Newsletter September 2008
*Warning, this is a long newsletter, but will be quite informative if you have the patience to read it.*
I'm sure that by now, you've heard what has been happening to the market. Both the Dow Jones and S&P/TSX index dropped more than 500 points Monday due to Lehman Brothers filing for bankruptcy. In short, it was a slaughter.
But is it really?
Let me give you a background of what happened before I go into the details on how your investments may be affected.
Let's start with Lehman Brothers. Lehman Brothers is one of the largest investment banks in the US if not the world. I was established in 1850, it is an innovator in global finance and serves the financial needs of corporations, governments, municipalities, institutional clients and high net worth individuals worldwide.
It does financing, asset management, investment management, fixed income sales, trading and research.
So what went wrong?
Well, the best way I can explain it is this, it innovated itself in to a hole. As you may or may not know, stock prices goes up because of good earnings reported by companies. Sure, speculation is part of it, but a good deal of why a stock goes up is because the company reports good earnings. One way of reporting good earnings is to continually earn money of course.
The way they bumped up their earnings is by buying mortgage backed securities. These are the sub-prime loans that's been repackaged and sold like equities or stocks. Of course, because they didn't report this as a bond holding or a debt holding, it was reported as an asset. Being an asset, it was reported as an earnings. As their earnings goup, their stock is rewarded by the market so their stock price goes up. As their stock price goes up, everybody who works at Lehman gets a bonus since their bonus is tied to earnings and the CEO's earnings are based on the performance of the stock.
The problem lies in that these mortgage backed securities are based onthe assumption that the mortgagee will be able to pay the monthly dues. Here's an example on how these work.
Say for example you use your credit card or you have a mortgage. You borrow from it and you pay just the minimum or whatever the ammortization is on that loan. As long as you are able to pay that loan, that counts as an asset to the bank.
In the old days, banks are allowed to lend 10:1. Meaning, for every$100 they have in reserve, they can lend up to $1,000. For them to be able to lend more money, they need to have more reserve. This is a problem because there's only so much money a bank can raise and as youknow, banks make money from lending money and not from your bank fees.
So how do they circumvent these restrictions? Well, the magic of modern finance has allowed banks to navigate around these reserve requirements. Here's what they did.
Say you have a mortgage of $100,000. That means, the only reason the bank is able to lend you $100,000 is because they have $10,000 in reserve. If they already lent you $100,000, they can't lend to anyone anymore because that will violate their reserve requirements. So what they do is, they package your mortgage and sell it as a security or stock. They sell it to another entity which could be a corporation, a finance company or an individual investor. The investor buys the securities and makes money from the interest payments. So the banks are basically passing their loan risk (you) to another entity. The banks still makes money off of that because the majority of the interest you pay, around 60% is still paid to the bank and the balance is paid to the other entity.
Since the bank has sold off the mortgage and got cash back, the loan is off the books and they are free to give out another $100,000 loan. So effectively, they have just circumvented the 10:1 restriction without really raising any reserve requirements.
Now, multiply this my millions of mortgage borrowers and lenders, and you have what we call a bloated credit market which is over leveraged. So from a 10:1 leverage, they're now possibly into 200:1 to 1000:1 leverage.
This is fine as long as the mortgagee are of good credit and are gainfully employed. The problem is, because of greed and a real estate bubble. Every bank wanted to capitalize on this growth so they started lending to people who have bad credit. This is where the sub-prime term comes in. The borrowers are less then prime borrowers, meaning, they are more high risk because either they have bad credit, no creditor at not gainfully employed.
Think of it this way, who would you rather lend your money to? Your brother who is a doctor and gainfully employed or to your uncle who's a bum? I'm not saying your uncle is a bum, it's just an example. :)
What the banks did is they started lending money to their uncle who's a bum because they ran out of doctors who they can lend money to. They tried to offset the risk of lending to their uncles by charging higher interest rates than what they charge the doctors.
Of course, they offset the risk even further by packaging these mortgage to their uncles and calling them "mortgage backed securities"and selling to another entity. And the cycle goes on and on.
You would be thinking now, why would anyone buy these risky mortgages and why are they willing to get 40% of the interest if they're holding the risk and not the banks? What the banks did is they partnered with rating agencies, manipulated the ratings and rated these securities as AA or AAA. How did they do that? They just said that these are very secure instruments because they are backed by collateral, which is the properties and homes of these mortgagees. Hence it's called "mortgage backed securities" or securities collateralize by mortgages.
