Navigating the Financial Crisis

As I write this article, our country is facing what is likely to be one of the worst financial crises ever. The media continues to bombard us with fears of a depression (not recession) and severe financial collapse of the US Banking system while our leaders in government debate ways to avoid this pending disaster. This article is not to sugar coat the situation but to consider what is at hand.

Throughout the last 12 months, I’ve written many articles regarding the causes for the crisis (go to www.billfewassociates/knowledgecenter.cfm to view past articles) so I’m not going to focus too much on that now. A quick overview is that the first domino to fall was people losing their homes to foreclosure which started increasing dramatically last summer.

The next domino to fall was in July when the banking system was shaken with bank failures. Although banks fail every year, the number significantly increased this year. These, by the way, are the banks that were most exposed to bad mortgage loans.

The crisis of August was the US Government part in all of this with Fannie Mae (FNMA) and Freddie Mac (FHLMC). Both are stockholder-owned, government sponsored entities (GSEs). While Fannie Mae was created to help people buy homes that would otherwise not be able to get a mortgage Freddie Mac was created to expand the secondary market for mortgages in the US. Along with other GSEs, Freddie Mac bought mortgages on the secondary market, pooled them, and sold them as mortgage-backed securities to investors on the open market. So when homebuyers could not make their mortgage payment and the banks couldn’t cover their capital requirements and meet obligations, we learned that FNMA and FHLMC weren’t solvent enough to provide coverage for the loans and did not provide adequate collateral for the mortgage-backed securities. Hence the last government bailout in August.

The most recent domino to fall was last week (week of September 15th). That involved the big investment bankers on Wall Street who used those bad mortgages to provide collateral for investment securities. So when the loans went bad, there was little or no collateral to cover the securities. Those who were most exposed at the minimum suffered severely and have been forced to sell off assets at deep discounts or are in the throws of going away. So in a very simplified nutshell, that’s how we got to where we are today.

The next question is “what do we do now?” The best option for the vast majority of us is to do nothing. Virtually every form of financial asset has been affected by this - there is no hiding from it. Let’s look at our choices. We’ll start with bank depositors which likely covers just about everybody.

If you have a checking account, savings account, or even a certificate of deposit then you are a bank depositor. These deposits (check with your institutions) are FDIC insured. See the above URL to find a complete article describing FDIC insurance. If you are still concerned about bank insurance, you may think the risk-free option is to pull your money

out of the bank and put it under the mattress. But you have only shifted your risk from the bank to other risks: fire, theft and loss of earnings. If you have thousands or hundreds of thousands of dollars, most people can’t sleep any better at night with the latter risks. Not to mention, that if we all did that we would cause the collapse of the banking system. Do you remember the movie “It’s a Wonderful Life?” If not, watch it this Christmas with a little different perspective!

Now let’s look at investment securities i.e. stocks, bonds, and mutual funds. Because the heart of the crisis is stemming from financial institutions as noted above all of these securities are suffering. Do you pull out of the market until things “settle down”? And buy back when it feels good again? That means selling low and buying high – not a good investment strategy. In fact, basic investing tells us that is the opposite of what makes sense – even if it feels good. It’s great to see savvy investors like Warren Buffet, buying up companies and pumping $5 billion into the large investment banking firms in times like this. He knows a good deal when he sees one.

So if the right thing (not to be confused with the feel good thing) to do is to stay invested, let’s look at the current stock market correction in perspective. The following are some historical data to consider.

• The average bear market decline since WWII is 32% over 14 months. This bear market is down 21% over 10 months. Thus far, a pretty average bear market. Amazingly, despite the demise of a half-dozen iconic American financial titans, since March 14 the S&P 500 is down only -2.6% as of September 24th. In other words, it feels a lot worse than it is.

• Bear Market Troughs. The S&P 500 has declined by 26% (as of 9/17) since peaking in October and by 21% since the beginning of 2008.History suggests that we may have further to fall, but are approaching the bottom. If the current bear market follows historical precedent, the S&P 500 would trough at 1070 (it is at 1199 as of the writing of this-September 26th). Market bottoms usually occur four months before corporate profits trough.

So do you need to revisit your life goals in light of this current situation? If your overall investment strategy is sound (which means making sure your short-, intermediate- and long-term goals are met) then you should not have to change your life goals as a result of current events. If you were planning to retire (and let’s clarify that – withdraw income from your investments of 3% or more), then you should not have had such risky investments that a market correction would force you to change that goal. I would argue that your strategy was not prudent PRIOR to 2008. The worst thing for any investor is to be forced to sell at times like this.

I love the old cliché “What doesn’t kill you makes you stronger”. So, assuming the guys on Capitol Hill are coming up with the best possible bailout for this mess, lots of good will come out of it. Hopefully Americans will get back to living within their means, banks will get back to lending money in a reasonable fashion, Corporate America will be taught a tough lesson that there are consequences of being greedy and the government will hopefully continue to be as scrutinous as they have been with the most recent bailout program. When things do turn around and the growth numbers start improving, we can be comfortable that the economy is growing on a strong foundation and not on bad debt.

All of that being said, the long-term doesn’t mean anything if you don’t survive the short-term. It is most definitely a good time to assess your own financial situation and if you can’t do it on your own objectively, then talk to someone who can help guide you through these unsettling times.