Straight Talk about the SubPrime Mess

The following is an email I received from Kim Snider. It clarifies what has recently happened in the financial market. -Brian
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MAKING SENSE OF THE HEADLINES
A quick-and-dirty guide to what’s going on

By Kim Snider | September 18, 2008

When the news broke over the weekend about Lehman Brothers seeking bankruptcy protection and Merrill Lynch being sold to Bank of America, I knew we would receive lots of calls. What I didn’t expect was my mother to be the first one!

She woke me up early Monday morning under the guise of making sure we were OK after the storms of the weekend. Hurricane Ike wound up moving fairly east of the Dallas area, so we got some wind and rain, but nothing serious. What she was really calling about, however, was to find out if her money was OK. She had seen the headlines about Lehman, Merrill and AIG, and she was understandably nervous.

I figure that if my mother is nervous, you’re probably nervous as well. It’s easy to see why, given the incendiary headlines (which are typical of the press, I’m afraid). One I saw in very large type was “Wall Street Meltdown.” I think that’s extreme.

Going on a bender

Basically, what’s happening is that these Wall Street investment banks and insurance companies have gotten super-silly drunk on risk in the subprime mortgage market. They took on far too much risk, thinking that they were bulletproof and that the risk would never come back to haunt them. What we’re dealing with now is the hangover — you can’t get super drunk without feeling terrible the next morning.

Several years ago, the Federal Reserve kept lowering the target Fed Funds rate — the interest rate that banks charge each other for overnight loans. Commercial banks are required to keep a certain amount in reserve to back up their deposits, and these overnight loans help them meet these requirements. When the Fed lowers its target rate, that creates additional liquidity in the financial markets, which means banks have more cash available to lend to individuals and businesses.

Armed with lots of money to lend, the commercial banks set out to make lots of loans in hopes of turning a big profit. Some of the more lucrative loans were mortgages.

The investment banks discovered that they could purchase, slice, dice and repackage these mortgages into securities that could be sold on the open market. Seeing that these securities — also known as collateralized debt obligations (where many different pieces of mortgages are combined, or collateralized) — had the potential to be quite profitable, the investment banks created even higher demand for the mortgages.

To keep up with the demand, the commercial banks needed to write more mortgages. But the supply of traditionally qualified borrowers started to dry up, so the banks relaxed their lending standards. They found a fresh pool of borrowers, and sold riskier loans, which gave the investment banks more pieces to slice, dice and sell. Demand increased, so the commercial banks sold more loans to even less qualified borrowers, and you get the idea.

The investment banks figured that if they put enough of these high-risk loans together into securities, the risk would somehow mitigate. After all, they figured, there’s no way all these loans could go bad at the same time! Of course, they were wrong. And the fallout began.

Add to this the problem of leverage. Banks and investment banking firms are highly leveraged. In the case of Lehman brothers, they would lend out $30 for every $1 they actually had in assets. As the subprime loans fell apart, they realized that the assets backing that dollar were worth less than they thought — again, this is the risk they took. Creditors and credit rating agencies demanded that they bring their capital structure in line, and when they couldn’t, the house of cards began to topple.

Merrill Lynch was able to avoid collapse and bankruptcy by selling itself to Bank of America. Lehman Brothers wasn’t so lucky. It filed for bankruptcy protection on Monday — the largest filing in U.S. history — and now its investment banking and trading divisions are apparently going to be absorbed by Barclays. Lehman’s shareholders and employees are paying the price for their management’s binging, and it’s likely we haven’t seen the end of the fallout. More big financial institutions are probably going to fail, and the headlines will get even worse.

But back to the “getting drunk” analogy: Bank of America and Barclays are playing the role of designated driver for Merrill and Lehman. Meanwhile, it looks like the government has taken the keys away from AIG. So what does it all mean, and what happens next?

There are a couple of issues at play here that get garbled up in all the news coverage. First, you should know that the problems at investment banks affect people differently than do the problems at some of the brokerage firms. Because Lehman Brothers and Merrill Lynch had both banking and brokerage arms, it’s easy to get confused. So let’s start with the banking side of the business.

The banks

Investment banks like Bear Stearns, Lehman Brothers and Merrill Lynch got caught up in the subprime mess, but so did some of the big money center banks and regional savings and loans like Washington Mutual. Right now, it looks like the financial institutions with little to moderate exposure to the subprime mess will be OK. Fidelity’s and Schwab’s banking arms appear to be dealing with everything well. Wells Fargo appears to have kept its nose clean, and it’s too early to tell whether Bank of America’s purchases of Merrill Lynch and Countrywide will put them in trouble.

The fundamental question is, “Is your money safe in the bank?” Chances are, yes, but you should check a few things. The Federal Deposit Insurance Corporation guarantees bank deposits up to $100,000 per person. Joint accounts are insured up to $100,000 per person, and retirement accounts are insured up to $250,000 per person.

Remember, though, that these are amounts per person per bank. Add up all the accounts in your name at a bank, including checking, savings, and money-market accounts as well as CDs. Kiplinger’s has a good article on FDIC coverage, and you can also get more information at the FDIC’s special website, www.myfdicinsurance.gov.

