The current financial crisis started small and ballooned into something big and chilling. We don’t know when the crisis will end, but we think we know how it will end. As we see it, when the crisis is in the process of being resolved, there will be six telltale signs. The signs pertain to the financial-services sector’s size, profitability, and rate of deleveraging; tangible prices being set for mortgage securities; lending loosening up; new regulations; and a stabilized housing market.

The current financial crisis is a sobering story of how something seemingly small became something incredibly big.

It all began with subprime-mortgage loans, which only a few years ago seemed a relatively minor and inconsequential financial instrument. In early 2007 subprime mortgages -- designed to help consumers with scant or spotty credit histories buy homes -- accounted for just 14% of all mortgages outstanding. But the ultimate effect of subprime mortgages has been huge, a near-catastrophic shriek of economic pain whose reverberations have unnerved and undermined the entire global financial system. As such, the illustration for a recent feature story in The Economist about the financial crisis seems highly appropriate: a caricature of Edvard Munch’s iconic expressionist painting The Scream, which depicts a tormented man, wailing with a mouth grotesquely agape and hands clasped to his ears, against a blood-red sky.

The chill spreads

This chilling scream of a financial crisis has sounded with increasing intensity, leading to the paralysis of credit worldwide, the sudden deaths of once-vital financial institutions like Bear Stearns and Lehman Brothers, the accumulation of heaps of illiquid debt by the financial-services sector, the partial nationalization of the U.S. financial system, the crippling of a previously sprinting global economy, and the bear market in stocks that has vaporized more than $29 trillion in wealth during the 12-month period ended October 31. To be sure, many historic cataclysms of all kinds have had similarly negligible origins. Notes Roger Lowenstein in his book When Genius Failed: The Rise and Fall of Long-Term Capital Management, about an earlier financial crisis precipitated by the demise of a high-powered hedge fund: "A load of tea is dumped into a harbor, an archduke is shot, and suddenly a tinderbox is lit, a crisis erupts, and the world is different."

In the case of the current financial crisis, easy credit was the initial shot. Easy credit boosted demand for homes, drove up housing prices, and helped a record 69% of American households to own homes -- including many Americans who never would have qualified for mortgages previously. And it wasn’t just subprime borrowers who found easy credit appetizing. Consumers who were more creditworthy and financial institutions also gorged on debt, to their ultimate detriment.

Nor was a weakness for credit solely an American phenomenon. For instance, in Iceland, whose banking system and credit rating collapsed in October, the average debt per household is 213% of disposable income, according to The Economist. In contrast, the debt figure is "just" 140% in the U.S. -- a level that makes Americans seem almost paragons of thrift in comparison.

For their part, financial institutions worldwide made bad loans and used leverage to invest in deceptively risky, complex mortgage-related securities and derivatives that in some cases decimated their balance sheets. As a result they have to date taken more than $400 billion in write-offs, with still more to come.

Cash is king

In retrospect, the financial crisis, in simplest terms, is the product of an unmanageable debt load that no longer could be offset by rising asset values. Now, the financial pendulum is swinging the other way. Debt is out, cash is in.

According to Economist Ed Yardeni, from September 10 to October 30, banks raised their cash reserves to a near record $549 billion and overall liquid assets to a record $1.8 trillion. And consumers are following suit; in the second quarter, U.S. households cut their level of debt for the first time in 25 years.

The upshot of all this has been a rapidly deteriorating global economy and what The New York Times calls "a show of financial shock and awe" by the world’s governments and central banks that’s intended to bolster confidence in, and help rescue, a teetering financial system.

We believe the public and private sectors, working in tandem around the world, will solve the financial crisis. In truth, the world’s governments have plenty of weapons at their disposal to win this battle. For instance, they can nationalize firms and industries, declare bank holidays, suspend stock-market trading, purchase debt and equity, revise the terms of mortgages to prevent foreclosures, and last but not least, print money. It’s clear to us that the governments will lend as much as they must and to whomever they must to prevent this scream of a financial crisis from becoming even more harshly shrill.

So, when will this financial crisis end?

Still in flux

As we noted in a letter to clients in early October, we simply don’t know. The financial system is still in flux, with new, unforeseen developments and consequences surfacing at a pace that at times threatens to spin even the most unflappable investment analyst’s head around 360 degrees, like the demonically possessed Linda Blair character in the movie The Exorcist.

