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By any standard, 2008 was an extraordinary year for investors. As chroniclers of these events, we ran out of superlatives halfway through the year; those of us who weren't alive during the Great Depression were presented with unfamiliar situations at every turn. In that context, selecting the biggest game-changer is no easy task. Our nominees are:
Mortgage-backed securities/ CDOs/ CDSs/ ABSs, etc.
One of the pillars of the housing bubble was the notion that securitization enabled risk to be diversified among numerous participants in the financial system. That was true ... in the same way that an epidemic enables disease to be widely disseminated among the members of a population. Mortgage-backed securities and other products of Wall Street quants' alchemy were no philosopher's stone, as the relationship between risk and return defied every attempt to subvert it.
The death of investment banks
The investment bank business model seemed like a straw house in a hurricane in 2008. Between bankruptcy (Lehman Brothers), acquisitions (Bear Stearns and Merrill Lynch by JPMorgan Chase (NYSE: JPM ) and Bank of America (NYSE: BAC ) , respectively) and conversions to bank holding companies, technically, there are no major investment banks left. Practically speaking, Goldman Sachs (NYSE: GS ) and Morgan Stanley (NYSE: MS ) are left standing – it remains to be seen how successful their new model will be in a new era of increased regulation and lower appetites for risk.
From mortgage giants Fannie Mae (NYSE: FNM ) and Freddie Mac to insurer AIG (NYSE: AIG ) , the government went on a huge shopping spree-turned-rescue mission. Top banking institutions were partially nationalized, most prominently Citigroup (NYSE: C ) . As a major shareholder in the financial system, the government's role is a critical new variable for investors.
When future economic policy-makers are kids, they go to bed worrying that deflation might be living in their closet. Deflation is tougher to tame than inflation, and it doesn't have the same self-damping mechanisms. In November, the Bureau of Labor Statistics announced the steepest one-month drop in the 61-year history of the consumer price index (CPI). All investors should hope we're able to stamp out this devil. The last period of significant deflation was during the Great Depression, and we don't want to revisit that.
The return of risk premiums
In the buildup of the credit bubble, investors appeared to project rising home prices and healthy economic conditions unto eternity -- uninterrupted. Risk had been relegated to a forgotten age. However, the Hydra burst out of its cage in 2008 with terrible ferocity. Take junk bonds, for example. In mid-2007, they were yielding less than 2.5 percentage points over Treasury bonds; last month, the spread peaked at almost 22 percentage points. Risk premiums are back. Big time.
The nominees are in; all that remains is for you, our reader, to select your biggest game-changer of 2008.