by Stephen Gandel and Paul J. Lim
As the most serious credit crisis in decades rocks your finances, you've got to have questions. Here are the answers.
Back in January, when it first became clear the economy and the markets were in for a rough patch, the consensus forecast was that we'd have seen the worst of it by now.
Perhaps you put a bit more cash in the bank, trimmed the fat from your budget and tweaked your 401(k) allocations, but otherwise you were confident you could stay the course.
Then came the extraordinary events of September: the government's seizure of Fannie Mae and Freddie Mac and rescue of American International Group; the bankruptcy of Lehman Brothers and pending sale of Merrill Lynch; the first money market fund loss in more than a decade; a series of bank fire sales; and a politically charged federal bailout plan that could carry a $700 billion price tag. You can't help but wonder what all this means to you.
Here are some key questions, from when stocks could bounce back to what's ahead for the economy and home prices. Choose a topic to get some answers.
The Economy
How Did We Get Here?
By now you likely know that the crisis in the financial markets is the culmination of years of reckless mortgage lending and Wall Street dealmaking. It's the final gasp of the burst housing bubble. But how exactly did this happen?
To find the root cause of Wall Street's woes, you have to go back to the collapse of a different bubble - tech. In 2001, after the dotcom craze ended and the bear market began, the Federal Reserve started aggressively slashing short-term interest rates to stave off recession. By eventually reducing rates to a historically low 1%, the Fed reinflated the economy. But this cheap money sparked a new wave of risk taking.
Homeowners, armed with easy credit, snapped up properties as if they were playing Monopoly. As prices soared, buyers were able to afford ever-larger properties only by taking out risky mortgages that lenders were happily approving with little documentation or money down.
At the same time, Wall Street investment banks got a brilliant idea: bundle the riskiest of these mortgages, then slice and dice these portfolios into tradable bonds to be sold to other banks and investors. Amazingly, bond-rating agencies slapped their highest ratings on the "best" of this debt.
This house of cards came down when subprime borrowers began defaulting on their mortgages. That sent housing prices tumbling, unleashing a domino effect on mortgage-backed securities. Banks and brokerages that had borrowed money to boost the impact of those investments had to race to raise capital.
Some, like Merrill Lynch, were forced to sell. Others, like Lehman Brothers, weren't so lucky. "What we always tell investors is beware of too much leverage in a company," says Brian Rogers, chairman and portfolio manager for T. Rowe Price. "Leverage is the enemy of the investor."
Sure, everyone from former Fed chairman Alan Greenspan to your friends and neighbors played a role in stoking this casino culture. But troubled banks and brokerages can't pass the blame. "These firms closed their eyes and made very bad bets on risky securities that they didn't truly understand," says Jeremy Siegel, finance professor at the University of Pennsylvania's Wharton business school. "Investments that they did not have to make led to their demise."
How Bad Could the Economy Get?
Before the meltdown, economists fell into two camps: those who thought the economy had already slipped into recession and those who thought a recession could still be avoided.
While forecasters still differ on the timing and severity of a downturn, "the consensus view is that we're headed for recession and will be in one until next year," says Mark Zandi, chief economist for Moody's Economy.com.
Corporate profits are already on the verge of falling for a fifth straight quarter, according to Thomson Financial. The next shoe to drop will be consumer spending. "Two years ago, people were using their homes as ATMs, pumping out cash," says Robert Arnott, chairman of the investment consulting firm Research Affiliates in Pasadena. "As banks continue to tighten their lending, that spending is disappearing."
But softer profits and slower spending haven't translated into widespread layoffs yet. "This is the strongest recessionary job market in 40 years," says James Paulsen, chief investment strategist of Wells Capital Management. A jump in unemployment could still be coming, especially given bank and brokerage failures and mergers. But outside of finance and housing, much of the rest of the economy is strong, he says.
The weak dollar is boosting demand for our goods abroad, and lower gas prices are making Americans feel more flush. Add in the cash that the Fed has been hosing into the banking system and we are bound to see growth in 2009. "If all this stimulus has no effect on the economy, that would be a rarity indeed," says Paulsen.
Standard & Poor's chief economist David Wyss expects a mild recession that ends next spring. "Gradually we will regain confidence in the market. Lower oil prices and a falling trade deficit will help," he says. "This is a financial panic, not an economic one."
Of course, that could change if the financial panic doesn't abate soon. If banks remain too scared or broke to lend, would-be home buyers will be frozen out of the market. If that happens, home values could fall even more, crimping confidence and putting the brakes on the economy's greatest engine: the consumer.
Does All This Mean I'll Pay Higher Taxes?
