Q3 2008: The credit crunch intensifies
The stock market treaded water in July and August but fell sharply in September, as a flurry of government-sponsored rescues and corporate takeovers changed the face of Wall Street. Earlier in the quarter, investors found some comfort in the declining prices of crude oil and other commodities. With inflationary pressures easing, it seemed that the Federal Reserve Board (“the Fed”) might be less inclined to raise interest rates and consumer spending would be less constrained by high energy costs, both potentially supportive factors for stock prices.
In the quarter's final weeks, however, a number of household names in the financial sector ran aground, unnerving investors, driving share prices lower, and triggering corporate takeovers and unprecedented U.S. Government intervention. While news of the Treasury Department's $700 billion economic rescue plan proposal resulted in a sharp rally near quarter-end, its positive impact on the stock market was fleeting. When the House of Representatives failed to come up with the necessary votes to pass the measure on the second-to-last day of the quarter, the Dow Jones Industrial AverageSM (“the Dow”) posted its largest point loss ever and shed almost 7% of its value. The dizzying volatility spilled over to the final day of the period, when the market regained much of the ground lost on the previous day. Please see the list of key events provided at the end of this overview.
During the quarter, the Dow, a measure of blue-chip activity, suffered a decline of 4.40%. In the process, the venerable benchmark closed as low as 10,365, almost 27% below its all-time high above 14,164, set on October 9, 2007. The S&P 500® Index, a measure of large-cap activity, fell 8.36%, while the technology-heavy Nasdaq Composite® Index lost 8.77%. Small-cap stocks, as measured by the Russell 2000® Index, held up better, but still lost 1.11%. Foreign shares struggled against the headwinds of slumping economic activity abroad and a sharp rally in the U.S. dollar, resulting in a decline of 20.56% for the MSCI® EAFE® Index, a measure of foreign developed markets.
High-quality bonds fared relatively well during the quarter, as reflected in the decline of the yield of 10-year Treasury notes from just under 4.00% to around the 3.83% level. Bond prices move in the opposite direction to interest rates (or yields); when yields rise, the prices of existing bonds fall - and vice versa. The 10-year Treasury yield had actually fallen as low as 3.25% on an intraday basis amid a surge of concern about further weakness in the economy but rebounded sharply after the Treasury Department announced its bailout proposal. Against this backdrop, the Lehman Brothers® U.S. Aggregate Bond Index finished the quarter with a -0.48% return.
Market Performance as of 9/30/08*
| Index | 3Q 2008 | One Year | Five Years (annualized) | Ten Years (annualized) |
| Lehman Agg. | -0.48% | +3.66% | +3.78% | +5.20% |
| DJIA | -4.40% | -21.91% | +3.19% | +3.30% |
| S&P 500 | -8.36% | -21.91% | +5.16% | +3.06% |
| Nasdaq Comp. | -8.77% | -22.57% | +3.20% | +2.13% |
| Russell 2000 | -1.11% | -14.48% | +8.15% | +7.81% |
| MSCI EAFE | -20.56% | -30.50% | +9.69% | +5.02% |
* Source: Morningstar EnCorr
Reversing the trend from the previous quarter, value had a huge edge over growth. In the large-cap arena, the Russell 1000® Value Index returned -6.12%, which was considerably better than the Russell 1000® Growth Index's -12.33% result. In mid-cap stocks, which had the weakest performance of the three major capitalization groups, the Russell Midcap® Value Index's -7.53% return compared favorably with the -17.75% return of the Russell Midcap® Growth Index. Surprisingly good performance came from small-cap value stocks, as shown by the Russell 2000® Value Index's gain of +4.96%, versus -6.98% for the Russell 2000® Growth Index. Among S&P 500 sectors, financials and consumer staples had the strongest returns, while materials and industrials had the steepest losses.
A flight to quality benefited Treasury securities of all kinds, particularly those with longer-dated maturities. By the same token, high-yield bonds suffered, as investors sought to scale back their exposure to investments with higher risk. These developments were reflected in the +1.38% mark of the Lehman Brothers® 1-3 Year Government Bond Index, versus -8.89% for the Lehman Brothers® High Yield Bond Index. For comparison purposes, 13-week Treasury Bills returned +0.44%. (Source for all index returns: Morningstar EnCorr) Indexes are unmanaged, do not incur fees or expenses and cannot be purchased directly for investment.
Wall Street in turmoil: How we got there What a difference a year makes! It seems hard to believe that the S&P 500 and most other well-known equity benchmarks made all-time highs as recently as October 2007. In a little less than a year's time, the financial markets have experienced a series of shocks that have left investors dazed and wondering which Wall Street icon will be the next domino to fall. How did we get to this point?
The present crisis has its roots in a combination of factors, including accommodative monetary policy, loose lending practices, extreme complacency among homebuyers and Wall Street's fascination with complex “derivative” securities that few people fully understand. Derivative securities derive their value from one or more underlying assets, such as mortgages, for example. Following the dot-com bubble of the late-1990s, the Fed slashed short-term interest rates in an effort to soften the 2001 recession and get the U.S. economy growing again. As the chart below illustrates, the target federal funds rate got as low as 1% and remained below 2% for three years, from the end of 2001 to the end of 2004.
With interest rates in bargain-basement territory, home loans were easy to get, regardless of a borrower's qualifications. Many of the loans in the subprime category - those made to individuals with troubled credit histories - had extremely low teaser rates that were set to adjust sharply higher in a year or two. So-called “liar loans” - mortgages for which the lender required little or no documentation to prove the borrower's income and assets - also were prevalent. Many of these loans fell into the “Alt-A” category, meaning the borrowers were considered somewhere between prime and subprime credit risks.
