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8:30 AM EST Monday, May 19, 2008: I am dipping my toes back into my favorite Vanguard funds. I had sold out of all of these in November, thinking the market would crater and I'd be proven brilliant. In fact, I'd have been more brilliant if I had come back in on April 1, not the third week of May.

Which just goes to prove, once again, that you can't time the market. Now, I knew this when I pulled out. But I figured the markets would totally crater -- like big time. But they didn't -- though, knowing my luck, they may still.

If you read the financial press, you'll get enough doom and gloom to thoroughly depress you. There is serious inflation in oil and food, which will affect consumer spending -- two-thirds of the economy. That's not the part that worries me (and my friends). They worry about the credit crunch, which has curtailed their borrowing for all their various "projects" (especially real estate). There's an excellent survey on banking in the latest Economist. A depressing excerpt:

If the crisis were simply about the creditworthiness of underlying assets, that question would be simpler to answer. The problem has been as much about confidence as about money. Modern financial systems contain a mass of amplifiers that multiply the impact of both losses and gains, creating huge uncertainty.

Standard & Poor's, one of the big credit-rating agencies, has estimated that financial institutions' total write-downs on subprime-asset-backed securities will reach $285 billion, more than $150 billion of which has already been disclosed. Yet less than half that total comes from projected losses on the underlying mortgages. The rest is down to those amplifiers.

One is the use of derivatives to create exposures to assets without actually having to own them. For example, those infamous collateralised debt obligations (CDOs) contained synthetic exposures to subprime-asset-backed securities worth a whopping $75 billion. The value of loans being written does not set a ceiling on the amount of losses they can generate. The boss of one big investment bank says he would like to see much more certainty around the clearing and settlement of credit-default swaps, a market with an insanely large notional value of $62 trillion: “The number of outstanding claims greatly exceeds the number of bonds. It's very murky at the moment.”

A second amplifier is the application of fair-value accounting, which requires many institutions to mark the value of assets to current market prices. That price can overshoot both on the way up and on the way down, particularly when buyers are thin on the ground and sellers are distressed. When downward price movements can themselves trigger the need to unwind investments, further depressing prices, they soon become self-reinforcing.

A third amplifier is counterparty risk, the effect of one institution getting into trouble on those it deals with. The decision by the Fed to offer emergency liquidity to Bear Stearns and to facilitate its acquisition by JPMorgan Chase had less to do with the size of Bear's balance-sheet than with its central role in markets for credit-default and interest-rate swaps.

Trying to model the impact of counterparty risk is horribly challenging, says Stuart Gulliver, head of HSBC's wholesale-banking arm. First-order effects are easier to think through: a ratings downgrade of a “monoline” bond insurer cuts the value of the insurance policy it has written. But what about the second-order effect, the cost of replacing that same policy with another insurer in a spooked market?

The biggest amplifier of all, though, is excessive leverage. According to Koos Timmermans, the chief risk officer at ING, a big Dutch institution, three types of leverage helped propel the boom and have now accentuated the bust. First, many banks and other financial institutions loaded up on debt in order to increase their returns on equity when asset prices were rising (see chart 1). The leverage ratio at Bear Stearns rose from 26.0 in 2005 (meaning that total assets were 26 times the value of shareholders' equity) to 32.8 in 2007.

Second, financial institutions were exposed to product leverage via complex instruments, such as CDOs, which needed only a slight deterioration in the value of underlying assets for losses to escalate rapidly. And third, they overindulged in liquidity leverage, using structured investment vehicles (SIVs) or relying too much on wholesale markets to exploit the difference between borrowing cheap short-term money and investing in higher-yielding long-term assets. The combined effect was that falls in asset values cut deep into equity and triggered margin calls from lenders. The drying-up of liquidity had an immediate impact because debt was being rolled over so frequently.

That is not to suggest that the credit crunch is solely the responsibility of the banks, or that all of them are to blame. Banks come in all shapes and sizes, large and small, conservative and risk-hungry. Alfredo Sáenz, the chief executive of Santander, a Spanish retail giant, recalls attending a round-table of European bank bosses during the good times at which all the executives were asked about their strategic vision. Most of them talked about securitisation and derivatives, but when it was Mr. Sáenz's turn, he touted old-fashioned efficiency. He did not get any questions. “There were 'clever' banks and 'stupid' banks,” he says. “We were considered one of the stupid ones.” No longer.

Beyond the banks, a host of other institutions must take some of the blame for the credit crunch. The credit-rating agencies had rose-tinted expectations about default rates for subprime mortgages. The monolines took the ill-fated decision to start insuring structured credit. Unregulated entities issued many of the dodgiest mortgages in America.

And no explanation of the boom can ignore the wall of money, much of it from Asia and oil-producing countries, that was looking for high returns in a world of low interest rates. “It is indisputable that the global glut of liquidity played a role in the 'reach for yield' phenomenon and that this reach for yield led to strong demand for and supply of complex structured products,” says Gerald Corrigan, a partner at Goldman Sachs and an éminence grise of the financial world.

Many blame the central banks: tougher monetary policy would have encouraged investors to steer towards more liquid products. Others blame the investors themselves, many of whom relied on AAA ratings without questioning why they were delivering such high yields.
Wheel-greasers

Still, the banks have been the principal actors in this drama, as victims as well as villains. The S&P 500 financials index has lost more than 20% of its value since August, and many individual institutions have fared far worse. Analysts have been forced to keep ratcheting down their forecasts. “The downside will be longer than anyone expects,” says David Hendler of CreditSights, a research firm. “There is so much leverage to be unwound.”