Yes. "Taxes will rise regardless of who wins the Presidency," predicts Greg Valliere, chief political strategist for Stanford Group Co.
It's impossible to say what the final bill for rescuing Wall Street will be. Even before the bill to buy $700 billion of unwanted mortgage-backed debt, the government had already signed on for nearly $365 billion in loan guarantees and other costs.
The eventual price tag will depend in part on the housing market. If it recovers by 2010, the value of mortgage-backed securities could rise, minimizing the tab for taxpayers, says Brian Bethune, chief U.S. financial economist for Global Insight.
"On the other hand," Bethune adds, "if the economy continues to tank into a deeper recession, dragging the housing market along with it, then the costs to the taxpayers easily could escalate to several hundred billions of dollars."
Under Treasury Secretary Henry Paulson's original debt-buyback proposal, some economists predicted the federal deficit could soar to $900 billion in 2009. Even without a bailout, the federal budget was expected to hit $482 billion next year. If government aid pads that figure by $200 billion, the deficit will be back to where it stood in the 1980s - around 5% of GDP. At the very least, that will make it hard for a future President to keep tax-cut promises.
The Stock Market
When Will Stocks Bounce Back?
Don't expect an immediate rebound. "Investors shouldn't get overly enthusiastic," says Jean-Marie Eveillard, portfolio manager for the First Eagle Funds. Why? Even if Washington gets its act together, the economy will remain a drag. "In a time of slow growth, profits will not be that great," Eveillard says.
Remember too that a massive government rescue plan could have unintended consequences. If the budget deficit were to balloon - as many economists assume it would - that could further weaken the dollar, which would lead to another bout of inflation fears.
Rising inflation and a falling dollar, in turn, would likely boost market interest rates, since it will take a big carrot to entice foreign investors to buy U.S. bonds. When rates are on the rise, investors typically aren't willing to pay up for stocks in the form of higher price/earnings ratios.
Economists are predicting that a recession could last through next spring or even the fall. Does this mean stocks will languish that entire time? No. Equities have a knack for rallying in anticipation of an eventual recovery. So a stock market rebound could take place sometime in the first half of 2009. Until then, don't hold your breath.
If the Outlook Is So Bad, Why Not Dump Stocks?
Selling stocks after they've sunk to a three-year low in hopes of buying them back after they're trading at higher prices is a surefire recipe for losing your shirt.
While it's understandable to want to flee, Bohemia, N.Y. financial planner Ronald Rogé suggests taking a cue from Warren Buffett. "Here's the smartest guy on the block, and his firm, Berkshire Hathaway, is down like most other stocks this year." But instead of looking to sell, Buffett is buying. Recently he agreed to plow $5 billion into Goldman Sachs.
Still have the urge to purge your portfolio? Consider this: So far this year, fund investors have yanked more money out of their stock funds than they've put in, marking only the third time in recent memory this has happened. The other two times? In 2002, just before a five-year bull market, and 1988, the start of a 12-year bull.
"If you leave the market now entirely, you probably won't make it back in time to enjoy the recovery," says Torrance, Calif. financial planner Phillip Cook. According to Standard & Poor's, equities typically recoup a third of what they lost in a bear market in the first 40 days of a new bull.
Are Stocks Still Best for the Long Run?
If you've been a stock investor over the past decade, you probably feel like the mythical Sisyphus: You've been trying to roll your portfolio up the hill, only to see the market keep batting it back down. Stocks are trading lower than they were at the start of 2000. Even boring bonds have beaten equities during this time.
But disappointing performance doesn't erase the case for stocks. Over the long term (meaning more than a decade), equities give you something fixed-income investments can't: a share of growth. The benefit of owning a stake in a company - as the Treasury Department, no doubt, understands with the majority position it is taking in exchange for helping AIG - is that you get to share in the earnings of the firm. And because stock prices, over time, reflect corporate profit growth, you're likely to far outpace the long-term rate of inflation.
If your faith in stocks is still wavering, consider the last time they performed so poorly: the 1930s. "What if you concluded then that stocks weren't the best place to be?" says Alan Skrainka, chief market strategist for Edward Jones. "You'd have missed out on decades of bull markets."
Your Savings
Are There Any Safe Havens Left?
It sure doesn't feel like it. Even conservative investments - like ultrashort- term bond funds and a single money market fund - have lost value recently. But rest assured, your cash accounts are still extremely safe. To shore up confidence in money-market mutual funds after a prominent portfolio "broke the buck," the Treasury Department launched an insurance plan to guarantee their value.
What's more, bank money-market accounts and CDs are as protected as ever. While it's certainly hard to tell which banks will eventually survive this financial meltdown, your accounts are FDIC-insured.