As long as the real estate market is going up, these mortgages are worth a lot of money. Of course, we call know that the real estate market in the US is in the sewer, so they are not even worth anything now since even if they seize these properties, they can't get back what they bought it for because the property market is down some 20%or more. So they ended up at a loss.
Going back to Lehman Brothers, what Lehman did was "innovate" and marketed all these mortgage back securities. They purposely exposed themselves to over leverage by purchasing securities backed by residential and commercial real estate loans. Sub-prime to prime mortgage. Since the real estate market in the US collapsed, so did these securities.
Their debt exposure is US$613 Billion dollars. To put this in perspective, the US National debt is US$9.69 Trillion dollars, the Canadian national debt is CAD$3.2 Trillion, the Philippine national debt is US$80.77 Billion.
The debt of Lehman brother is 7.6 times that of a small country and 20% of the the Canadian national debt!
How could a company have this much debt? Simple, over leverage. Scary isn't it?
If you're interested, here's a list of companies that Lehman Brothers owes money to.
http://www.reuters.com/article/marketsNews/idINLF73920080915?rpc=44
So the big question is, how is this going to affect your portfolio?
If your invested 100% in Lehman Brothers, say goodbye to your retirement. But of course, I don't do that to your portfolio. I always put you in a well diversified basket of stocks and bonds diversified by asset classes, countries, industries, sectors and market cap.
Yes, these bankruptcies are going to affect the overall market. But it is going to affect a certain sector more than others. It will also affect world stock market as well as Canadian markets. I think we're going to see a flat to down market until the end of the year so don't expect to make money this year. I would expect to just hopefully break even or stay with a small loss.
Here's some data YTD (Year-To-Date) meaning, from January 1, 2008 to today, 17 September 2008.
Dow Jones down (-20.02%)
S&P500 (-21.25%)
S&P/TSX Comp (-14.14%)
FTSE100 (-23.92%)
Hang Seng (HK) (-36.59%)
Nikkei (-23.24%)
SENSEX (India) (-34.67%)
My portfolio, consist of 100% equities, high risk, resources, dividends, international and small caps. It is down (-30.86%) ouch!
I'm crazy, I know. I'm doing worst than the market. But some of the reasons I have that kind of portfolio is to also learn about the companies so I know what to expect before I recommend them to my clients. I do not recommend funds or companies that I don't have money in or have not done my research. But I still continue to put money in monthly to take advantage of this low market. I'm actually excited this happened. Like I said, I'm crazy or maybe I'm just smart. Only time will tell. :)
But as you may know, I don't do that to your portfolios, I usually take a safer route with your portfolios since my objective with your portfolios is to try not to lose you money. Making money is easy, trying not to lose the money is harder especially in a bear market.
Some of my clients who are well diversified are down 7% and some are down just 3% depending on their investment objectives and time horizon. This is less than half of what the market is doing. So is this good? Well, yes and no.
Yes it's good, because you haven't lost as much as the market which means you are doing well. No, because you still lost money.
Log in to your accounts and see what is your return is now.
So what should you do now? Should you withdraw your funds? Should you stay in the market? Should you change your portfolio?
If you're not retiring within the next 3 years, I suggest you stay with what you have. I've personally have been waiting for another market like this to happen again since I see it as an opportunity to look for bargains in the stock market. The last time this happened which was around 2001, I wasn't in a position to invest heavily in the market and have seen opportunities slip from my fingers.
I would hold cash now and start to look for a good time to enter the market. Or, you can start a regular investment plan or increase your monthly or weekly investments to take advantage of a low market.
In my 10 years of investment planning, the most successful investors I have are those who put money regularly whether the market is up or down. They make a lot of their returns when they continue putting money in a down market and take advantage of the low valuations. Once the market goes back to normal, they make positive returns on their portfolio even if the market is just back to even.
I'm in the process of reviewing everyone's portfolio. If I feel that there should be some changes, I will give you a call.
If you need someone to talk to to get a better sense of what you should do, give me a call.
I told you this is going to be a long newsletter, here's some more news.
Merrill Lynch is another large investment bank that was just bought by Bank of America.
