As I write this, stocks around the world are falling, the U.S. Federal Reserve is madly cutting interest rates to try to head off a recession, and everyone is worried about a global economic slowdown. All this uncertainty was spawned by plunging U.S. home prices and the crash of the subprime debt market, which has blown up into an international credit crisis. What caused this fiasco, who is to blame and what it means for investors has been the subject of much debate. Here are the myths and realities:
Myth: The crisis resembles the one that hit the U.S. savings and loan industry two decades ago, necessitating a multibillion-dollar government bailout.
Reality: The current situation is very different from the savings and loan debacle of the 1980s. Back then, lenders used government-insured deposits to make risky investments with the full knowledge that if those investments failed, the government would have to make good on the depositors' balances. In the current crisis, the financial institutions are absorbing all the losses and no government bailout is planned.
Myth: The blame for the bubble in the housing market rests with former U.S. Federal Reserve Chairman Alan Greenspan, who kept interest rates too low for too long.
Reality: While it certainly can be argued that Greenspan mismanaged short-term interest rates, that was not the major cause of the bubble. Soaring home prices were a worldwide phenomenon driven by demographics and low long-term interest rates, which were caused by low inflation and the huge buildup of savings in Asia. In fact many countries completely outside the dollar sphere, such as the U.K. and Spain, experienced an even greater real estate bubble than the U.S.
Myth: Because the current slowdown is due to the sharp cutback in the willingness of financial firms to lend, central banks can do little to improve the situation.
Reality: Central banks can and have done much to stabilize credit markets. The crisis was marked by a sharp increase in interest rates on bank lending over the targeted cost of funds set by central banks. Partly by injecting reserves into the market, central banks have ensured there is sufficient liquidity and reduced the "risk premium" attached to loans. The London Interbank Offered Rate (LIBOR), the peg for trillions of dollars of bank loans, has fallen from 5.75% last August to just over 3% today because of actions by the U.S. Federal Reserve. These declines have eased the anxiety in the credit markets.
Myth: Since almost all stock markets went up and down in unison during this crisis, international diversification is no longer an effective strategy for investors.
Reality: Although it is true that in the very short run stock markets have become increasingly correlated, there is no evidence that over longer time periods correlations between markets have increased. The speed of international communications means that traders instantly transmit both fear and euphoria across global markets, leading to similar day-to-day volatility. But longer-term movements depend on economic and profit trends within each country. Since more than half of the world's equity capital is now headquartered outside the U.S., maintaining a diversified international portfolio is as important as ever.
Myth: Most of the decline in the prices of financial stocks can be explained by the huge write-offs of mortgage-backed debt.
Reality: The decline in financial stocks far exceeds even the most bearish estimates of loan losses from mortgage-backed securities. From May 2007 to its recent low in January, financial stocks in the S&P 500 Index have declined by more than 35%, erasing more than $1 trillion in market capitalization. The market value of financial stocks headquartered outside the U.S. have also declined substantially. These losses far exceed the worst-case scenario of $200 billion in mortgage write-downs.
The only possible rationale for these huge price declines is that investors believe an economic downturn will significantly impair other assets of the banking industry and there will be a permanent decline in income from lending. The truth is that banks have greater access to central-bank liquidity now than before the crisis and will likely recapture some of the lending that has been lost over past years to the asset-backed commercial-paper markets.
Certainly over the past few years there was much foolish lending that had led to severe losses, and the economy will suffer in the short run. But actions by central banks will assure that this credit crisis does not morph into a full-blown recession or worse. And in the long run, saner lending and more reasonable home prices will lead to a stronger economic recovery.
Jeremy Siegel is the Russell E. Palmer professor of finance at the University of Pennsylvania's Wharton School