In one of its recent head-spinning twists, the financial crisis has spilled over into emerging nations like Russia, China, and Brazil. And in another twist, Treasury Secretary Henry Paulson announced on November 12 that the $700-billion Troubled Asset Relief Program, known as TARP, wouldn’t be used to actually purchase troubled mortgage assets, as originally planned; instead it would focus on injecting more capital into financial institutions and stimulating credit by matching private investments with government investments; providing federal financing to private investors buying AAA-rated asset-backed securities; and enabling struggling mortgage borrowers to avoid losing their homes in foreclosures. Additional twists are likely to follow. So to paraphrase Winston Churchill, we have no idea whether this is the end of the beginning or the beginning of the end of the financial crisis.

Even so, although we’re reluctant to hazard a prediction on exactly when the financial crisis ends, we do have definite views on how the financial crisis is likely to end; we have convictions about the particular signs -- specific revealing developments -- that would show the crisis is being resolved.

As we see it, the financial crisis will be on its way to becoming history when certain telltale events, involving consumers, the financial-services sector, and governments, help accomplish two things: 1) the unwinding of the excesses of debt and leverage built up in the sector during this decade and 2) the restoration of the housing and credit markets to more or less normal functioning. Specifically, these six signs, whenever they happen to appear, would suggest to us that the problems of the financial crisis are finally being brought to ground:

Consolidation looms

Sign #1: the number of failures of financial firms becomes less frequent, partly as a result of consolidation, and the financial-services sector returns to profitability.

The financial crisis has cast a glaring spotlight on this predicament: there are too many financial firms today. That in turn has contributed to the current state of unprofitability in the sector and put the future of the weakest competitors in jeopardy.

As a consequence of this overcapacity, acquisitions of the most vulnerable financial firms are likely, which would help reduce the number of failures of firms. Over the past 12 months, more than 10% of financial-services firms have gone under or been eliminated. We think that number should rise over the next 12 months, although perhaps not to the same scale that it did during a previous financial crisis, the 1989-1991 implosion of the savings and loan industry, when about 25% of publicly traded financial companies were taken out by merger, acquisition, or bankruptcy.

Major acquirers are likely to be banking’s new Big Seven: Bank of America, Citi, JPMorgan Chase, Goldman Sachs, Morgan Stanley, U.S. Bancorp, and Wells Fargo. Shrinking the number of financial firms should enhance the survivors’ pricing power, competitive advantages, and market shares, just as consolidation helped the technology companies that managed to stay alive during the dot-com shakeout early in this decade. Indeed, some of our contacts in the industry say that the Big Seven may end up holding more than half of all domestic bank deposits.

We think the financial-services sector’s earnings, which have been negative for the past three quarters, have bottomed and could turn positive soon. The consensus expectation of Wall Street analysts is that the sector should return to profitability in the fourth quarter and report earnings growth in every quarter of 2009. However, we caution that banks, chastened by the financial crisis, are likely to use less leverage than they did in the recent past and the recession may be worse than anticipated, both of which may put a continued damper on earnings. According to Morgan Stanley, the entire sector’s long-term earnings-growth rate going forward is 10.2% annually -- a respectable rate, but below that of other sectors such as technology and health care.

Deleveraging: needed medicine

Sign #2: the pace of deleveraging by financial firms moderates.

Financial firms are enduring the painful, back-to-basics process known as deleveraging, i.e., reducing their previously heavy reliance on borrowing in the pursuit of higher investment returns. As noted, deleveraging may impair the sector’s profitability (as well as restrict the credit needed for the housing market to recover). But we think it’s a dose of medicine critical to bolstering the sector’s balance sheet in the short term and the financial system in the long term.

Under the federal TARP plan, some money will be injected directly into financial firms -- a strategy pioneered by the United Kingdom that has met with some initial success. Ideally, in the U.S. that strategy will expedite the process of deleveraging, encourage banks to start lending again, and help get the economy back on a growth track.

The price is right?

Sign #3: definite prices are established for mortgage securities.

Until prices are set for mortgage securities that are impairing the balance sheets of financial firms, the financial system is likely to remain unwell, in our view. Now that the Treasury Department has done an about-face and decided that buying these assets isn’t the best way to use TARP funds, the big question is this: what will the prices of mortgage securities ultimately be?

In reality, it would have been tricky for the Treasury to determine what price to pay for these securities at this time -- and might have cost far more than the $700 billion at TARP’s disposal. If nothing else, it’s an example of how the financial crisis has more crosscurrents than whitewater on the Colorado River. One of the most perilous crosscurrents swirling around the sale of mortgage securities, noted The Wall Street Journal, is that "trying to sell assets pushes down the assets’ prices, which makes them harder to sell and leads firms to try to sell more assets. That, in turn, suppresses these firms’ share prices and makes it harder for them to sell new shares to raise capital."

