Recent falls in share prices of US financial companies can be compared with the bear market associated with the savings and loan crisis of the late 1980s.

According to a General Accounting Office study, the S&L crisis cost $160 billion to resolve, equivalent to 2.9% of US GDP in 1989, when the bear market in financial stocks began. The equivalent percentage of GDP in 2007 would be $400 billion.

Will the subprime crisis inflict damage on this scale? Some estimates of the eventual losses are even higher but care is needed in the comparison, for two reasons. First, S&L damage was largely confined to the US, whereas foreign institutions have borne a significant portion of subprime losses. Secondly, the GAO estimate refers only to the cost of the rescue operation and excludes losses suffered by creditors and equity-holders of insolvent S&Ls.

It seems reasonable to assume that losses suffered by US financial institutions as a result of the subprime debacle may approach but will not exceed those of the S&L crisis. On this basis, the late 1980s bear market in US financial stocks may represent a “worst case” scenario for current events.

The chart below overlays the 1989-90 fall in US financial share prices on the current decline. (It is based on weekly closes and the peaks in February 2007 and October 1989 have been aligned and rebased to equal 100.) Four observations are:

1. Financial share prices would have to fall a further 15-20% from current levels to match the 1989-90 decline.

2. The comparison suggests a bottom may be in place by March.

3. Share prices recovered strongly in late 1990 and 1991, regaining their prior peak within nine months of the trough.

4. The 1990 recovery began following five cuts totalling 125 bp in the Fed funds rate; the funds rate has already declined by 175 bp in the current easing cycle and markets expect a fifth reduction this week.

Risks remain high but the 1989-91 experience suggests a significant buying opportunity is brewing.