Smart401k Blog

In my previous post on the current financial crisis, I reviewed the players involved in the crisis.  I also covered how an overheated real estate market and lax lending standards were the tinder that helped fuel the financial crisis we’re now smack in the middle of.

In this post I’ll talk a little bit about what happened to all of those mortgages once a borrower closed on a house/apartment/condo and how they added to the fire.

Historically, banks originated loans and held them on their balance sheet as assets.  They made money by lending at a higher rate than they paid on customers’ deposits.  Since the banks were holding the loan on the balance sheet (i.e. they were hurt if the loan went into default or otherwise underperformed) they were generally very selective in the loans they made.  This began to change when many of these banks and other lending institutions began to sell the mortgage loans they originated to financial institutions who would package them into mortgage backed securities (MBS) a type of asset-backed security. 

These structured securities allowed the originating bank to book a profit on the loan quicker and also freed their balance sheet and enabled them to make more loans.  Since the originating bank was no longer at risk if the loan went bad many began to relax their lending standards.  In order for banks to sell their loans, the loans just had to meet the minimum standards of the Federal Housing Administration (FHA) — an entity whose stated goal was to boost the rate of homeownership in the United States.

Financial institutions then created the MBS and sold them to institutional investors who desired a “stable” asset that produced a regular level of income.  The idea behind mortgage backed securities was that if you pooled a large enough number of mortgages you were actually decreasing your overall risk by diversifying through large numbers of individual loans and over various geographic areas.  In other words, one bad loan wouldn’t ruin your day.

In addition, mortgage backed securities were divided into “tranches” based on risk level and interest rate, allowing buyers to make purchases based on level of risk they were willing to accept.  The process for rating these tranches was similar to other fixed income securities. Rating agencies like Standard & Poor’s and Moody’s would give the tranches with the least risk investment grade ratings (think GE and Berkshire Hathaway debt), while slapping lower ratings on riskier tranches.  So in many cases, a pile of high risk sub-prime loans were magically turned into supposedly high-quality, investment grade fixed income securities.

After securitizing and selling the loans, these financial institutions were able to buy more loans and repeat the process over and over again.  As the real estate market continued to boom, all parties involved got hungrier and hungrier for more and more loans.  Everyone involved was happy until the real estate bubble started to deflate.  As defaults began to rise, the buyers of the MBS’s started to see losses that they weren’t expecting to see from such a supposedly high grade security.  Buyers quickly stopped buying the MBS’s, sticking the financial institutions with a bunch of unsalable mortgages. That caused the financial institutions to stop buying new loans, which in turn meant that the originators had to hold them on their balance sheets and quickly curtail their new lending.  In the end, this meant that a new home buyer suddenly had a lot more trouble finding a loan, which helped slow the pace of home buying.  With new buyers kept at bay, home prices started to fall and those who had overextended themselves to buy a property found themselves without clear path to safety.  It’s not too hard to see how this situation can feed on itself and create a downward spiral.

So now we have between $1 and $1.5 trillion dollars in sub-prime mortgages that no one wants and a large number of buyers who can’t keep up with the payment on loans they shouldn’t have taken out. The result? A frozen market.  Individual and corporate balance sheets are now full of loans they don’t want, which restricts their ability to spend or lend additional money.  And the spiral continues…

As always, please feel free to add to the commentary and ask any questions you might have.

Scott H

I wanted to let everyone know that our Chief Investment Officer, Adam Bold, has put together an impressive panel of mutual fund managers for his radio show this weekend.  I  think this is a great opportunity to learn about the market from the perspective of the guys who are making the buy/sell/hold decisions for their funds.

Scheduled to appear are the following managers:

Dan Fuss - Loomis Sayles Bond and Loomis Sayles Strategic Income

Don Hodges - Hodges

Kent Croft - Croft Value 

Michael Cuggino - Permanent Portfolio

If you aren’t a regular listener go here to find out when it will air in your area. If you aren’t able to listen on Saturday, they typically post excerpts from the show within a day or two on the show website www.mutualfundshow.com.

Good listening,

Scott H

On Friday, I wrote that I thought the market was acting irrationally.  The next couple days have been further evidence that the market is struggling to figure out its identity. 

On Monday, we were greeted with an increase of more than 11% or 900 points on the DOW and everyone was relieved (I would have been happy with a increase of 300 points and thought the 900 point increase portended more volatility).  Tuesday was relatively quiet.  And today, as many have seen, the DOW declined almost 8% or more than 700 points.

I, like many of you, have felt a bit of whiplash lately.  I couldn’t remember a time when we had this much volatility on a day-to-day basis so I went back and did some digging.  Here’s what I found.

In the eleven (11) trading days we’ve had in October the smallest point swing in the DOW, from intraday high to intraday low, has been 475 points. The average daily swing in October has been more than 800 points. 

To put this in perspective, over the last five years, 1259 trading days, we’ve had only twenty-one (21) days where the point swing was equal to or greater than the smallest we’ve experienced in October.  In fact the average point swing was only about a quarter (25%) of what we’ve experienced lately.

So what does it all mean? 

In my opinion, the market continues to follow a herd mentality.  Whichever way the leader points, the herd goes.  Either euphoria reigns like it did on Monday, or panic reigns like it did today.  I am not discounting the effect of the ongoing turmoil in with financial institutions or the economic weakness that we are seeing.  I am however saying that this is nothing new.  The market has had time to reflect on a slowing economy as well as the time to adjust itself to a slowing economy for the last several months.

On the positive side, we’ve seen further action by a number of government’s worldwide.  Several, including the U.S., are investing directly into weakened financial institutions in order to shore up their capital structures and promote a loosening of the credit markets.  With time, these actions will work through the market and begin to free up the capital that businesses need to operate and grow.