Another facet of this crosscurrent: even if the government had paid more than bargain-basement prices for the securities, most of the firms would still have had to deplete their capital anyway. So as an alternative the government may simply decide to let the market be the final arbiter of what the securities are worth, although it hasn’t ruled out making what Secretary Paulson called "targeted forms of asset purchase." At any rate, as time passes, it should become more clear which securities are worth more than their current depressed prices and which securities aren’t. It’s anyone’s guess, though, as to how the pricing of mortgage securities will play out eventually. Nevertheless, setting new prices for them remains a prerequisite to easing the financial crisis, as we see it.

Lending: economic lifeblood

Sign #4: lending frees up.

Due in no small part to the financial crisis, nearly nine of every 10 Americans think the country is on the wrong path, the deepest expression of national pessimism in polling history, The New York Times reports. There’s no similar poll for banks, but there is a barometer that in a sense measures their state of mind in aggregate: Libor, or the London interbank offered rate. Over the past three months the Libor rate has been at historic heights, indicating the banks’ reticence to lend as usual.

For instance, in October the Libor rate more than doubled, the largest jump on record. Although it has come down since then, the three-month dollar Libor/overnight-index swaps spread was about two percentage points in early November. By comparison, the five-year average before the financial crisis began was a mere 0.11 percentage point. Until that spread narrows further, the credit freeze won’t truly begin to melt.

Actually, interest rates are advantageous to lenders now. As of October 31, the yield differential between two-year and 10-year Treasury securities stood at 2.40 percentage points. With short-term rates relatively low and long-term rates relatively high, banks can borrow cheaply at short rates and lend the money at longer rates, pocketing the difference. Instead, banks are tightening loan standards and, according to a Federal Reserve survey, are worried about "counterparty risk" -- the risk that consumer and corporate borrowers won’t repay their loans. In the process they are charging a higher premium for access to precious capital, as credit spreads have widened. The higher borrowing costs are being passed on to borrowers and further compounding the rapidly growing list of global economic woes. Indeed, one reason why auto sales in the U.S. have been so abysmal lately is that consumers are experiencing difficulty getting credit.

Since credit is the lifeblood of the economy, it’s critical for banks to begin lending in earnest soon. It’s critical because the economic benefits from lending tend to lag the date of a loan’s origination by three quarters. So economic activity and business investment will likely languish in the interim.

Coming: more regulation

Sign #5: new regulation limits the issuance of derivatives, increases disclosures about derivatives, and establishes more stringent mortgage-lending standards.

We think more regulation is almost certain to be applied to financial services going forward -- and is necessary in some cases.

Take derivatives, for instance (and as some badly burnt investors in banks with losses attributable to those often opaque securities might say, "Take my derivatives, please"). Even the most ardent advocate of free markets would find it hard to deny that the destructive impact of derivatives like credit-default swaps (CDS) has been woefully underestimated by both business and government.

For one thing, the market for CDS is almost entirely unregulated. In fact, credit-default swaps aren’t even considered securities; they’re private contracts that, because they don’t trade on exchanges, are free from disclosure requirements (hence the sardonic characterizations of them as "the Invisible Man of finance" by BusinessWeek and as "financial weapons of mass destruction" by Warren Buffett). For another thing, the difficulty in establishing the value of certain derivatives points up the need for more disclosure. Merrill Lynch, for instance, got only 22 cents on the dollar for the billions of dollars of mortgage-backed derivatives it sold last July. Analysts at Credit Suisse speculate that most of these securities might be worth about 60 cents on the dollar. But no one really knows.

We like this thought by Peter Diamond, an economics professor at the Massachusetts Institute of Technology: "‘Well-regulated free markets’ is not an oxymoron, but a necessity for good economic outcomes." In that spirit, we think new financial-services regulations may focus on what’s been called "the shadow banking system" -- non-banking companies, derivatives and other off-balance-sheet investments, and hedge funds, all of which, rightly or wrongly, now serve as convenient scapegoats for much of the borrowing and lending extremes that triggered the financial crisis. As we see it, the new regulations might achieve the following:

• establish a centralized clearinghouse for trading credit-default swaps and other derivatives, so that their prices and risks are more visible;
  
  
• require specific levels of capital reserves for, and more disclosures about, derivatives, so that

their risks and values could be more easily quantified;

• require hedge funds to disclose their investment positions every quarter, just as institutional investors and mutual funds do, as a means of monitoring their activity and the potential ill effects of the leverage they use;
  
  
• limit the amount of leverage that financial firms can take on; and
  
  
• impose more conservative standards in issuing mortgages. (We think that a lot of the grief from the financial crisis could have been avoided if all mortgages in recent years had reflected such traditional standards of lending prudence as stipulating a minimum of 20% down on the purchase price of a home and prohibiting the loan amount from exceeding three times the borrower’s annual income.)

