The last two days the stock market has recovered some lost ground. On Friday, it recovered because of the Fed action to reduce the discount rate. Much was said about this but what does it really mean? It means that banks can borrow money from the Fed at a reasonable market rate that hopefully allows them to invest and earn a profit. This helps with liquidity. It does not, however, address the most fundamental issues facing the market, unless it results in an overall reduction in interest rates along the yield curve.
Let me explain this. The basic problem with the "subprime" crisis is that liberal lending standards have resulted in large pools of assets that investors of all sorts have purchased at relatively low spreads over the market interest rates. This means that there is a low risk premium built into those investments. If in fact, the underlying mortgages have higher than expected default rates, higher foreclosure rates, and higher loss rates, the investors are not fairly compensated and the investments in those bonds are not worth what was paid for them. While we cannot predict the future, it appears that this will in fact be the case. Mortgage default rates are increasing, real estate values are decreasing, and the likely result is that more losses will accrue on those portfolios and the bonds will be worth less than full value.
Now let's say that you are a Hedge fund. If you purchased a lot of these bonds and in order to increase the return on the equity put into your Hedge fund, you leveraged those bonds by borrowing against them, then the value of your assets may be less relative to the debt you owe against them. Then the value of the equity investments in your fund can rapidly decline or become zero.
So what would a Hedge fund manager or any other holder of the bonds want to do? Sell them. The problem is that the market now perceives the risk to be a lot higher and so requires a higher return. That means they have to buy the bonds at a lower price. Consequently, the current holder of the bonds will have to write them off at a loss.
While the Fed has provided liquidity to the holders of these investments, allowing them to hold onto them longer rather than fire selling them, this does not affect the value of the actual investment in the long run.
So until the market establishes a new value for all these mortgage backed investments, we will not know the extent of losses that various players will incur. Only know this, there will be a steady stream of loss announcements coming out of the financial sector. We have not even begun to see these.
So how do you invest? Good question. The value of stocks have fallen appreciably. So it may be time to buy for the long term. On the other hand, the market might react negatively to these earnings announcements and stock values may suffer. The overall economy is strong. The folks losing money are the ones that should lose money. They provided funds to a mortgage market without adequate risk protection. Their losses will be someone else's gain.
My suggestion is that you expect more negative reactions in the stock market for certain firms. This will create some stock price volatility. Yet, in the long run, the economy will produce positive returns for most firms including financial firms. Virtually all firms have been punished in the declining market, yet some will not be that adversely affected. Pick your investments. Know if you can stay in for the long run or not. Evaluate the balance sheets of the companies you have invested in to see what their potential loss exposure is, and reallocate or not based on your findings.
Neither over nor under estimate what the Fed can do. If it can lower all interest rates, the value of bonds will increase and losses will be minimized. But the Fed can only control short term interest rates and the policies it pursues can have additional affects on the value of the dollar and future inflation, which can turn long term interest rates the opposite direction, reducing the value of long term bonds.
Author has 23 years on commercial banking and has served as president of a bank, loan approver for large commercial loans, and regional manager for commercial banking for a major US bank.