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The Week Capitalism Failed

Finally, one of the most extraordinary weeks in stock market history is coming to an end. The week began with Lehman Brothers (LEH) filing for bankruptcy, followed by an $85 billion dollar government bailout of insurance giant American International Group (AIG), and concluded with the federal government announcing plans to take bad loans off of private company's balance sheets as well as halting short selling in financial stocks for 10 days (with a possible extension). The market reaction was deep depression followed by euphoria, with 2 days of 4% drops mixed in with 2 days of similar gains. With such massive federal intervention, did we just witness a failure of capitalism, or can we not afford to let it work? Who's to blame for this mess and are these the right steps to prevent a redux? What does all this mean for investors, particularly Magic Formula investors?

A Quick Synopsis of the Problem

First, a quick synopsis. As we know, banks got lax on lending standards, and for some reason believed that a below-prime borrower that could barely afford an introductory rate on an adjustible rate mortgage (ARM) was magically going to be able to afford rates 5-6% higher in 3 or 5 years. Now that those loans are resetting at higher rates, foreclosures are rising leading to increased loan defaults. When 15% of a bank's loans default, and the bank had only provisioned for 3% of them, that's bad news.

Exacerbating the problem is the incredible amount of financial "innovation" that occurred this decade. Investment banks greedily bought up these mortgages from lenders, and then went to financial culinary school, slicing, dicing, and combining them into alphabet soup derivative securities like MBSs (mortgage backed securities), CDOs (collateralized debt obligations), and so on. These securities were then bought by all sorts of companies, from banks to insurance companies to electric utlities. In effect, the mortgage crisis is putting all of those buyers at risk now. It's clear why Warren Buffett referred to these securities as "financial weapons of mass destruction" back in 2003.

The daisy chain doesn't end there. AIG got into trouble because it sells credit default swaps. In effect, this is insurance against another company going bankrupt. You can see where this is going. With so many firms exposed to this mortgage mess, bankruptcies may skyrocket, leaving the insurers like AIG with a tidal wave of claims to cover. If it can't meet those obligations, bankruptcy is imminent.

Why Not Let the Market Solve It?

So that's the synopsis. It's disturbing how fragile the financial pillars of the economic system really are. Is this a failure of capitalism? I don't think so. In a pure capitalistic system, the banks holding the mortgages would certainly fail, and some of the insurers and other firms exposed to them would also go belly-up. In theory, the conservative lenders would survive, and the firms that relied on cash flow instead of debt, or invested in non-exotic securities, would also live on. In effect, the companies that made the mistakes would pay for them, while the strong survive. Theoretically, allowing the market to function should solve the crisis.

But does the theory match reality? Human nature says no. Mass failure of huge companies causes widespread panic. Stock markets plunge, destroying personal and business savings. This fear leads to irrational behavior, such as pulling bank deposits, which leads to more bank failures. The downswing would likely feed upon itself, and it's not unfathomable that another period similar to the Great Depression could have been the result. This crisis is that serious. People rely on government to protect them, and this is the reason behind the extrodinary steps being taken to alleviate the public's fear.

Who is to Blame for this Mess?

There is plenty of blame to go around here. In order of most aggregious to least, the top 3 offenders are:

  1. Lenders and Investment Banks: These were the folks making loans to people who could not afford them. Instead of researching creditworthiness and value of collateral, the dollar signs in their eyes did just the opposite. "You can afford it! The value of your house will go up, allowing you to refinance!" "No money down and no documentation required!" "Low payments for the first 3 years!" It looked great for a few years, but when the tide went out, quite a few were swimming naked. Long term, successful banks have always been conservative lenders. This mess reiterates that fact.

  2. Government Oversight: The government likes to stay out of the market when things are going well but step in when they are going bad. In effect, this privatizes profits but socializes losses, and all taxpayers should be furious at this. Government should play a role by limiting both the wild upside and downside of pure capitalism. After all, deep depressions always follow euphoric bubbles. Where was the government oversight when these ridiculous loans were being made? Preventing this at conception would have been a hell of a lot cheaper for us taxpayers. Now we foot the bill while the CEO's of Freddie Mac and Fannie Mae get paid 7 million dollars each. That's failure of oversight.

  3. Over-their-head Borrowers: The people that took out loans they couldn't afford can't escape without blame for this either. When you make a financial committment, you should be damn sure you can live up to it (extenuating circumstances aside, of course). I put these people 3rd on the list because they will be punished properly, while the other two will not.

Does the Solution Prevent a Redux?

I agree that the government had to step in. Allowing a potential depression when there are the means to prevent it is not acceptible. But does the solution of public bailouts and buying bad assets prevent this from happening again?

A somewhat similar solution, the Resolution Trust Corp., was used in the early 1990's to clean up the bad assets of the Savings and Loan companies that failed in the 80's. The new plan appears to be a little different. The government will buy bad assets on the cheap from banks that want to get them off of it's books. This provides liquidity that is needed to function. The bailout for AIG is really just an expensive loan that allows the company to liquidate in an orderly fashion. The solutions themselves are not terrible ideas. The companies at fault are being punished, the government is just preventing a frenzied free-for-all asset auction while they are largely dismantled.

To consider the case closed, there will have to be stricter regulations on these "creative" loans and securities. Finance has to be a conservative undertaking.

What Does All This Mean for Magic Formula Investors?

This is a site about finding the best Magic Formula stocks, and while I've gone off on a tangent here, there is a coorelation. First of all, we are lucky - the Magic Formula by definition avoids traditional and investment banks as well as insurance companies. That's a huge break. Just being a MFI investor in the first place has kept you out of Bear Stearns, Freddie and Fannie, AIG, and Lehman Brothers (not to mention all other financial institutions which have been roundly pummeled). Regardless of strategy doctrine, there are plenty of reasons that banks are difficult investments and should be avoided.

MagicDiligence picks are always financially healthy and sport great management teams. This helps to avoid investing into the greed of managements who are in it for themselves. Do you think the CEOs of Fannie and Freddie care much about the shareholders that collectively lost billions? With strong financial health, the Top Buys can easily survive economic downturns, and come out stronger on the other side. Finally, with durable competitive advantages, they can maintain sales and profits better through a downturn than MFI stocks that rely on sales that can disappear overnight.

Most importantly for investors, DON'T PANIC! Those that sold en masse early in the week missed the big gains towards the end. If you are holding good stocks, continue to hold them. If you have the cash, now is a good time to go shopping. This has always been the successful investor's way, and it will continue to be going forward.

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