It is very easy to consider the free market as nothing but a vehicle to decide winners and losers. However, it is more than that. It is a vehicle to restore order and balance, insuring that the fundamental principles of economics are obeyed.
In the events of the past weeks, we have seen stalwarts such as Merrill Lynch and Co., Lehman Brothers, Bear Sterns, Freddie Mac and Fannie Mae all begin to fade into obscurity.
As this is the political silly season in the U.S., politicians are quick to point blame at each other, some of which is well deserved. However, the current troubles are the result of violating basic economic principles. Yes, I repeated the phrase, because it bears repeating.
Companies in the U.S. can safely take on debt (leverage), if their cash flow permits it. Additionally, debt can be used to lessen taxes. However, with debt comes risk. Failure to properly evaluate risk can result in being over leveraged and unable to pay back the debt. That is exactly what we have seen in this current economic situation.
Individuals took out mortgages well in excess of their ability to pay. These mortgages were bundled, chopped into pieces (tranches), and sold. Lehman, Merrill, etc., bought these seemingly low-risk securities and then used them as collateral for new debt. In both the individual and corporate cases, they were over-leveraged. People have been missing mortgage payments. The tranches with bad mortgages have lost value. That value which was used as collateral is now insufficient to pay back corporate loans. Badda bing, badda boom, companies go out of business.
Let this be a lesson, conservative risk management rewards in the long run. Bank of America, JPMorgan and Goldman Sachs, while taking it on the chin in the short run, are well positioned to weather this storm. The market is correcting the excesses and that's exactly what it is supposed to do.