The past few weeks has been eventful, to say the least. We have watched the disappearance of Lehman Brothers and the changing status of Goldman Sachs and Morgan Stanley to bank holding companies from investment banks; seen Merrill Lynch, Wachovia, Halifax Bank, and Fortis get bought; and witnessed the nationalization of Bradford & Bingley, Fannie Mae and Freddie Mac. This doesn’t even come close to describing the heartburn that many institutions and individuals are experiencing every day as they watch equity market movements and the events as they continue to unfold.

U.S. news programs are interviewing people at retirement age who will now need to work five to 10 more years before they consider retiring, and retirees who are thinking about getting jobs again.

Much of the activity in the financial services sector resulted from weak balance sheets and/or a high exposure to poor quality mortgage assets. Many were unable to raise the equity needed in order to shore up their balance sheets (or they didn’t like the discount that was offered). In any event, all this activity has resulted in tightening credit conditions as the banks are loathe to lend to each other, much less you or I. Bank losses usually have the direct impact of making it harder for individuals and companies to get loans for otherwise creditworthy pursuits.

Policy-makers have taken numerous actions in an attempt to restore some sense of order to the financial system. Nevertheless, global money, credit and equity markets have come under severe strain due to rising concerns about the health of the financial sector and emerging worries about a global slow down. The consumer accounts for two-thirds of U.S. gross domestic product. With job losses mounting, housing prices continuing to fall, no savings and no more tax rebates to spend, it is safe to say that it is unlikely the U.S. consumer will be able to contribute much to the growth of the U.S. over the short term. A similar situation exists in the U.K., Spain and Ireland. The big question as always is China—will China be able to grow at the pace it has over the past few years? If the falloff in Indian steel exports are any indication, things have definitely slowed in China.

While initially a credit crisis (remember Bear Stearns?), this “credit crunch” has moved from being a liquidity issue to one of solvency. The current problems are structural in nature and will take time to sort out. This means that investors will have to be much more patient than they have been over the past few years. There is still considerable risk of further credit losses, some of which will not be known for some time yet. Tightening credit conditions and de-leveraging of balance sheets are compounding an already bad situation.

So what does this mean for investors?

  • It goes without saying that institutions and individuals are going to be incredibly unhappy when they review returns from the most recent quarter. If recent market conditions have exceeded your risk tolerance, then risk should be reduced to an appropriate level. It is important not to overreact and change managers on a like-for-like basis. Investors should remain cautious and stay at the lower end of their risk tolerance.
  • Equity markets have fallen materially. However, with equity volatility elevated, on a risk adjusted basis, equities may not be as “cheap” as they appear. The phrase, “catching a falling knife” is a refrain that has been uttered by many over the past few weeks. Furthermore, market volatility is expected to stay high due to financial and economic risks.
  • There are potentially attractive shorter-term opportunities in the distressed/structured credit markets for investors with the governance capability and a longer-term time horizon. However, current liquidity conditions make such an investment difficult. Distressed debt and equity funds have been and are being raised by private equity managers and could be of interest to those with a longer-term time horizon. These funds are poised to take advantage of the current environment and forced asset sales that will occur during the de-leveraging process.
  • The headwinds from higher costs of leverage and likely increased shorting costs (if allowed at all) may be significant for some hedge funds. It is prudent to wait for this situation to be resolved before deploying additional capital into funds with long lockup periods.
  • The increased costs of leverage and the tightening credit conditions will cause many private equity and infrastructure funds to deliver less healthy returns than in prior years. We have already seen a number of announced deals fall apart, portfolio companies be written off, and fundraising cycles extended.

The dislocation in financial markets is acute and will not be quickly fixed. Therefore, while various risk premia have risen, investors will have to be patient—longer time horizons may be necessary in order to benefit from them. Thus, investors should remain cautious, taking risk in investments with more supportive fundamentals and valuations.