AIG, the largest insurer in the world is in financial trouble. Check out this letter from the CEO of AIG Canada to see how this will affect you if you have AIG Canada Insurance.
http://web.aig.com/2008/clf8183/clf8183news_en.pdf
I'm sure that by now, you've heard what has been happening to the market. Both the Dow Jones and S&P/TSX index dropped more than 500 points Monday due to Lehman Brothers filing for bankruptcy. In short, it was a slaughter.
But is it really?
Let me give you a background of what happened before I go into the details on how your investments may be affected.
Let's start with Lehman Brothers. Lehman Brothers is one of the largest investment banks in the US if not the world. I was established in 1850, it is an innovator in global finance and serves the financial needs of corporations, governments, municipalities, institutional clients and high net worth individuals worldwide.
It does financing, asset management, investment management, fixed income sales, trading and research.
So what went wrong?
Well, the best way I can explain it is this, it innovated itself in to a hole. As you may or may not know, stock prices goes up because of good earnings reported by companies. Sure, speculation is part of it, but a good deal of why a stock goes up is because the company reports good earnings. One way of reporting good earnings is to continually earn money of course.
The way they bumped up their earnings is by buying mortgage backed securities. These are the sub-prime loans that's been repackaged and sold like equities or stocks. Of course, because they didn't report this as a bond holding or a debt holding, it was reported as an asset. Being an asset, it was reported as an earnings. As their earnings goup, their stock is rewarded by the market so their stock price goes up. As their stock price goes up, everybody who works at Lehman gets a bonus since their bonus is tied to earnings and the CEO's earnings are based on the performance of the stock.
The problem lies in that these mortgage backed securities are based onthe assumption that the mortgagee will be able to pay the monthly dues. Here's an example on how these work.
Say for example you use your credit card or you have a mortgage. You borrow from it and you pay just the minimum or whatever the ammortization is on that loan. As long as you are able to pay that loan, that counts as an asset to the bank.
In the old days, banks are allowed to lend 10:1. Meaning, for every$100 they have in reserve, they can lend up to $1,000. For them to be able to lend more money, they need to have more reserve. This is a problem because there's only so much money a bank can raise and as youknow, banks make money from lending money and not from your bank fees.
So how do they circumvent these restrictions? Well, the magic of modern finance has allowed banks to navigate around these reserve requirements. Here's what they did.
Say you have a mortgage of $100,000. That means, the only reason the bank is able to lend you $100,000 is because they have $10,000 in reserve. If they already lent you $100,000, they can't lend to anyone anymore because that will violate their reserve requirements. So what they do is, they package your mortgage and sell it as a security or stock. They sell it to another entity which could be a corporation, a finance company or an individual investor. The investor buys the securities and makes money from the interest payments. So the banks are basically passing their loan risk (you) to another entity. The banks still makes money off of that because the majority of the interest you pay, around 60% is still paid to the bank and the balance is paid to the other entity.
Since the bank has sold off the mortgage and got cash back, the loan is off the books and they are free to give out another $100,000 loan. So effectively, they have just circumvented the 10:1 restriction without really raising any reserve requirements.
Now, multiply this my millions of mortgage borrowers and lenders, and you have what we call a bloated credit market which is over leveraged. So from a 10:1 leverage, they're now possibly into 200:1 to 1000:1 leverage.
This is fine as long as the mortgagee are of good credit and are gainfully employed. The problem is, because of greed and a real estate bubble. Every bank wanted to capitalize on this growth so they started lending to people who have bad credit. This is where the sub-prime term comes in. The borrowers are less then prime borrowers, meaning, they are more high risk because either they have bad credit, no creditor at not gainfully employed.
Think of it this way, who would you rather lend your money to? Your brother who is a doctor and gainfully employed or to your uncle who's a bum? I'm not saying your uncle is a bum, it's just an example. :)
What the banks did is they started lending money to their uncle who's a bum because they ran out of doctors who they can lend money to. They tried to offset the risk of lending to their uncles by charging higher interest rates than what they charge the doctors.
Of course, they offset the risk even further by packaging these mortgage to their uncles and calling them "mortgage backed securities"and selling to another entity. And the cycle goes on and on.
You would be thinking now, why would anyone buy these risky mortgages and why are they willing to get 40% of the interest if they're holding the risk and not the banks? What the banks did is they partnered with rating agencies, manipulated the ratings and rated these securities as AA or AAA. How did they do that? They just said that these are very secure instruments because they are backed by collateral, which is the properties and homes of these mortgagees. Hence it's called "mortgage backed securities" or securities collateralize by mortgages.
