Monday, September 15, 2008

Will the Sun Come Up Tomorrow?

Over the weekend there were many discussion by investment banks and regulators about how to solve the liquidity problem with Lehman Brothers, AIG and Merrill Lynch. Late Sunday night Bank of America and Merrill lynch agreed to make Merrill Lynch a part of Bank of America. The issue of what to do with Lehman and AIG was left unresolved as no buyers were identified to purchase the financially troubled companies. At midnight when I went to bed Lehman had not filed for bankruptcy and to the best of my knowledge through the close of business on Monday they still had not filed for bankruptcy. The fate of Lehman Borthers and AIG are still in doubt.

In speaking with a client earlier today I asked, If I told you on January 2nd that by September, Merrill Lynch, Lehman Brothers, Bear Stearns would be gone you would have thought I was smoking something illegal? All of the stock markets around the world are down today because investors are selling, fearing the worst. While this is scary, nobody likes to loose money and it may feel like the end of the world, it is not.

I remember the panic of October 1987 when the market was off 22% in one day. By comparison today’s decline at its worst was off just over 4.5%. I am willing to admit that to me it feels somewhat like 1987, but in many respects, it is much different. I believe that the economy is slowing down and may well be in recession. The prices of commodities have fallen dramatically. Oil today was down almost $6 and below $100. All the other commodities were selling off which points to lower inflation.

Interest rates fell this morning and in turn mortgage interest rates will be lower going forward. The buzz on the street is that at tomorrow’s meeting of the Fed it will cut short-term interest rates by one quarter of one percent (25 basis points) one/half of one percent (50 basis points). I think it is more likely that the Fed will not lower interest rates tomorrow, but changes its policy statement moving its bias towards cutting interest rates in the future.

Many people are asking why this happened and how all of this came about in such a short period. I think there are several reasons, but most of all I think it was the deregulation of the brokerage business. The cost of transactions was based on a fixed fee schedule. The brokers could figure out how much they could earn from the transactions business. I liken this to the deregulation of the airline industry. When the fixed fare went away, the entire industry had to react to price declines. Over the years, companies came and went out of business because they thought they had a business model that could make money. For the most part these models did not turn out to be realistic. The result of deregulation is fewer airlines with less competition and in turn we now have higher prices.

The brokerage business had other ways to make money and so when they could not make money in stock transactions they developed a vast array of investments designed to produce more income for them and hopefully their shareholders. As these alternatives produced more and more income the firms developed more and more sophisticated investments generating even more cash flow, but more risk. Now many of these structures, like start-up airline companies, didn’t turn out to be as profitable as they thought they would be. As the deals have to be valued for balance sheet purposes their values are coming under scrutiny and downward pricing pressure.It seems ironic to me that the same rating agencies that made many of these investments AAA now rate them to "Junk" in a matter of days.

How about an example: Let's say you spend $100 to buy something today that you think will go up in value and which you hope to sell later for something higher. What happens if you have to sell it sooner than you expected? You may not be able to sell it for the price you wanted and in fact you may have to sell it for less than what you paid for it in the first place. This a simple illustration of what is going on in the financial markets today. Theses firms borrowed significant sums of money to build investments that they hoped would turn out to make them and their investors more money. These investments, in some cases, didn’t work out and now when the firms want to sell them because they need the money to pay other obligations and nobody wants to buy these investments at anywhere near the purchase price.

The rest of the world is looking to American to figure out how to deal with this problem because they may well be going through the same thing in the very near future. It will take time to figure things out. The most important ting to do at the moment is not to panic sell. Look at each of your investments and try an be as objective as possible to look at the prospects for the investment. Ask, does the company have a viable long-term business and what percentage of my total assets is in each position? Limit your exposure to no more than 5% of your portfolio in any one investment.

If you decide to sell an investment take the money from the sale and invest it in 90 Day T-Bills. The next thing to do is to figure out where you want to invest your cash when the time comes. You could add to your existing holdings or look for something new. Take your time and ease your money into investments. There is no rush. Lastly, take a deep breath and realize that things will be different 6 months from now.

Dan Perkins

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