The Stock Market Crash Of 2008

CNN Money

CNN Money

The Economy

How Did We Get Here?

By now you likely know that the crisis in the financial markets is the culmination of years of reckless mortgage lending and Wall Street dealmaking. It’s the final gasp of the burst housing bubble. But how exactly did this happen?

To find the root cause of Wall Street’s woes, you have to go back to the collapse of a different bubble – tech. In 2001, after the dotcom craze ended and the bear market began, the Federal Reserve started aggressively slashing short-term interest rates to stave off recession. By eventually reducing rates to a historically low 1%, the Fed reinflated the economy. But this cheap money sparked a new wave of risk taking.

Homeowners, armed with easy credit, snapped up properties as if they were playing Monopoly. As prices soared, buyers were able to afford ever-larger properties only by taking out risky mortgages that lenders were happily approving with little documentation or money down.

At the same time, Wall Street investment banks got a brilliant idea: bundle the riskiest of these mortgages, then slice and dice these portfolios into tradable bonds to be sold to other banks and investors. Amazingly, bond-rating agencies slapped their highest ratings on the “best” of this debt.

This house of cards came down when subprime borrowers began defaulting on their mortgages. That sent housing prices tumbling, unleashing a domino effect on mortgage-backed securities. Banks and brokerages that had borrowed money to boost the impact of those investments had to race to raise capital.

Some, like Merrill Lynch, were forced to sell. Others, like Lehman Brothers, weren’t so lucky. “What we always tell investors is beware of too much leverage in a company,” says Brian Rogers, chairman and portfolio manager for T. Rowe Price. “Leverage is the enemy of the investor.”

Sure, everyone from former Fed chairman Alan Greenspan to your friends and neighbors played a role in stoking this casino culture. But troubled banks and brokerages can’t pass the blame. “These firms closed their eyes and made very bad bets on risky securities that they didn’t truly understand,” says Jeremy Siegel, finance professor at the University of Pennsylvania’s Wharton business school. “Investments that they did not have to make led to their demise.”

Jeremy Siegel: Even in a Bearish Market, Bullish on Stock

In an open discussion with executives in the Securities Industry Institute, Wharton professor Jeremy Siegel examined investment strategies in the current market. Siegel, author of the landmark books Stocks for the Long Run and The Future of Investors, drew upon historical records in making sense of the current downturn.

Based on Siegel’s analysis of data from 1802 to the present, stocks have outperformed every other major asset class — including treasury bills, bonds, and gold — over the entire period, including important sub-periods. A dollar of gold in 1802, for example, would be worth just $2.45 in December 2007 after adjusting for inflation. In contrast $1 invested in stocks would have grown to more than three-quarters of a million dollars. Stocks have delivered 6.8 percent return per year after adjusting for inflation. “It is remarkable how consistent this has been across all long-term periods,” says Siegel, who also teaches in the Investment Strategies and Portfolio Management program for investment professionals and individual investors. “Equities are about the last asset class that you can buy at or near its long-term historical value.”

The gap between stock and bond performance has been widening. While bonds have delivered 3.5 percent returns above inflation over two centuries, returns are going down. Since the end of World War II, bonds have delivered only a 1.7 percent real return per year. Currently Treasury Inflation-Protected Securities (TIPS) have a real return of about 1 percent. Of course, for experienced investors who can recognize values outside the triple-A bond market, there may be opportunities. “Safe bonds are of no value today. They are one of the worst values,” Siegel says. Continue reading