WSJ: Jason Zwieg: What Should Investors Do Now?

The Intelligent Investor: When the Dow drops 778 points in one day, it seems like there's nowhere to hide.




Jason Zweig gives us some great perspective on today's events, a couple excerpts from this excellent article:

On whether we are heading for another Great Depression:

"First, when you spend time studying the Crash of 1929 and the depression that followed, what stands out the most is the dearth of doomsayers. Even Roger Babson, the economist known to posterity as "the man who called the crash," did no such thing; he forecast only a 15% to 20% drop, not the apocalypse that actually occurred. Depressions start not when lots of people are worried about them, as we have today, but when no one is worried about them, as in 1929.

Second, the Great Depression and the Panic of 1873 (which triggered what arguably was the worst depression in U.S. history) both occurred before the Federal Reserve Bank had aggressively grown into its role as "lender of last resort." In the wake of 1873, after a railroad-building boom had swept the nation and then gone bust, companies and consumers alike were left gasping for capital. Nothing but the passage of time could supply it; the Fed would not be established until 1913. After the crash of 1929, when the Fed was still weak, years passed before the federal government could flood the economy with cash.

Today, however, the resolve of the Fed is not in question; nor is there any doubt that the Treasury department is willing to provide the financing it takes to get the economy moving again. Furthermore, U.S. non-financial companies have just under $1 trillion in cash on their books."


I encourage you to read the whole article.

Scott Dauenhauer CFP, MSFP, AIF

Bailout Fails - Investors Bail

Well, well, well......yesterday everyone was told that congress was ready to play nice with each other and actually work for the American people. In the end we found out that in fact, they just didn't have it in them. They couldn't hold themselves back from playing the same political games that are partially responsible for the mess we are in now. I don't know if it was Pelosi's speech that threw Republicans into a tizzy (if it was, how utterly ridiculous and thin skinned of those Republicans), but the speech was certainly not needed. Regardless, the bailout package failed and investors bailed on stocks - giving us the worst one day point loss in two decades.

Where do we go from here? I can only imagine that the two parties will come back together, curse each other out, blame each other then come back to the American people with a package that works....and actually pass it. This will not be the final measure, but it would be a good start - it is a bank bailout or a partial recapitalization of the banks (after all, we are overpaying for the assets).

The bottom line is that America is suffering from a lack of leadership, Paulson and Bernacke are attempting to step in, but so far are not making necessary progress. President Bush is a lame duck with a low approval rating and congress has the worst approval rating in history - we are in a leadership vacuum. We need strong leadership and we need more transparency in our markets, we also need a solution to the housing/foreclosure problem - without this, nothing will change.

This doesn't mean you should be eternally pessimistic about stocks. Stocks are on sale, they may go on sale further (I guess that might be a clearance?) but they are not going to go down forever. History shows us that stocks recover and those that hold on should be well rewarded.

Hang in there and read my next post with Jason Zweig.

Scott Dauenhauer CFP, MSFP, AIF

WSJ: Calling JP Morgan

I've been reading "The Panic of 1907" as a way of better understanding our financial crisis history. Its amazing the parallels of today and back then. The panic happened over 100 years ago (there were 13 previous ones) and yet, America survived. We will survive this panic as well.

Today's events are a little unbelievable, but not unprecedented. If you want a fascinating read about how JP Morgan solved the Panic of 1907 in just eight weeks and what we can do now to get through this crisis......you've got to read this article.

Scott Dauenhauer CFP, MSFP, AIF

Historical Market Reaction to Financial Crises

I realize that these graphs may be difficult to read, but if you click the above link it will take you to a page that will allow you to download them and those are very easy to read. The main point....stocks have always rebounded after a crisis.





Scott Dauenhauer CFP, MSFP, AIF

MBS, CDO's and CDS's In Layman's Terms......

You've probably been hearing a lot about securities that you've never heard of before. I bet you never thought it would be important to know what an MBS or CDO or CDS was......now you may be wondering. I'll try to give you a brief synopsis of each.

MBS - Mortgage Backed Security

This is in its simplest form a bond. The bond is backed by a pool of mortgages that are being paid by homeowners across the United States. Each month a homeowner makes a payment, that payment basically sent to the holder of this bond. If one were to buy a Mortgage Backed Security (MBS) they would receive an interest payment and a partial repayment of their principal (since some of a homeowners payment is interest and principal). These securities are issued by Fannie Mae, Freddie Mac and Ginnie Mae - but can also be issued by other institutions. When an investor buys a Fannie Mae bond, they are essentially buying the cash flow from different homeowners as they make their monthly mortgage payments. If a homeowner defaults on their mortgage or misses a payment, the MBS holder suffers....of course this is where Fannie, Freddie and Ginnie step in and make them whole. With so many people in foreclosure and not making payments......you can see why Fannie and Freddie had to be bailed out.

O.K. - as if MBS was not hard enough - Collateralized Debt Obligations or CDO's.

These are tough to understand and I won't bore you with the internals, but think of this as a Mortgage Backed Security on steroids. Instead of one investor owning the cash flow of a mortgage - multiple investors could own it. Here is an example of how a CDO might work:

Pretend that you have a mortgage (okay, most of us aren't pretending) and you make principal and interest payments each month - these payments are made to your loan servicer and then split up as follows:

Investor A - Gets all of the interest payments from years 1 - 4
Investor B - Gets all of the principal payments from years 1 - 4
Investor C - Gets all of the interest payments from year 5
Investor D - Gets all of the principal payments from year 5
Investor E - Gets the interest and principal payments from years 6 - 10
Investor F - Gets interest payments from years 11- 24
Investor G - Gets principal payments from years 11 - 24
Investor H - Gets the remainder of principal and interest payments, if made from years 25 - 30

Imagine you are the borrower - your payments don't just go to your local bank anymore - they get split up depending on the year you are making a payment and how much is principal and interest. All of these investors who are in line to receive these payments have bought into a trust - called a CDO. The trustee of the trust has a fiduciary responsibility to each of these investors. Now you know why when someone who is having problems paying their mortgage and is on the brink of foreclosure is having such problems trying to get their loan modified - if the trustee changes the interest payments, one of multiple investors may get hurt at the expense of another, same goes for principal changes. The trustee is in an impossible situation and thus does nothing........the house forecloses even though a workout was entirely possible.

CDO's were purchased by investors who were told by "creditable" ratings agencies that these securities were "investment grade". Some of these investors obviously didn't believe the credit agencies and decided to seek insurance in the case that their CDO defaulted. They went out and bought.........Credit Default Swaps or CDS.

There is nothing wrong with a Credit Default Swap - it is basically an insurance policy against the failure of a specific asset. The reason these have been in the news is because some companies - like AIG, Lehman and Fortis (and many others) found these insurance policies to be very lucrative business. AIG in particular issued Credit Default Swaps on CDO's so that institutions that held CDO's would be made whole if the CDO defaulted. The problem is that AIG didn't foresee that ANY of these would default - they thought this was a risk free operation. AIG took in a ton of money to insure the CDO's through Credit Default Swaps - but never reserved for losses. As we all know now, AIG made a huge mistake as there were and is risk with CDO's. Credit Default Swaps are basically just insurance policies for securities.

Consider this a 101 class on mortgage derivatives.....its probably boring to you, but it might help to explain a little of what is going on right now.

If you're an expert in these derivates please don't e-mail me telling me how I botched these explanations.....they are correct enough to ensure normal people understand the basics of what is going on!

Scott Dauenhauer CFP, MSFP, AIF