In recent months, certain high-profile stock market commentaries have suggested that the subprime mortgage crisis is over. To use a baseball term, I would argue that we are not yet in the ninth inning. If we are lucky, we are actually just in the fifth inning – and it will be another 12 to 18 months before things normalize again.

Since last June, the Bank Index (BKX) and the Mortgage Finance Index (MFX) have declined by more than 45 percent and 65 percent respectively. The declining value of these stocks is directly proportionate to the writedowns that banks have been announcing since last August. (And there are more to come!)

The subprime mortgage crisis was founded and engineered by the finest minds on Wall Street. These minds created exotic credit derivatives and debt securitization that expanded home ownership in the United States to include the desperate issuance of high-ratio (very high loan-to-value ratios) mortgages to the poor while avoiding regulatory and accounting disclosure. This is the very scenario that predicated the collapse of Enron, which engineered various “off-balance” sheet derivatives based on energy trading versus high-ratio mortgages. Former Enron CEO Ken Lay, who died prior to starting his 16-year prison term, must be crying foul for facing such a punishment while ex-CEOs of the banks received rich cash-laden “golden parachutes” on their way out the door during the subprime fiasco.

This blind date between an un-creditworthy borrower (whose only security was an assumption that real estate values would rise in perpetuity) and a lender financing the exotic derivative (a mismatch brokered by the investment bankers) only compounded their troubles and ours. Once Wall Street could no longer retain their smoke and mirrors and find a “greater fool” to buy these investments, they were left with no choice but to hold them on their own balance sheet and write them off.

In short, real estate and the financial system (in combination with some government regulation or lack thereof) collaborated to create a bubble not unlike the technology bubble that “popped” in 2000. The bank lends money to a home buyer with no money down, or worse, lends money with no money down and no proof of income. The home buyer buys a home and assumes that the value of that home will appreciate in value more than the cost of funds (the interest paid on the mortgage). Because banks want to grow their customer base, they simply introduced an “introductory” rate on their mortgage for the first year or two at a rate substantially below the market (i.e., at a massive discount) only to reset it a year or two later, presumably when the consumer would earn more income.

In turn, when these mortgages “reset” to a higher rate and the consumer or home buyer could no longer afford the higher mortgage payments, they would sell the home at a profit, buy a new home and start the process over again. This worked fine until the home market flooded with people selling and home prices began declining.

Although it would be hard to fathom how so many big banks could simultaneously behave so stupidly, they did! Now their creditability is shot, the creditability of the U.S. is shot and, in turn, the financial system in the U.S. is pretty much shot as well.

The U.S. Federal Reserve is attempting to correct the problem by pumping billions of dollars of liquidity into the system and changing the security it is willing to receive, while dropping interest rates dramatically (even significantly lower than inflation). It has been reported that the banks have written off more than $400 billion in bad loans and raised more than $400 billion in new equity (however, investors have failed to make money on their newly acquired bank investments, which will likely make raising more money quite difficult).

Today, we believe the banks will announce a further $200 to $300 billion in writedowns. Raising additional equity capital will become more difficult and inflation has accelerated with rising oil and food prices. We believe that investors should still be underweight in global financial stocks (Canadian financial stocks have been pulled into the mud but unjustifiably so to some extent, with the exception of CIBC) and should favour hard and soft commodities while retaining a diversified portfolio of investments.