Lenders made risky loans and borrowers took on excessive debt assuming that real estate prices would continue to spiral upward, creating the equity necessary to refinance or sell at a profit. In fact, U.S. consumers became so complacent that they began to spend more than they earned, resulting in a negative savings rate in 2005, as shown in the following chart.
Investment banks such as Bear Stearns and by government-sponsored entities Fannie Mae and Freddie Mac, which bought groups of mortgage loans and packaged them into securities that were sold to investors, created another layer of risk. While Fannie and Freddie were limited to buying “conforming” loans - those that met certain standards for credit quality and loan size - private investment banks bought large quantities of riskier subprime and Alt-A mortgage loans.
These mortgage-backed securities (“MBS”) were popular investments and also helped increased liquidity among mortgage lenders, adding fuel to the housing boom. For these reasons, MBS as a percentage of total mortgage debt outstanding rose from just over 10% in 1980 to about 55% by the end of 2006, according to the Fed.
Unfortunately, none of the players - investors, lenders or borrowers - was prepared for what might happen if the housing boom ran out of steam. With the economy on the mend in the middle of 2004, the Fed embarked on a two-year campaign to raise interest rates, reflected in the federal funds rate chart (the first chart referenced in this report) as rising stair steps. As financing became more expensive, housing prices rose more slowly at first then began actually falling in many parts of the country. At the same time, loans with teaser rates began to reset at higher levels, triggering a rash of delinquencies and defaults. Because of the interconnected web of loans and investments based on mortgages, what was initially a seemingly manageable problem for the subprime lending industry metastasized into a broader crisis that has shaken the very foundations of Wall Street.
Investors had hoped that the March 2008 takeover of investment bank Bear Stearns by JPMorgan Chase marked the turning point of the crisis in the financial sector and a durable low for the stock market, but an extraordinary series of events in the third quarter of 2008 kept downward pressure on stock prices:
July 11 - Federal regulators seize IndyMac Bank, the most expensive bank failure since Continental Illinois failed in 1984
September 7 - The U.S. Government rescues Fannie Mae and Freddie Mac, the two government-sponsored entities that jointly issued roughly 40% of mortgage-backed securities in 2006.
September 14 - Fearful of its prospects for survival, brokerage and investment bank Merrill Lynch arranges to be bought by Bank of America.
September 15 - Lehman Brothers, the fourth-largest U.S. investment bank, files for Chapter 11 bankruptcy protection, the largest corporate bankruptcy filing ever in the United States.
September 16 - Insurer American International Group (“AIG”) receives an emergency $85 billion loan from the U.S. Government after its stock plunges and its debt is downgraded by all three major credit-rating agencies. The loan is seen as offering AIG a lifeline to gradually unwind its complex operations and gives the government almost an 80% stake in the company.
September 19 - Treasury Secretary Henry Paulson unveils a sweeping $700 billion proposal to purchase hard-to-sell mortgage assets from banks. The government hopes to buy the assets at a discount and sell them at a profit when the housing market returns to health.
September 21 - Federal regulators agree to allow the last two surviving U.S. investment banks, Goldman Sachs and Morgan Stanley, to become bank holding companies. The move is intended to help the banks survive the financial crisis and gives them easier access to credit. The action also aims at increasing regulatory supervision of the two banks, streamlining their borrowing from the Fed, and bolstering investor confidence. The conversion marks the end of the separation of investment banking from commercial banking in the United States.
September 25 - Savings and loan Washington Mutual, on the 119th anniversary of its founding in Seattle, is seized by federal regulators, becoming the largest bank failure in U.S. history. Its loan portfolio and retail branches are sold to JPMorgan Chase.
September 29 - Citigroup agrees to acquire the banking assets of Wachovia, the nation's fourth-largest bank, which experienced large losses in part due to its exposure to the mortgage market. The deal excludes Wachovia's brokerage and asset management businesses, which will remain independent. On the same day, the U.S. House of Representatives defeats the Bush administration's economic rescue plan, sending stocks sharply lower.
Outlook
On Friday, October 3, the U.S. House of Representatives followed the action taken by the U.S. Senate and passed the Emergency Economic Stabilization Act of 2008, an expanded version of the rescue plan that had been on the table since September 19. President Bush signed it into Law the same day. Immediate market reaction to the legislation was not positive and left many investors feeling uneasy about the near-term prospects for the U.S. economy. During volatile market conditions and times of economic uncertainty such as these, some investors may be tempted to abandon longstanding investment plans. History has repeatedly shown the wisdom of staying fully invested at such times, however, for they have often occurred at or near positive transitional periods for share prices. During the third quarter, we saw strong relative and absolute performance from the financials sector overall, despite the downfall of a select few firms. On the other hand, sectors that had outperformed in previous quarters, energy and materials, posted sizable losses. It was also a quarter in which Treasury bonds outperformed most sectors of the stock market. In our view, these facts underscore the importance of maintaining adequate diversification, not only to all sectors of the stock market, but also to a variety of asset classes, in accordance with an investor's risk tolerance and time horizon.
The information provided is the opinion of MassMutual Retirement Services Investment Services as of 10/1/08 and is subject to change without notice. It is not to be construed as tax, legal or investment advice. Of course, past performance does not guarantee future results.
