The ongoing credit and liquidity crisis in the U.S. and globally has produced some amazing results.
First, Fannie Mae and Freddie Mac are no longer independent companies. Merrill Lynch & Co., Lehman Brothers Holdings Inc. and American International Group Inc. also are fundamentally changed. Second, we find that Morgan Stanley and Goldman Sachs Group Inc. have turned themselves into traditional, deposit-gathering banks. On this last note, it is fascinating to comment that it was another financial crisis the Great Depression that led to the 1933 Glass-Steagall Act that split investment banks and brokerage firms from traditional banks. Now, the financial crisis of 2008 has reversed this course and brought these financial firms all back together. It took 75 years, but we have come full circle.
The Glass-Steagall Act was formally repealed in 1999 with the passage of the Gramm-Leach-Bliley Act, which allowed investment banks and traditional banks to merge and recombine. Still, the full impetus of this law was not felt until the financial crisis of 2008. Since 1999, investment banks and traditional banks have changed their business models. Previously, banks would make loans and keep the loans on their balance sheets, managing the risk and collecting the interest as revenue. But over the past 10 years, both investment banks and traditional banks shifted from managing risk on their balance sheets to being transaction-oriented and selling the risk off their balance sheets. The mortgage market is a good example.
At the heart of the subprime mess is a mortgage loan to a less-than-prime-grade borrower. Small banks and mortgage lenders make these loans and then sell them in pools to larger financial institutions, primarily the Federal National Mortgage Association and Federal Home Loan Mortgage Corp. Fannie and Freddie take the mortgage pools and issue mortgage-backed securities essentially bonds backed by the underlying pool of subprime mortgages. Investment banks purchase these securities and repackage them yet again into new investment pools called collateralized debt obligations. These CDO pools then issue another round of securities backed by the mortgage-backed securities held in the CDO pool. You can see that this house of cards quickly gets stacked very high, built upon a shaky foundation of individual subprime mortgages. When the underlying mortgages began to default, the whole financial structure collapsed.
So what do we do now? First, recognize that in times of financial turmoil, investors' risk aversion increases dramatically. When this happens, investment horizons collapse. Investors no longer think about investing for the long term they are concerned about next month, next week, next day.
The result is that safety and security become king, and risk is not rewarded. Witness the three-month U.S. Treasury bill bid at one basis point last week. Essentially, investors were willing to lend money to the U.S. government at no cost for the safety of a U.S. government guarantee. To use a Godfather analogy, this is money going to the mattresses. Every asset class that has embedded risk stocks, high yield, emerging markets, real estate is being penalized right now and risk premiums are soaring. For example, by my own estimate, the equity risk premium for U.S. stocks is now above 6%, compared with a long-term equity risk premium that is, the premium for stocks over U.S. Treasury bonds of about 3.9%.
For an investor with a long-term focus such as a pension fund, endowment or foundation, now may be a good time to capture these high risk premiums. In chaos, there is opportunity, and the opportunity before us is the ability to lock in the high risk premiums being offered by risky asset classes. High risk premiums translate into undervalued asset classes. And while high risk premiums might continue or even go higher for some period, eventually, these risk premiums should come down and the underlying asset values should increase.
What's the catch? The catch is that there is very difficult to predict when these high risk premiums will return to their long-term normal market trends. It might take 12 months, it might take 18 months. Without a crystal ball, it is anyone's best guess. Therefore, to take advantage of this opportunity, investors must have the intestinal fortitude to look beyond tomorrow, next week or next month. If you can look out 12 months or longer, the opportunity to capture some rich risk premiums may be before you.
Mark Anson is president and executive director of investment services at Nuveen Investments Inc., Chicago. Views expressed in his commentary are his own and not necessarily those of the firm.