Finally, if you're looking for a safe option within your 401(k), consider a stable value fund. These portfolios often invest in a diversified mix of short- to intermediate- term bonds that are backed by different insurers. Plus, they've been yielding around 4% lately.
Is My Bank or Brokerage Going to Disappear?
Even with the government stepping in to buy up the crummy mortgage-backed securities that are endangering the health of so many banks and brokers, this relief won't be immediate. It may take weeks for the Treasury Department to put together a team to evaluate these bonds. In the meantime, more banks and brokers could go under or be forced to sell out to healthier firms.
Still, the tally of failed banks is unlikely to come close to the number we saw in the savings and loan crisis. Between 1986 and 1995, 1,043 thrifts went under (though many of them were tiny). So far this year, only 13 banks and savings and loans have failed, according to the Federal Deposit Insurance Corporation. That includes Washington Mutual, the nation's largest S&L, which was shut down before its deposits were sold to J.P. Morgan Chase.
Regardless of what the final tally is, it's important to keep in mind that your bank deposits are for the most part safe. Deposits up to $250,000 per person per institution and $500,000 for joint accounts will be protected by the FDIC (The FDIC temporarily raised the limits from $100,000 and $200,000 respectively through December 30, 2009.). Some retirement accounts are covered up to $250,000.
Investment banks and brokerages have also come under pressure. Here too you are mostly protected. Unlike commercial banks, which use your deposits to lend to other customers, brokerages are supposed to segregate your assets from theirs. So if you own 1,000 shares of General Electric and your brokerage collapses, your 1,000 shares of GE should still be there and will most likely be transferred to another broker on your behalf.
If for any reason your failed broker can't locate your securities, up to $500,000 of your assets per account is covered by the Securities Investor Protection Corporation, a nonprofit funded by member firms. With a few exceptions, SIPC limits its safety net to SEC-registered investments. So while your stocks, bonds and mutual funds will be covered, foreign currency, precious metals and commodity futures contracts won't be.
Insurance
What Would Happen If My Insurer Went Under?
You may have wondered that very thing before the federal government stepped in with an $85 billion loan guarantee to save American International Group from bankruptcy. Since then no other large insurance company appears to be in similar peril. That's because few insure mortgage bonds, the business that contributed to AIG's problems.
In the event that your insurer goes belly up, you have protections. If you have an outstanding claim when your insurer fails, a state guaranty fund will cover it. The rules vary, but funds typically pay up to $300,000 in claims on most policies.
In nearly all states, disability payouts have no caps. With a variable annuity, you are completely protected because you're investing in mutual-fund-like separate accounts held in your name, and insurance companies can't touch those assets when they liquidate.
If you have yet to collect on your insurance policy, will you face any coverage gaps? With life insurance, you shouldn't lose coverage: In past failures, regulators have moved policies of failed insurers to healthy ones. For most other types of insurance, you'll have 30 days to find another insurer. And if you have paid in advance for, say, a year's worth of homeowners insurance, you can apply for a refund from your state insurance fund.
The Real Estate Market
Is There Any Hope for Home Prices?
The burst real estate bubble that kicked off this crisis is unlikely to reinflate quickly. "I don't see the slump in housing prices ending anytime soon," says Dean Baker, co-director of the Center for Economic Policy and Research. The government takeover of Fannie Mae and Freddie Mac lowered mortgage rates briefly (which helps buyers afford your home).
But the bankruptcy of Lehman Brothers, the failure of Washington Mutual and the sale of Wachovia, as well as the stock market sell-off, have made investors nervous about everything, mortgage bonds included. And that has pushed home-loan rates right back up.
The proposed government bailout could help home prices if the banks that get relief turn around and make new loans, but it's not clear that they will. More important, housing prices are not just a factor of mortgage rates. Foreclosures and slow sales have left 4-million-plus homes on the market, nearly half a million more than two years ago. That could get worse before it gets better if rising unemployment translates to fewer buyers to work off that fat inventory.
"In the long run none of what we're doing now is going to matter that much to real estate," says Wellesley economics professor Karl Case. "Home prices have to do with the scarcity of land and perception of that scarcity."
Until homes for sale are again scarce, it will continue to be better to be a buyer than a seller. Most economists expect another 10% drop in housing prices nationally over the next year. Some, like Nouriel Roubini of New York University, say a 15% to 20% drop is more likely.
The Credit Market
How Tough Is It Really to Get a Loan Today?
