The Globe and Mail, Report on Business
Published September 1, 2007

By Tom Bradley

Are we experiencing another immaculate correction?

That’s how I describe the market corrections we’ve experienced while living under the protective umbrella of U.S. President George W. Bush and former Federal Reserve chairman Alan Greenspan.

Typically, when the financial markets take a jolt, there is a little scare and it becomes front page news for a week or so. But before the correction has time to take hold, the Fed comes to the rescue with an interest rate cut - and investors are sheltered from any pain or blame.

The rate cut ultimately gets the equity markets going again - and investors pay even less attention to risk than they did before the scare.

I don’t know whether or not we’re now experiencing another immaculate correction. Certainly conventional bond and stock investors have suffered only modest losses so far. But as a senior manager in the industry said to me last week, this isn’t your regular stock or bond market decline. What we’re experiencing is a correction of the ”new capital markets.”

As a result, we’re observing what creative, credit-driven markets look like when they are in disarray and how the new power players - hedge funds, private equity firms and investment banks – are handling the stress.

In any case, we’re accruing lots of benefits from the current crisis beyond a lesson in modern finance. Investors who have been insensitive to risk have been given a wake-up call and, in many cases, have taken a financial hit. The subprime fiasco along with other weak spots in asset-backed securities have affected investors of all stripes, including Canadian corporations like Transat A.T. and Canfor, Chinese and German banks, and hedge funds from all parts of the world.

In general, the liquidity crisis has allowed corporate and real estate lenders to regain some control of their business, and they are once again assessing risk in a more balanced way. The crisis has definitely curtailed ridiculous lending practices that were occurring in the U.S. housing market. Hopefully in the future, more sanity in this area will save the people who can’t afford to own a home a lot of grief.

In this correction, the ”there is no contagion” viewpoint has once again been thrown into disrepute. This argument was trotted out a few months ago to reassure people that the subprime problem was an isolated case and wouldn’t affect other parts of the financial markets. In this day of highly integrated markets, such a contention is nothing short of laughable and should be exposed as such.

And finally, this correction has given investors plenty of opportunity to straighten out their asset mix if it was out of whack. The stock market has been in a downtrend, but the extreme volatility has given investors lots of up days to sell into if they needed to do so.

So if those are some of the benefits of an immaculate correction, what’s not to like? Few have been badly hurt and we’ve all learned more about how the new capital markets work.

Well, at the risk of getting flooded with mail, I’d suggest there is lots to not like.

In general, an effective correction should purge the market of its excesses and give investors a solid base on which to generate future returns. The current crisis hasn’t yet achieved that.

So far, we have not seen investors pay enough of a price for assessing risk poorly. As with other Bush/Greenspan corrections, everyone is still looking for the Fed to bail them out with lower interest rates. And in specific product areas such as money market funds and other asset-backed securities, investors are being bailed out before they even realized they had a problem.

As long as this keeps happening, investors don’t really learn to assess risk the way they should and product manufacturers can continue to market investment products that misprice capital protection.

In addition, this downturn hasn’t yet given equity investors enough screaming buy opportunities. Either stocks haven’t got cheap enough yet or they haven’t stayed cheap long enough for managers to accumulate meaningful positions.

But perhaps my assessment of the market crisis is too equity-oriented. As an old analyst, I’m using stock prices and valuations as the measure of the correction. In this type of financial crisis, however, stock market declines may just be collateral damage when compared to the hits that the housing and credit markets are taking.

What looks like an immaculate correction from an equity perspective, may indeed prove to be something much more severe when the total picture is taken into account.