If you’re shopping for a new bank, I’d be careful. Look online for the banks that aren’t believed to be in trouble (Washington Mutual comes to mind). While they are FDIC insured and the FDIC assures everyone they have enough money to cover all these potential exposures, we don’t know for sure. So why tempt fate?

The brokerages

If your money is in a brokerage account at Merrill Lynch or Lehman Brothers, you appear to be OK for now. (I suspect most of our clients don’t have money in these places, but a few of you reading this article might.)

Lehman’s brokerage unit did not file for bankruptcy; its parent company did. If you had a brokerage account with Lehman, you still have it. If the deal with Barclay’s goes through, you’ll become a Barclay’s customer. Different companies may have different rules regarding your account, you may have a new account number, and your broker may or may not move over to the new firm, but your account should remain mostly the same.

It’s a similar deal with Merrill Lynch. If you were a Merrill Lynch customer, you’ll now become a Bank of America customer. If this hadn’t occurred during a media frenzy, it would be no different than when A.G. Edwards was absorbed by Wachovia.

Brokerage customers’ assets are kept separate from the brokerage firm’s own assets. If the firm fails, your assets can’t be touched by the failed company or its creditors. If for whatever reason you are missing some assets, they’re protected up to $500,000 by the SIPC. The New York Times had a good rundown on this coverage on Tuesday, as did CNNMoney.com.

AIG

So what should we make of the U.S. bailout of AIG? What the government is basically doing here is saying that they won’t let the financial system collapse, and they will take little steps where they can until this entire situation plays out.

Now the question is, why bail out AIG and let Lehman fail? At this point, they’re making a case-by-case determination of what is too big to fail. I think the government figured that if Lehman failed, it would be ugly for shareholders and employees, but the repercussions throughout the world’s financial markets wouldn’t be that great. With Fannie Mae, Freddie Mac and AIG, however, the systemic risk of a collapse was just too great.

By taking this step, I think the government is saying that they are making sure your money is safe. If you have an insurance policy or an annuity through AIG, the government is attempting to make sure it’s still able to pay out.

The overall issue

When looking at what’s going on in the financial markets this week, we need to step back a little. The biggest issue as it affects you shouldn’t be whether your money is safe.

This unfortunately isn’t a once-in-a-blue moon event. Because of the nature of Wall Street, events like this will happen again and again. Whether it’s junk bonds or the tech bubble or the subprime mess, Wall Street has an incentive to create extremes in the market.

What we know about the market is that extremes can’t last indefinitely, on either side. But Wall Street creates these extremes in an attempt to make a lot of money. That’s fine for them, but it’s not fine for you.

The big lesson to take from all this is that these events always happen and will continue to happen, but you can’t let them keep you from investing. These ups and downs we’re seeing are going to be painful unless you choose to do something about it.

The good news, as I see it, is that you can do something about it. You can take control of your own investments. Even though these Wall Street types are supposed to be the smartest guys in the room, they consistently get caught up in these extremes.

What you have to do as an investor is:

Avoid getting caught up in the latest fad just because everyone else is buying or selling something.
Avoid spending money you don’t have just because someone is willing to lend it to you
Avoid panicking when the market loses 500 points or so. Instead, look at it as an opportunity to make sound investment decisions when everyone else is being irrational.
I realize that last point is terribly difficult for many of you, because your retirement savings — and the lifestyle you’re potentially able to enjoy — may be directly tied to the ups and downs of the market. A major drop in your account value can have serious implications for your future income. Believe me, I understand.

If you are interested in learning about an alternative approach, I encourage you investigate the Snider Investment Method®. It’s a system of investing geared toward what I think really matters to the retiree and near-retiree: income.

To learn more about it, register for a free information session in October, where I’ll discuss the Snider Method and the philosophies behind it. You can also download a chapter from my new book, How to Be the Family CFO. The chapter is about creating passive income streams, which is the heart and soul of the Snider Method’s approach.

While it’s certainly no guarantee that cash-flow investing and the Snider Method can solve your financial worries, it is an alternative that may make sense to you.

As always, please give us a call at the office if you have any questions or concerns. I or any one of our advisors will be happy to help you. The numbers are 214-220-0055 or 1-888-6SNIDER. You can also email us at support@snideradvisors.com.

SOURCES:

1. Light, Joe, “What to do if your broker fails.” CNNMoney.com, 15 September 2008. [accessed 16 September 2008]

2. Lieber, Ron and Tara Siegel Bernard, “What Changes in the Financial World Mean to Customers.” The New York Times, 15 September 2008. [accessed 16 September 2008]

3. Golwasser, Joan, et al. “Is My Money Really Safe?” Kiplinger’s Personal Finance, October 2008. [accessed 17 September 2008]

This article is not a complete discussion of the benefits and risks of the Snider Investment Method®. For a complete discussion, read the Snider Investment Method® Owner’s Manual, available by calling 888-6SNIDER.

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