # 1

It all began with housing and it will end with housing.

When U.S. home prices began to skid, the damage inflicted was swift and devastating. We know now that that the quality of many loans was poor, causing large write-offs across the industry. With house prices in the US and the UK still well above their long-term averages relative to disposable income (see chart 2 below), there is no reason to believe that they will not continue to fall for quite some time yet. The write-offs will spread from sub-prime to prime and to many other countries as well, a process which has, in fact, already begun. Two criteria must be met before property will start to appreciate in value again – house prices must reach (or fall below) their long term equilibrium values and the current overhang (see chart 1) must be dramatically reduced. All this will take time – years rather than months.

Chart 2: Current overvaluation of U.S. and U.K. homes

Source: GMO Quarterly Letter, July 2008

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