Mortgages represent the largest component of the credit market, so it stands to reason that the financial crisis will persist until many of the current risks posed by mortgages abate.

The potential for an increased number of mortgage foreclosures is especially problematic. Our research shows that about one out of every five mortgages today is greater than that home is worth. That’s a huge incentive for borrowers to just walk away from their mortgages -- and in the process escalate the number of foreclosures sharply. According to Moody’s Economy.com, a research firm, as many as 7.3 million homeowners are expected to default on their mortgages between 2008 and 2010, with 4.3 million of them losing their homes. If that happens, the housing market would continue to be anemic, in our view.

One criticism of the TARP bailout originally was that it failed to address the problem of rising home foreclosures. Critics say the best way to keep the problem from worsening is to modify the terms of the mortgages of financially strapped borrowers so that they can stay in their homes.

Government and business are now taking steps to try to do exactly that. For instance, TARP is now being applied in support of mortgage debt and other forms of consumer credit. Also, the Treasury Department and the Federal Deposit Insurance Corporation are reportedly working on a plan that would channel at least $40 billion into adjusting mortgages that are underwater. And JPMorgan Chase announced a plan in early November to modify the terms of $70 billion in mortgages for as many as 400,000 borrowers.

Altogether, we think four things have to occur for the housing market to stabilize:

One, the average U.S. home price stops falling for three months or more. For that to happen, the economics of home prices have to improve -- and they are improving. According to Charles Schwab, the median home price in July was $204,000. If a 6.4% mortgage rate were obtained to buy that house, it would translate into an initial after-tax monthly payment of $795, which would represent 20.7% of the after-tax income for the average American family. That’s an affordable ratio by historical standards, which makes us think that the housing market may be near a bottom and that housing prices could stabilize sooner rather than later.

Two, sales of homes exceed 5.5 million on a seasonably adjusted annual basis. The National Association of Realtors reports that the current annualized sales rate is about 5 million. That rate isn’t quite brisk enough to significantly reduce the nation’s inventory of unsold homes, which represents a 10.4-month supply at the current rate of sales (the average backlog historically has been less than six months).

Three, the gap between the one-month Libor rate and the Fed funds rate tightens. Historically, the two rates have been close, about 0.50 percentage point apart. However, as of October 31, they were much further apart -- 1.80 percentage points.

Finally, oil prices must remain below $100 a barrel. As of October 31, the price of a barrel of oil was about $68 -- 53% beneath the peak price of $147 last July. Standard & Poor’s estimates the decline in oil prices provides the average American with at least $80 more each month to pay his mortgage. In an economy in which millions of budget-stressed consumers can identify with the forlorn figure in Munch’s The Scream, that extra $80 can in many cases mean the difference between paying the mortgage or not.

In sum, those are the six keys that we think would likely signify an end to the financial crisis. At times, the end has seemed a remote prospect, inasmuch as the scope and duration of the crisis have proven far worse than economists, market strategists, portfolio managers, chief executives, the business press, and governments around the world expected.

To us, the crisis has served as a reminder about how fragile the global financial system can be. Four years ago in the U.S., when home prices nationally were soaring at double-digit rates, when speculators were flipping Miami Beach condominiums profitably after a month, when mortgage securities were the investment du jour, and when the financial-services sector was flourishing, fragile was perhaps the last adjective that would have come to mind in describing the financial system. But of course most everything in this world, no matter how invulnerable it may seem, is fragile, is susceptible to the subtle and not-so-subtle forces of degradation, randomness, and disorder -- whether it’s the water quality in Ethiopia, the human chemistry of the New York Knicks basketball team, success at work, or the global financial system.

However, we think the fragility of the financial system should be reversible. And we think the six aforementioned signs involving fundamentals in the financial-services sector should help tell us when this scream of a financial crisis is fading like a suntan in autumn.

No scream lasts forever. What’s remarkable about this one is that it began as a whisper, with a relatively modest number of subprime loans fomenting a host of Hydra-headed problems of such momentousness that they destabilized the entire financial system. When the scream does die down, we then might even hope to hear a collective global cheer -- a cheer inspired by a newly sound financial system that, after suffering some short-term pain, is once again widely helping consumers and businesses to lend, borrow, and prosper over the long run.