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  Article - Economic Open Heart Surgery  
 

The Economy Undergoes Open Heart Surgery

By William W. McGinnis, CFA

This article was published in the BizTimes Milwaukee on November 14, 2008

 

Recent events in our markets and economy have been confusing: significant turbulence in the stock market; big swings in oil, grain and commodity prices; a credit crisis; financial institution failures and forced mergers; government takeovers.

 

 

What does it all mean?

 

Challenging issues are often clearer if you can relate them to something more common. Reflecting on recent events and conditions, a story comes to mind.

 

I play quite a bit of tennis, at a fairly competitive level. A few years ago, one of the guys in our group had a heart attack – at age 50. We had all played with Mark for over 10 years. He was seemingly in very good shape and frequently beat us. Now, he was facing a quadruple bypass. No one would have guessed.

 

Or would they? We play tough, aggressive tennis. Everyone is tired at the end of an evening’s play. But Mark always seemed to be gasping for air during our matches. Looking back, it was an obvious sign, but it never registered at the time. Sure, we commented about it, but nothing more. Some of us would even run him a little extra to win more points.

 

 

Dose of reality

 

Mark knew that he should have been eating better, taking better care of himself and seeing a doctor more regularly.

 

The heart attack was a stark dose of reality.  Suddenly, the gasping came into perspective. Mark wished he’d been more diligent about his health. It was just too easy not to.

 

Fortunately, the attack wasn’t fatal, just a dramatic warning that things needed to change.

 

Over the last couple of months, our markets and others around the world suffered an attack of their own. It started with a bit of discomfort, but quickly, our markets were flat on their back.

 

Sirens blaring, the rescue teams were dispatched: the Federal Reserve, the Treasury Department, politicians galore. They didn’t know exactly what they would find. What they did know was that “the patient” was in very serious condition.

 

Looking back, experts had been saying for some time that real estate prices had advanced too far, too fast. We knew that credit risks had expanded. Subprime mortgage loans were made to people who normally wouldn’t have qualified for a loan. Through the miracle of financial engineering, those loans were chopped into pieces and sold off as packages. The “math” behind them suggested that these were perfectly healthy investments.

 

But like a daily breakfast of bacon and eggs with a mid-morning donut chaser, the stresses caught up with the markets. Years of bad habits resulted in crushing pain.

 

The exact trigger for the markets’ attack will never be known. However, it seems likely that large, rapid increases in oil, commodity and food prices stressed subprime borrowers to the breaking point. Combined with other factors, the markets were seizing. The lifeblood of our economy – credit – came to a near standstill.

 

In Mark’s case, the answer was clear and straightforward – quadruple bypass.

 

 

Uncharted territory

 

Unfortunately, in the case of our markets, the complexity of the problems is unprecedented. Never before have our markets been so internationally entwined. New instruments like credit swaps and sophisticated collateralized debt obligations have created intermingled relationships that are nearly impossible to sort out in the short-term.

 

It may not even be possible in the long-term … at least not until it’s too late.

 

Thus, lacking any precedent and having only incomplete information, our government and those of countries around the world still needed to respond. The patient was getting worse. Increasingly so, by the day. One thing was clear, the required surgery was going to be much more complex than any that had ever been performed before. There was much strategizing and planning ... and guesswork. Guesswork regarding both the approach to use and the amount of money to toss at the problem. Toss, because all of the approaches are very imprecise.

 

Today, the patient is still on the operating table. The complications have been more severe than hoped. But the vitals are improving, and the patient seems to be stabilizing.

 

Clearly, the patient is not out-of-the-woods. There are likely to be more setbacks. We can only hope they’ll be less severe than what we’ve already seen. The good news is the doctors are monitoring the situation very closely and are prepared to do whatever it takes to get the markets and our economy back on their feet.

 

 

Slow recovery

 

The surgery itself could easily take months more. Only then will we begin to understand how much damage has really been done. … and whether more surgery will be necessary.

 

Mark’s recovery was a long process. The first few days after the surgery, he was still groggy from the anesthesia. But the doctors wanted him up and walking the very next day. They knew it was the fastest path to recovery. But Mark was still unstable ... and tired ... and sore. Still, the doctors wanted Mark walking. They watched him closely. He began gaining strength.

 

We’ll eventually see the same thing with our markets and economy.

 

After a week, Mark was sent home. He certainly wasn’t ready to hit the tennis court, but he could get to the bathroom on his own. A few weeks later, he began physical therapy.

 

That was a real test, both physically and emotionally. It was hard for everyone around him.

 

Within six months, Mark was back on the tennis court – beating us again. Today, he’s actually faster, stronger and has more endurance than before the attack.

 

There’s every reason to believe that the prognosis is the same for our economy. There is definitely a healing period in front of us, and it will be challenging. Not every day will be better than the last. There will be backslides. The recovery will take time. Longer than we’d hope. But, in the long term, the economy will come back stronger than before.

 

Some of the economy’s old habits like subprime lending will be gone forever, or at least greatly reduced. Like most patients, the economy will be most cautious during the initial period of recovery. But there is always a tendency to slip back toward the old familiar habits.

 

Like Mark’s wife, politicians will be tempted to lay down the law with a new diet and strict rules. They won’t work – Mark and the economy will always find a path of their own. While it was difficult, Mark’s wife realized that love and encouragement work better than rules and restrictions. Let’s hope our politicians are as wise.

 

 

 

 

William McGinnis, CFA, is an expert witness who testifies in investments and securities lawsuits.  He owns Milwaukee-based W. McGinnis Advisors, LLC and has worked in investment analysis, portfolio management and mergers & acquisitions for more than 25 years.  

 

 

 

 

 

 

 

 

 

 

 

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