As long as the real estate market is going up, these mortgages are worth a lot of money. Of course, we call know that the real estate market in the US is in the sewer, so they are not even worth anything now since even if they seize these properties, they can't get back what they bought it for because the property market is down some 20%or more. So they ended up at a loss.
Going back to Lehman Brothers, what Lehman did was "innovate" and marketed all these mortgage back securities. They purposely exposed themselves to over leverage by purchasing securities backed by residential and commercial real estate loans. Sub-prime to prime mortgage. Since the real estate market in the US collapsed, so did these securities.
Their debt exposure is US$613 Billion dollars. To put this in perspective, the US National debt is US$9.69 Trillion dollars, the Canadian national debt is CAD$3.2 Trillion, the Philippine national debt is US$80.77 Billion.
The debt of Lehman brother is 7.6 times that of a small country and 20% of the the Canadian national debt!
How could a company have this much debt? Simple, over leverage. Scary isn't it?
If you're interested, here's a list of companies that Lehman Brothers owes money to.
http://www.reuters.com/article/marketsNews/idINLF73920080915?rpc=44
So the big question is, how is this going to affect your portfolio?
If your invested 100% in Lehman Brothers, say goodbye to your retirement. But of course, I don't do that to your portfolio. I always put you in a well diversified basket of stocks and bonds diversified by asset classes, countries, industries, sectors and market cap.
Yes, these bankruptcies are going to affect the overall market. But it is going to affect a certain sector more than others. It will also affect world stock market as well as Canadian markets. I think we're going to see a flat to down market until the end of the year so don't expect to make money this year. I would expect to just hopefully break even or stay with a small loss.
Here's some data YTD (Year-To-Date) meaning, from January 1, 2008 to today, 17 September 2008.
Dow Jones down (-20.02%)
S&P500 (-21.25%)
S&P/TSX Comp (-14.14%)
FTSE100 (-23.92%)
Hang Seng (HK) (-36.59%)
Nikkei (-23.24%)
SENSEX (India) (-34.67%)
My portfolio, consist of 100% equities, high risk, resources, dividends, international and small caps. It is down (-30.86%) ouch!
I'm crazy, I know. I'm doing worst than the market. But some of the reasons I have that kind of portfolio is to also learn about the companies so I know what to expect before I recommend them to my clients. I do not recommend funds or companies that I don't have money in or have not done my research. But I still continue to put money in monthly to take advantage of this low market. I'm actually excited this happened. Like I said, I'm crazy or maybe I'm just smart. Only time will tell. :)
But as you may know, I don't do that to your portfolios, I usually take a safer route with your portfolios since my objective with your portfolios is to try not to lose you money. Making money is easy, trying not to lose the money is harder especially in a bear market.
Some of my clients who are well diversified are down 7% and some are down just 3% depending on their investment objectives and time horizon. This is less than half of what the market is doing. So is this good? Well, yes and no.
Yes it's good, because you haven't lost as much as the market which means you are doing well. No, because you still lost money.
Log in to your accounts and see what is your return is now.
So what should you do now? Should you withdraw your funds? Should you stay in the market? Should you change your portfolio?
If you're not retiring within the next 3 years, I suggest you stay with what you have. I've personally have been waiting for another market like this to happen again since I see it as an opportunity to look for bargains in the stock market. The last time this happened which was around 2001, I wasn't in a position to invest heavily in the market and have seen opportunities slip from my fingers.
I would hold cash now and start to look for a good time to enter the market. Or, you can start a regular investment plan or increase your monthly or weekly investments to take advantage of a low market.
In my 10 years of investment planning, the most successful investors I have are those who put money regularly whether the market is up or down. They make a lot of their returns when they continue putting money in a down market and take advantage of the low valuations. Once the market goes back to normal, they make positive returns on their portfolio even if the market is just back to even.
I'm in the process of reviewing everyone's portfolio. If I feel that there should be some changes, I will give you a call.
If you need someone to talk to to get a better sense of what you should do, give me a call.
I told you this is going to be a long newsletter, here's some more news.
Merrill Lynch is another large investment bank that was just bought by Bank of America.
AIG, the largest insurer in the world is in financial trouble. Check out this letter from the CEO of AIG Canada to see how this will affect you if you have AIG Canada Insurance.
http://web.aig.com/2008/clf8183/clf8183news_en.pdf
Comments
Post a Comment