For months you've likely been hearing about (or even experiencing) tight credit: frozen home-equity lines of credit, lower credit-card limits, tougher loan standards. That could be just the beginning. One reason regulators have been so anxious to step in during this crisis is the fear that consumer and business borrowing will be shut off altogether.
For now, though, many people are still able to get loans. "If you have good credit, job stability and low debt, there is a good likelihood that you will get a mortgage," says Marc Savitt, president of the National Association of Mortgage Brokers.
In general you'll need a 660 credit score and a 10% down payment to qualify for a loan. Another important criterion is how much of your monthly income goes to repaying all your debts. Today lenders want you to cap that at 41% of your income.
Getting a small business loan is similarly tough. But if you can borrow and have the itch to strike out on your own, small business experts say economic downturns can be a good time to start a venture. In bad times, you may find better deals on, say, advertising and office space. And some of the land mines are more apparent.
"When existing companies are stumbling, it's more obvious what mistakes are to be avoided," says Bob Chalfin, a Metuchen, N.J. small business adviser and a lecturer at the Wharton business school. "When there is change, there is opportunity."
The Job Market
How Safe Is My Job?
If you are an investment banker, you already know the answer. If you work in most other fields, you're likely nervous but not panic-stricken. In the past year the U.S. economy has shed just over 550,000 jobs, according to the Bureau of Labor Statistics, but most of the layoffs have come in home building, the auto industry and financial services. Take those three industries out of the equation and our economy has created 90,000 jobs.
"Companies are continuing to add executive positions even as the market slows," says Mark Anderson, president of ExecuNet, a Norwalk, Conn. firm that tracks management hiring.
The recent financial turmoil could make the jobs outlook tougher, and not just for Wall Street types. If business lending stays choked off, hiring will suffer. In a deeper recession, some economists predict more than 1 million jobs will be lost in 2009.
Now is the time to make sure your emergency fund is in place. Three months of expenses is standard, but if you are in an at-risk industry, sock away enough for six months to a year.
At work, lower your chances of being the first out the door by making yourself valuable - and conspicuous. This may be the time to reconsider your flexible schedule. Demonstrate that you can find ways to bring in revenue and cut costs, don't be afraid to point out the good job you and your team are doing and, to be safe, step up your networking, both inside and outside your company.
Your Retirement
Will I Ever Be Able to Retire?
If you have several years, if not decades, to go, don't worry. Yes, your 401(k) and IRAs have taken a significant hit. But history shows that you'll make up 80% of your bear market losses within the first year of the recovery, according to Standard & Poor's Equity Research.
If you're planning to retire in the next few years, the answer is still yes, with a bit of effort. Why? The decade before you quit your job and the first five years that you're out of the work force are vulnerable times. How much your investments earn - or lose - during this time will go a long way toward determining how much money you can afford to spend for the following 30 years or more.
Say you planned to quit this year and begin withdrawing 4% of your retirement funds annually. If you started with a $1 million retirement portfolio last year (split 70% stocks, 30% bonds), the market has already cut that down to $833,000. That means if you pulled 4% of your remaining money out, you'd be left with just under $800,000 after Year One, cutting your odds of having your money last 30 years from nearly 80% to less than 50%.
Sounds scary. But you can fix this problem. For starters, pledge to work one more year. A study from T. Rowe Price found that putting in another 365 days at the job would boost your annual retirement income by 7%. Work three years more and your retirement income could soar by 22%.
By staying at your desk longer, you can also delay taking Social Security benefits. For each year you put off starting your benefits between ages 62 and 70, you boost your Social Security payments by 8%.
What if you don't want to - or can't - work longer? You still have an option: spend less. The traditional advice is to withdraw 4% of your assets in the first year of retirement and boost subsequent withdrawals by the inflation rate. But in this type of market, consider withholding your inflation adjustments for the first three years after you retire. T. Rowe Price found that a retiree with a 55% stock/45% bond allocation in 2000 would have cut his odds of running out of money by half simply by following this approach.
What Should I Be Doing With My Portfolio?
Every long-term investor has to face nerve-rattling times like this - likely more than once - and your success will hinge on your ability to keep a cooler head than many others around you.
If you own a diversified portfolio, your asset-allocation strategy has probably protected you from the worst of the storm. While the S&P 500 has lost more than a quarter of its value over the past year, a portfolio consisting of 70% stocks and 30% bonds has fallen around 17%, thanks to the gains fixed-income funds enjoyed.
Still, markets like this are a good time to check if your asset-allocation strategy is still appropriate for your time horizon and if you need to rebalance. You'll likely find that you own too big a stake in bonds - or at least more than you bargained for.