According to research by Morgan Stanley and Oliver Wyman, investment banks will be more severely affected by this crisis than by any other period of turmoil for at least 20 years. By the end of March the crunch had already wiped out nearly six quarters of the industry's profits, thanks to write-downs and lower revenues. Huw van Steenis of Morgan Stanley reckons that the final toll could be almost two-and-a-half years of lost profits (see chart 2).

Other industries have gone through similarly turbulent times: airlines in the wake of the terrorist attacks on September 11th 2001, technology firms when the dotcom bubble burst. Even within the financial sector the banks are not the only ones currently suffering: hedge funds, insurers, asset managers and private-equity firms have been hit too. But banks are special.

The first reason for that is the inherent fragility of their business model. Bear Stearns, an institution with a long record of surviving crises, was brought to its knees in a matter of days as clients and counterparties withdrew funding. Even the strongest bank cannot survive a severe loss of confidence, because the money it owes can usually be called in more quickly than the money it is owed. HBOS, a big British bank with a healthy funding profile, watched its shares plummet on a single day in March as short-sellers fanned rumours that it was in trouble. It survived, but the confidence trick on which banking depends—persuading depositors and creditors that they can get their money back when they want—was suddenly laid bare.

The second reason why banks are special is that they do lots of business with each other. In most industries the demise of a competitor is welcomed by rival firms. In banking the collapse of one institution sends a ripple of fear through all the others. The sight of customers queuing last September to withdraw their money from Northern Rock, a British bank, sparked fears that other runs would follow.

The third and most important reason is the role that banks play as the wheel-greasers of the economy, allocating and underwriting flows of credit to allow capital to be used as productively as possible. That process has now gone into reverse. Banks have seen their capital bases shrink as write-downs have eaten into equity and off-balance-sheet assets have been reabsorbed. Now they need to restore their capital ratios to health to satisfy regulators and to reassure customers and investors.

For some, that has meant tapping new sources of capital, often sovereign-wealth funds. For most, it has meant reducing the size of their balance-sheets by selling off assets or by cutting back their lending. Quantifying the impact of this tightening is hard, but one calculation presented by a quartet of economists at America's Monetary Policy Forum in February suggested that if American financial institutions were to end up losing $200 billion, credit to households and companies would contract by a whopping $910 billion. That equates to a drop in real GDP growth of 1.3 percentage points in the following year. If the banks suffer, we all do.

Which type of "indexing"? Talking about index funds (e.g. Vanguard), there's true indexing, and there's manipulated indexing. The true stuff mirrors the index. The manipulated index includes the same stocks but weights them differently. It includes factors like dividends. The manipulated guys say their "index" funds do better. The verdict is not yet in, because these things are young. I find the argument fascinating. Emotions run stronger than politics. For the latest on the argument, check out Joe Nocera's piece in Saturday's New York Times.

Please don't chase yields. Chase safety. Everybody (including me) got stuck in auction rate securities because they or their brokers were greedy. It is not good to be a yield hog today. A reader emails me:

I am looking to 'park' a sizable chunk of money into something safe with a decent return. Currently money market fund is paying 2.5% (taxable) Vs 5.00% (tax free) with those funds.

I haven't looked at the funds he wants to buy. I smell there's a sizable capital risk. He may lose more on his capital than he will gain on the higher yield.

Chasing yields is what got the world into the sub prime / banking mess. And the Economist makes that very clear. Read it.

Sunday school
LOT'S WIFE:The Sunday School teacher was describing how Lot 's wife looked back and turned into a pillar of salt, when little Jason interrupted, "My Mommy looked back once, while she was driving," he announced triumphantly, "and she turned into a telephone pole!"

GOOD SAMARITAN:
A Sunday school teacher was telling her class the story of the Good Samaritan.

She asked the class, "If you saw a person lying on the Roadside, all wounded and bleeding, what would you do?"

A thoughtful little girl broke the hushed silence, "I think I'd throw up."

DID NOAH FISH?
A Sunday school teacher asked, "Johnny, do you think Noah did a lot of fishing when he was on the Ark?"

"No," replied Johnny. "How could he, with just two worms."

HIGHER POWER:
A Sunday school teacher said to her children, "We have been learning How powerful kings and queens were in Bible times. But, there is a higher Power. Can anybody tell me what it is?"

One child blurted out, "Aces!"

This column is about my personal search for the perfect investment. I don't give investment advice. For that you have to be registered with regulatory authorities, which I am not. I am a reporter and an investor. I make my daily column -- Monday through Friday -- freely available for three reasons: Writing is good for sorting things out in my brain. Second, the column is research for a book I'm writing called "In Search of the Perfect Investment." Third, I encourage my readers to send me their ideas, concerns and experiences. That way we can all learn together. My email address is . You can't click on my email address. You have to re-type it . This protects me from software scanning the Internet for email addresses to spam. I have no role in choosing the Google ads on this site. Thus I cannot endorse, though some look interesting. If you click on a link, Google may send me money. Please note I'm not suggesting you do. That money, if there is any, may help pay Michael's business school tuition. Read more about Google AdSense, click here and here.
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