Five Lessons From the Credit Crisis

By Sean Hannon, CFA, CFP, of Covestor.com

During September, the Dow Jones Industrial Average has dropped nearly 10%. This compares with drops in the Nasdaq of 16%, the S&P small-cap index of 9% and the Wilshire 5000 of 14%.

While prices were dropping, the government became linked with the capital markets. Over the past year, we have seen the Treasury and Federal Reserve attempt to influence behavior.

All of these actions were done at the edge of acceptable policy and were meant to unclog the capital markets while allowing free enterprise to reign supreme. Over the past month, government intervention increased and free market ideology was swept aside.

To gain perspective, during September we have seen key linchpins of the housing market placed into conservatorship (Fannie Mae and Freddie Mac), the failure of two large banks (Washington Mutual and Wachovia), the nationalization of the largest insurance company (American International Group), the elimination of the stand-alone investment bank (Lehman's(LEH Quote) bankruptcy and Morgan Stanley(MS Quote) and Goldman Sachs(GS Quote) becoming commercial banks) and the disappearance of the largest brokerage firm (Merrill Lynch merging with Bank of America).

With the government failing to approve a rescue bill, we have entered a period of heightened uncertainty, lower tolerance for risk, lower levels of financial leverage and lower innovation.

These expected changes have a dramatic implication over how we will invest. To consider the effects, I have developed the "Five Lessons of the Crisis." They are as follows:

• Solvency, not liquidity, is king. After the collapse of Bear Stearns in March, many investors believed that a lack of liquidity had led to Bear's demise. Following this script, the Fed began allowing broker-dealers to access the Fed window and broadened its list of acceptable collateral with the intent of allowing firms to conquer short term funding issues. As we learned from Lehman, WaMu and others, this is not the case. Bad loans and poor trades eroded the capital base and left these companies insolvent. Rather than allow an insolvent company to grow out of its problems, we have seen bankruptcy, nationalization and asset seizures.
• Valuation is in the eye of the beholder. As a value investor, I have watched stock prices drop to levels I never thought possible as companies I thought would never be attractively priced are now outright cheap. However, these same stocks have become even cheaper. At a certain point, we will look back at this period and discuss how shrewd investors snapped up shares at bargain prices. For now, those same investors are experiencing escalating losses.
• Public policy cannot cure private market woes. As of now, every piece of government policy has failed. With each proposed measure, markets have rallied. Inevitably, the measure fails and markets swoon. Only through time and pain will excesses in the private markets be purged, bottom and lead to rebound.
• Deleveraging markets kill innovation. What started as a credit crisis has morphed into a Main Street crisis. The major negative to deleveraging is that new loans are not being made. Without new loans, companies do not expand, employment does not grow, the incentive to create and market new products declines and economic growth declines. Together, we have a weaker economy and a lower standard of living.
• No company is too big to fail. For years, the presence of the Greenspan Put and Helicopter Ben has led many to believe that certain companies are too big to fail. This thought no longer holds. Going forward we should expect investors' required return hurdle to increase as old rules no longer apply. The result will be lower future gains as the days of P/E multiple expansion are now past.

Knowing the rules of the market have changed, we need to decide how to progress. The answer is cautiously. Right now, buying stocks remains far from anyone's mind. However, within fear opportunities exist. Capitulation is needed for a market bottom and that has finally arrived. An investor looking for an excellent business at a cheap price should look toward XTO Energy (XTO Quote). XTO possesses oil and gas reserves in geopolitically safe areas. Market value of its natural reserves exceeds $60 per share, and a high amount of 2009 production has been hedged at energy prices that are higher than prevails today. Therefore, XTO offers excellent value with limited exposure to volatile commodity prices.