A survival guide for sub-prime bystanders

Monday, August 13, 2007

For months as the sub-prime mortgage mess has unfolded, Wall Street has talked incessantly about the risk of "other shoes'' dropping.

Other shoes? In recent weeks financial markets have resembled a Payless shoe store after a big sale. There's footwear all over the place.

There isn't much point in trying to predict how much worse the home loan debacle will get. Suffice to say it will be bad, and a lot of banks, brokerages, hedge funds and other big investors will lose hefty sums on mortgage-related securities.

Average investors, by contrast, really are innocent bystanders in all this. But they're having to cope with nasty fallout across markets. If you're trying to stay rational, here's a sort of field guide that might help: "It's not me -- it's you.'' That's what the stock market ought to be screaming at the bond market.

The stock market mostly was rolling along happily until mid-July, and for good reason. The U.S. economy still was growing, and growth overseas was even better. That was underpinning corporate earnings.

What's more, despite stocks' strong gains in the first half, the market still looked reasonably priced to many veteran investors.

Along comes the upheaval in the lending markets, centered on bonds backed by home loans made to people who really couldn't afford them (sub-prime). Stocks were dumped because in a panicked market nearly everything gets sold.

The crux of the problem in the trillion-dollar sub-prime bond market is that many big investors bought complex securities they didn't understand. Or at least, they didn't understand how much risk of loss was inherent in the bonds.

The nice thing about stocks, by comparison, is that it's relatively easy to understand what backs them up. You can research a business and come to some reasonable conclusions about its growth potential and the value of the assets.

The challenge for buy-and-hold stock investors now is to figure out whether they're happy with the long-term outlook for their companies and whether share prices are at appealing levels vis-a-vis that outlook.

The big risk: collateral damage as bond investors and banks turn skittish about lending money. That could weaken the economy, and thus corporate earnings, and substantially slow the buyout wave that had helped lift share prices.

But in the long run, the sub-prime crisis will die out, while many companies still will be alive and thriving.

Be prepared for bigger shocks. Financial crises often don't end until some very large players are carried out in body bags.

On Thursday, the latest market rout was triggered by worries about sub-prime infection in the European banking system.

Paris-based banking giant BNP Paribas told clients in three of its investment funds that they couldn't have their money back for the time being. The bank said that the funds owned some U.S. bonds backed by sub-prime mortgages and that it didn't know how to value those securities given the markets' revulsion toward anything labeled sub-prime.

BNP's own solvency certainly wasn't directly threatened. But the announcement created an element of fear missing until now in the sub-prime crisis: Big banks became reluctant to lend to one another on normal terms, driving up short-term interest rates in Europe and the United States.

The threat of a financial system-wide credit crunch forced the hands of the European Central Bank, the Federal Reserve and other central banks. They poured money into the banking system to keep the gears turning. It worked -- for now.

But the risks are high that yet-to-be-disclosed losses on sub-prime or other high-risk bonds at some big banks or investment companies will lead other financial firms to quickly cut off the victims' access to short-term loans, the system's lifeblood.

Portfolio diversification is working, more or less. Financial advisers always tell you to stay well-diversified. It's often during a crunch time for markets that the wisdom of that advice is most apparent.

There are times when nearly every investment will lose ground. But some will lose much less than others, and that's how diversification keeps your total portfolio from melting down.

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