Let's go back to that portfolio of 70% stocks and 30% bonds. If you hadn't traded in the past year, the market would have shifted your mix to 62% stocks and 38% fixed income. That might feel good now because bonds are less volatile, but it will mean that you will lose out on the higher returns on stocks when the market eventually recovers.
If you're selling bonds to add to stocks, what's safe to buy? It's fair to assume that the government's efforts to bail out Wall Street will add to our national debt, which will likely push up interest rates. Basic-materials stocks tend to do well when rates rise. So consider T. Rowe Price New Era, which owns energy and mining stocks. New Era is a member of the Money 70, our list of recommended funds and ETFs.
Also, beef up your blue chips. As Lehman and WaMu shareholders learned, not every large company can weather tough times. But as a whole, the category clearly can. The Vanguard 500 Index (VFINX) is the safest way to invest in the largest American companies.
Another sound option is the Fairholme fund (FAIRX). The managers of this Money 70 fund follow the Warren Buffett school of investing. They buy a stock only if it's trading well below its intrinsic value - perhaps a richly populated universe after this market meltdown.
If you see that the bond portion of your portfolio is underperforming, consider Treasury Inflation-Protected Securities (TIPS), one of the few types of bonds that can do well when rates rise.
I'm Retired. What Does This Mean for Me?
If you're living off a collection of dividend-paying stocks, it may feel as if you've been hit by the perfect storm. Not only have financial stocks, which generate around a quarter of all the dividends produced by the S&P 500, taken a huge beating - they've sunk nearly 45% since the start of this bear - but 30 blue-chip financial firms have cut their dividends.
Worse still, not all of the income you'll receive this year will be eligible for the beneficial 15% tax rate. For dividends to qualify for the rate, the company that issues them must pay taxes on them. And since many banks and brokers are reporting huge losses, they may not owe a penny to Uncle Sam this year.
As long as you diversify among different stocks as well as different sectors, dividend investing still has a lot of appeal. One strategy that's holding up, relatively speaking: Instead of focusing on companies with the highest yields - which could simply be a sign that a payer's share price has tanked or the dividend is at risk - concentrate on companies that are consistently growing their payouts over time. By doing so, the Vanguard Dividend Growth fund (VDIGX) has kept its exposure to the financial sector to only around 11%, and the fund is down just 10% so far this year, about half what the overall market has lost.
In the wake of the near failure of AIG, another worry for retirees is whether to buy an immediate annuity. In exchange for handing over a lump sum of money to an insurer, you get monthly or annual payments guaranteed for life with one of these policies. In this environment, it's hard enough to have faith that your financial institution will be around for the next three months, let alone three decades.
But bear in mind that no major insurer has failed in this meltdown. Even though AIG required $85 billion in loan guarantees to stay in business, it was the parent company that needed the help - not its insurance subsidiary.
In the event your insurer does fail, your state's life and health insurance guaranty association will attempt to find another carrier to take over the failed firm's contracts. If that can't be done, state guaranty funds will cover at least $100,000 in benefits (around 20 states cover more).
There is one reason to hold off awhile before you enter a new contract: Rating agencies like A.M. Best, Moody's, Fitch and Standard & Poor's are likely to re-assess the financial health of insurers in the wake of the financial crisis. Wait to see which insurers maintain the highest ratings.
How Will I Know When Things Are Recovering?
An oft-quoted Warren Buffett bit of wisdom goes that the stock market is designed to transfer money from the active to the patient. Keep that in mind when you wonder when this crisis is over for good.
Let's remember what this crisis is all about. It's not just about problems with bad mortgages and toxic mortgage-backed bonds. "That's just the tip of the iceberg," says Charles de Vaulx, portfolio manager for International Value Advisers. The reason that we're still stuck in a bear market and that loans are hard to come by is the ongoing crisis in confidence in the financial system that greases the wheels of the economy. It may take months, if not longer, for the markets to get enough courage to overcome this.
Whether you're an investor or a would-be borrower looking for a sign of better days to come, pay attention to the so-called overnight London Interbank offered rate. Libor is a rate banks charge one another. The lower it is, the greater the likelihood that banks are willing to lend freely - and the sooner this credit crisis may be over.
Historically, Libor has run fairly close to the federal funds rate, which the Fed is currently targeting at 2%. But lately the overnight Libor has fluctuated between around 3% and 6%, an indication that banks still perceive a great deal of risk in the market.
In the short run, that's not great news for investors or consumers waiting for banks to start lending again. In the long run, however, the fact that banks are starting to consider risk isn't necessarily bad. After all, says Steven Romick, manager of the FPA Crescent Fund, "the reason we're in this mess is that financial institutions tried to make money without any regard to the concept of risk."
