Saturday, August 11, 2007

The Roller Coaster continues – Hold on for the ride!

The Fed stepped into the market this week to inject an unprecedented amount of liquidity into the markets. On Friday, the Fed pushed $38 billion in temporary reserves into the system on top of the $24 billion added on Thursday. This is greater then the amount injected after 9/11. Similarly, the European Central Bank injected over $130 billion into their financial system.

Reserve acts to stem credit turmoil

The primary purpose of these injections was to prevent panic that would totally constrain credit and place the entire financial system under stress.

The other interesting note about the Fed’s operation is that they purchased mortgage-backed debt for cash. This type of temporary open market operation is rarely performed for mortgage debt, it usually involves the repossession of treasury or agency notes for cash.

Federal Reserve Bank of New York
Temporary Open Market Operations

At this point, it is a race to determine if the central banks can calm the markets by injecting liquidity and taking other steps to alleviate the credit crunch. The IMF and other entities have made statements that the turmoil should be “manageable”.

What lies ahead next week?
The expectation is that the markets will continue to see more of the volatile roller coaster ride that has been seen over the past couple of weeks. The market will be driven to daily extremes by a news-focused cycle due to the uncertainty surrounding the credit liquidity situation.

More stock volatility next week as Fed battles credit woes

In the meanwhile, more bad news continues to leak out from many major financial firms. With the SEC directly probing the books of Wall Street firms, they will quickly have to come clean publicly about credit losses due to mortgage debt. Most are expected to lose $1 billion or more. The announcements by these institutions regarding the exact nature of their losses are likely to help calm the markets, as firm figures can be associated with the losses rather then just speculation.

Citigroup seen taking $700 million in credit losses

SEC Probes Books of Wall Street Firms
SEC Probes Books of Wall Street Firms to Determine Their Exposure to Mortgage Turmoil

The mortgage credit issues appear poised to spread to other areas of the market. There is an expectation that junk bonds will be hit next as outlined by rating agencies such as S&P.

Credit troubles could spur more junk bond defaults: S&P

What should the Individual Investor do?

This is **NOT** the time to panic and drastically alter your allocations or investments. The purpose of diversified portfolio is to ride out these types of storms over the long term; you may take a temporary hit but if you are properly diversified then you still do well in the long term.

Investors need to evaluate their exposure to credit contagion in their money market funds, REIT holdings, and junk bonds. They should take steps to move any investments with exposure to other similar (but safer) investments (for example moving a brokerage CDO-backed money market funds to a FDIC-insured bank money market).

Note that money-market funds are traditional thought of as “safe”. Unfortunately money markets funds may be the asset area where the individual investor most likely has potential exposure. Many money market funds at brokerage and mutual funds firms are backed by mortgage related CDOs. Investors need to read the prospectus to identify the underlying holdings in their non-FDIC protected money market funds. After this they need to investigate the holdings on the web, or call their brokerage firm or mutual fund directly to determine if the holdings are backed by mortgage-related CDO debt.

Is Your Money Market Fund Safe?

Despite the turmoil, investors should not greatly alter their overall diversified portfolio due to the liquidity issues seen in the credit market. In long-term investments such as 401K plans, investors should remain properly diversified without significant alteration of their allocations to each of the selected funds. Keep in mind the long term picture rather then the short-term fear generated in the financial press.