In addition, oil closed today below $75/barrel, almost 50% below its peak in July, which will result in more money in everyone’s pocket.

What I’d like you to take away from this post is that I expect continued market volatility, however irrational it may be.  But I also continue to believe that this is a long-term buying opportunity.  The market and the economy have proven their resilience time and time again.  I believe this will again be the case and think we will look back on this time and realize that it was a good time to be a long-term investor.

Scott H

P.S. For those of you who haven’t joined the 1% challenge and taken advantage of the discount, I encourage you to do so today.  To learn more about the challenge, click here.

We now have a rescue plan that’s been voted on and approved by House and Senate and signed by the President.  You can find people on all sides of the debate from those who think it was an absolute necessity to those who are against the idea of intervening in any way.  I fall somewhere in the middle, believing that the action was necessary, but also that the bill is far from perfect.

Since we have a bill in place, I’m not going to debate the merits of the plan, but rather try to examine how the bill became necessary.  Because of the enormity of the situation, I plan to cover this in a series of posts.  In this post I’ll provide an overview of those involved and how it became a crisis. 

The Players

I’m sure by now that most have read that real estate is at the root of what’s going on around us.  You have probably also heard that sub-prime mortgages are one of the many factors that allowed the bubble to grow even larger.  Now you might be wondering who was involved and who’s really to blame.  Is it really Wall Street versus Main Street?

In my opinion the blame belongs on both sides of the street with everyone who participated in the process.  Below, I’ve listed a brief overview of the primary players involved:

• The individual who borrowed more than they knew they could afford.
• The broker who was focused on the transaction, even if he knew the loan didn’t make sense for his customer, because he was focused on the commission.
• The mortgage firm that wasn’t worried about the loans their brokers were originating because they were going to sell the loan ASAP.
• The investment banks that packaged the loans into mortgaged-backed securities.
• The ratings agencies who rated the packaged loans as high-grade loans with low default risk (Note: These agencies are paid by the same banks that are packaging the loans. Can anyone say “conflict of interest?”.)
• The buyers (mostly institutional buyers who should be knowledgeable investors) who competed to buy the mortgage-backed securities even thou they didn’t know the true underlying risk of the asset and therefore ended up overpaying for the assets.
• The investment banks — including many of the same that packaged the loans — that sold unregulated and unfunded credit default swaps.
• o Credit Default Swap - basically an insurance contact between two parties that says the seller will pay the buyer if the underlying mortgages default above the negotiated rate.

There were many levels of fallout that created the crisis that we’re currently in. The first was the real estate market.

The First Layer

Eventually all overheated markets reach a peak and begin to decline to a state of normalcy.

As interest rates declined early this century, buyers were able to buy houses that they previously couldn’t afford.  This pushed real estate prices up.  In order to enable individuals to continue to buy these newly revalued properties lenders started selling loans that weren’t based on standard lending requirements.  In some cases borrowers didn’t even have to prove that they had the income to support the loan.  In others, the borrower could just barely afford the loan payments that were based on an artificially low initial rate.  And as we all know, if something seems too good to be true… it probably is.

As is typical in an overheated market, people overestimated the true value of the asset and mercilessly bid-up home prices.  But eventually the price stretched too far, sellers started having trouble selling at the sky high prices, and a rush for the exit began.   This sent housing prices tumbling and scared many potential buyers out of the market.  Now we find ourselves in a waiting game, hoping that new buyers decide to reenter the market and help stabilize prices.

So now you know who participated in the crisis as well as the first layer of how it developed.  In the next post, I’ll take a look at how mortgage backed securities, the second layer, have impacted the situation.  Feel free to post a comment if you have any questions or if you would like to add more information on the situation.

Scott H

I’ll start out saying that “buying” means two things in this case:

• I am sticking with my current investment strategy for both my 401(k) and my IRA.
• I have been investing additional amounts from my savings account into the market. Today was the most recent day that I bought.

You might be asking why I am putting part of my savings account into the market when all it seems to be doing in going down.  Shouldn’t I be saving all that I can and protecting my downside when the economy is weakening?

I’m investing because I believe that the market is basing most of its movements on panic.  When panic sets in the markets decline becomes a vicious cycle.  As people pull their savings out of mutual funds, fund managers are forced to sell their positions to fund the redemptions regardless of whether they are bullish or bearish on those positions.  This then sends the market down further, which causes more people to pull out which continues the spiral downward.  Eventually this will end and people will realize that the market has declined beyond where it rationally should be.

I realize that this isn’t easy to watch day in and day out.  In fact, I believe watching it and reading all that the media has to say makes the situation harder to deal with.  And I’m not trying to call a market bottom.  The market may actually continue to decline (I don’t believe it should, but it might).  What I do believe is that we have gotten to the point where the market is based not on rational fundamentals, but rather, fear of the unknown. 

I’ll be up front and say that I have more than 20 years until I plan to retire so I have time to push through this downturn.  I’ll also mention that I am not advocating that everyone follow a similar strategy, but rather that I think panic has taken over and I think that those who continue to invest through this market will be rewarded over time.

In fact, I’d like to issue a challenge/offer.  I will provide anyone who joins me and increases their 401(k) contribution amount by 1% for the next six mos (click here to how much a small change can add up to). with a 15% discount off our annual subscription (or if you are already a client 15% off your next annual payment).  In addition, I am not advocating a more aggressive investment strategy.  The only requirement is that you invest more and follow your investment strategy.  If you’d like help designing an investment strategy feel free to contact our team of advisors at 877-627-8401 or info@smart401k.com.

If you want to take me up on the challenge, post a comment and email me directly at sholsopple@smart401k.com.

Scott H

P.S. I realized that I didn’t mention an end date.  The challenge is ongoing, but the discount ends as of 10/25/08.