08/16/2007: The meltdown in the financial markets will not be over any time soon. There is far too much consumer debt, too much government debt, and much of that debt has very unstable service structure in the form of variable rate components.
Don’t believe all the talk about subprime mortgages, as it is not the “subprime” loans that are causing the problem, but rather the variable-rate loans. Right now, the variable-rate subprime loans are taking the hit; keep in mind, however, that many prime loans–especially the jumbo loans, over 50% of which are variable-rate–have yet to rear their ugly head.
The credit crunch is impacting the entire economy, because when banks tighten up their lending requirements, the cost of doing business goes up for everyone. For a company, the cost of capital goes up. For you and me, the cost of borrowing goes up because (a) interest rates will be higher and (b) more up-front collateral will be required.
When businesses must pay a higher price to operate, then that cuts into profit margins and even drives some firms into the red. That means–you guessed it–layoffs.
Some people might think, “Big fat hairy deal! A few hedge funds are blowing up. Why should I care?” Trouble is, it’s no longer a few rich people who are putting money into hedge funds. Mutual funds, pensions, investment banks, and global investors have poured money into hedge funds. And hedge funds have poured a lot of money into credit markets, as they have provided the capital that has driven the growth of exotic loan products that carry substantial risks.
Those firms also provide backing for interest-rate “swaps”, which banks use to hedge their asset-liability balance against interest rate shocks. When the credit markets become volatile, the cost of purchasing such products gets higher. That cost is passed onto borrowers in the form of higher rates and higher collateral requirements.
To make a long story short, you and I will bear the brunt of the disaster.
Having said all of that, what can the little guy do to protect his ass(ets)? Toward that end, I would suggest the following:
(1) Consult a financial advisor who completely understands derivatives before putting money into any exotic hedging product. Transactions that involve commodities, currency hedges, and even options can be very risky. As Laise, Browning, Levitz, and Karmin reported in Tuesday’s Wall Street Journal, many middle-America types have tried to use tools that professional investors use–which include very complex use of derivatives–and that has not been terribly successful. That said, there is an option strategy that is very useful–and safe–that I highly recommend: the “protective put”.
(2) For your stock positions, I highly recommend “protective puts”, which are options to sell units of stock at a given price. That would protect you from large drops in your stock prices.
(3) If you have any debt that is variable-rate, then take a bite out of your pride and refinance to a fixed rate. It will cost you money now, but it sure beats the heck out of foreclosure and/or bankruptcy.
(4) If you have not done so, start building up that emergency fund. 6 months worth. Take a second job to do this if you have to. The unemployment picture is about to get ugly in the next 18 months.
(5) If you have credit card debt, pay it off. Quickly. Otherwise, you will find your rates going up, and this will end up in higher monthly payments and potentially a ding on your credit rating.
(6) As for specific investments, I would take most of my money out of stocks for now, leaving about 15% in stocks, 50% in money-market accounts, 5% in international funds, and 15% in inflation-indexed bond funds and another 15% in reverse-index funds. In another 6 months, it might be a really good time to get back into stocks, but I’d rather keep the money on the sidelines and watch the crash for now.
For that 15% stock portfolio, what would I buy? I’d stick 5% in an S&P500 index fund, and the other 10% I would stick in some relatively stable stocks. SYSCO Corporatin (SYY) might be one of my picks, as would EDS. If was going to speculate, I’d put a small amount on Royal Dutch Shell.