More gubu than guru

Serious Money:The world's financial markets have spoken and the message to investors is clear. The disturbingly infantile and naive predictions emanating from the so-called experts both here and across the globe have proved wide of the mark, writes  Charlie Fell.

The high-salaried gurus argued previously that the subprime mortgage crisis in the US would be contained. Once that proved incorrect, they declared confidently that the US Federal Reserve's response to the growing crisis, with a percentage-point cut in interest rates, would put the five-year bull market back on track, just as former Fed chairman Alan Greenspan's adjustment of monetary policy did a decade ago in the wake of the collapse of the hedge fund, Long-Term Capital Management (LTCM).

They suggested that any weakness in stock prices should be considered a buying opportunity as a US recession was unlikely and economic growth elsewhere would prove impervious to a US slowdown.

All such predictions have since proved suspect and pension fund trustees have just cause to ask why some of their investment managers remained fully invested in equities through the current turmoil.

The difficulties that surfaced in the US subprime mortgage market 12 months ago were just the tip of the iceberg, as the cheap money under the Greenspan Fed contributed to a disturbing excess in the world's credit markets.

The excesses have been bubbling below the surface for months and were apparent to those who bothered to look. Those investors who dug that little bit deeper have been positioning for the market turmoil for some time and reduced equity exposure in the final quarter of 2007. These investors have avoided the current quagmire.

A large contingent of investors continue to debate the ongoing subprime crisis and whether a recession will result, but that is yesterday's news. The turmoil has spread well beyond the market for mortgage-backed securities and has reached the world of credit insurance, while a downturn has already arrived.

The notion that the current crisis is comparable to LTCM - a singular event in 1998 - and that a recession can be avoided seems naive at best and negligent at worst.

The carnage that gripped the world's stock markets in recent days was precipitated by the revelation in Merrill Lynch's fourth-quarter results that it had written off more than $3 billion (€2.06 billion) in credit protection contracts purchased from ACA, a now ailing and defunct bond insurer.

A further blow was delivered last week when ratings agency Fitch downgraded the debt of the world's second-largest financial guarantor, Ambac, from AAA to AA, with further cuts in the pipeline. Moody's and Standard & Poor's are sure to follow with downgrades and MBIA, the largest bond insurer, almost certainly faces a similar fate.

Investors will ask why this matters and the answer is clear: the guarantors have insured $2.4 trillion in municipal debt and, when their AAA ratings go, so too do the pristine ratings afforded to those entities that sought their help in issuing bonds at lower yields than their underlying business deserved.

The inevitable downgrades will cost borrowers and investors more than $200 billion.

The business model of bond insurers hinges on having an AAA rating, which raises the question as to how such businesses were given a perfect credit rating in the first place.

The AAA rating allowed the financial guarantors via bond insurance to pass their ratings and the subsequent lower debt servicing costs on to their clients. Unfortunately, tight credit spreads pressured margins and the bond insurers rushed headlong into the world of structured finance, a big mistake as losses endured have ensured that the game is over.

The bond insurers' travails shook credit markets as worries spread to the world of credit default swaps - a market that amounts to $45 trillion.

Not surprisingly, stock prices dropped precipitously. The Ben Bernanke Fed responded with an emergency interest rate cut of three-quarters of a percentage point. While this unprecedented action restored a semblance of calm to stock markets, the world of credit remained shaky. Investors are clearly realising that monetary policy not only operates with a considerable lag but cannot force banks with depleted balance sheets to lend.

The credit crisis rolls on and the excesses of recent years need months if not years to be worked off. Those investment managers who took no action in recent months should not be allowed to abdicate responsibility for their poor performance. After all, their outsized salaries stem not only from their supposed skills but also the premise that risk and reward should be positively related. Trustees should remind the so-called investment elite that there is no such thing as money for nothing.

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