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The stock market has been incredibly volatile since early July, with
daily swings of 1% to 2% or more. It’s enough to cause even the most
seasoned investor to stop and wonder what is going on. The news
keeps talking about ‘credit swaps’, ‘CDO’s’ and sub-prime mortgages.
But what does it all mean and why is the market reacting the way it
is? I want to explain why there is a Crisis of Confidence, and how
to manage your money in the midst of it.
Since World War II, ours has become an economy that runs on debt. In
2001, the Federal Reserve drastically lowered interest rates to make
it easier for consumers to obtain credit, especially for homes. It
worked, at least for a while.
But over time, there were only so many people that could afford to
put down 20% to buy a home. To increase their profits, banks and
mortgage companies relaxed their requirements so buyers only had to
put down 10%.
This increased the demand for housing and caused home values to
rise. Before long, fewer people were able to afford to a 10% down
payment. Once again, loan standards were lowered, allowing people
with little or no credit to buy a home without putting up any money.
Many of those ‘nothing down’ loans were done with adjustable rate
mortgages (ARMs). The initial interest rate was low, but that rate
(and the monthly payment) would increase as interest rates go up.
Unfortunately for home owners, the Federal Reserve has been raising
interest rates lately due to inflation fears. Those with ARMs who
could barely make the payment when interest rates were low can’t
make the higher payment now and are having to default.
As the real estate market has declined, banks are taking a loss when
they try to sell these foreclosed homes. But it’s no longer the bank
that holds the mortgage paper. The bank and mortgage companies
quickly sell the mortgage paper to others, retaining a portion.
Traditionally, it was Freddie Mac and Fannie Mae that bought many of
these mortgages, packaged them into loans, and sold them to
investors.
In the last several years, large banks, insurance companies and
hedge funds saw an opportunity to increase their profits in the same
way. They turned these mortgages into Collateralized Debt
Obligations, or CDOs, and sold them in large blocks to other
institutions, including other banks, insurance companies, hedge
funds, mutual funds and pension funds
So if someone is unable to make their higher mortgage payment, it’s
not the local bank that takes the loss, it’s these big institutions.
If a big institution starts taking a loss they are going to try to
sell those bonds. But other institutions aren’t buying.
Another problem is that many of these big institutions, such as
hedge funds, leveraged their investments. They might borrow $9 for
every $1 they have, using that money to buy more stocks and mortgage
bonds.
So when stocks or bonds drop too much, they face a margin call. They
have to sell what they have, quickly, to pay back their lender. Of
course, this causes the prices to go down further. When many
institutions are involved it results in a sharp market decline.
That’s what we’ve been experiencing.
The Crisis of Confidence is that the lenders are concerned that they
won’t be able to get their money back because those that borrowed it
won’t be able to sell what they own. This is referred to as
liquidity.
Right now, there are those that have to sell regardless of the
price, to pay back their lenders. There are those who don’t
understand what is going on (typically individual investors) who
panic and sell because they’re afraid it’s the next crash. And there
are those professionals who are calmly waiting and picking up
bargains.
I don’t believe that we are on the edge of a market crash. The
economy is strong and I believe the crisis is one of confidence. By
the end of this year, the markets should have recovered. Now would
be a good time to move out of short term positions, but I would hold
on to medium and longer-term holdings that represent good companies.
You can read an expanded explanation on my website.
Nationally-syndicated financial columnist and Certified Financial
Planner® Jeffrey Voudrie provides personal, in-depth money
management services and advice to select private clients throughout
the USA. He’ll answer your financial question – FREE at
www.guardingyourwealth.com. |
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