The Subprime Mortgage Crisis: What Does It Mean for Your Investments?

Like a spreading fungus, the subprime mortgage crisis has gained footholds across the country and has the potential to bring on a recession in the U.S. — undermining an economy that is in most respects fairly robust. The crisis has hurt several sectors of the stock market, created a drag on the economy, and resulted in record numbers of foreclosures.

Origin of the Crisis
In 2003, as U.S. housing prices and sales were setting records, the Federal Reserve began lowering interest rates to keep the economy humming. Eventually, the Fed reduced short-term rates all the way to the unprecedented level of 1% and kept them there for a year. The stage was set for investors, who were still feeling the pain from the stock market bubble from 2000-2002, to turn to the “safety” of real estate investing.

Property valuations went through the roof and sales continued to set records. Houses became ATMs, and American spenders tapped into seemingly bottomless equity.

Mortgage bankers and brokers, eager to extend the good times, threw credit standards out the window. No-doc loans, creative payment schemes, and bloated appraisals soon became common. Nonqualified borrowers took on adjustable rate mortgages, attracted by low teaser rates, and the market roared on.

Low rates, engineered by the Federal Reserve, set off a desperate scramble for higher yielding short-term investments, especially by institutional investors. These investors looked to Wall Street for alternatives.

In response to this new demand, Wall Street began packaging these higher risk subprime mortgages into securities with yields well above those offered on safer investments. Yield hungry hedge funds and other investors snapped up the new securities. Rating agencies waived their approval by giving these securities higher credit ratings than they deserved. For a “tongue-in-cheek” explanation of what happened, go to: http://www.youtube.com/watch?v=SJ_qK4g6ntM.

In the middle of 2004, the Fed switched its worry meter from deflation to inflation. It began raising short-term rates until it got to 5.25% by early 2006. Not surprisingly, the housing market, which is highly responsive to changes in interest rates, turned 180 degrees. The sellers’ market became the buyers’ market as houses stayed on the market longer and inventories of unsold houses grew. Subprime borrowers were especially hard hit as variable interest mortgage payments kept getting bigger.

As delinquencies and foreclosures rose, the value of securities backed by mortgages fell sharply. As demand for the securities dried up, it became impossible to value the securities, and investors (banks, hedge funds, pension funds, even some money market funds, and others) are being forced to write down the value of the securities on their books.

There is no question that the “financial system” has been strained by these events. The good news is that the Federal Reserve and the U.S. Treasury, unlike the 1930s, have the tools to address the problems. Banks are coming together, under Treasury Secretary Henry Paulson to provide a fund for buying the troubled securities. This will prevent banks and others from having to sell these securities at deep discounts, which would place further strain on the financial system. In addition, the Fed has started lowering rates again, which will help the housing market and lessen the pressure on banks to pay higher rates, straining them further. And most recently, the Fed has made it easier for banks to borrow money to meet liquidity needs through an auction process.

BWFA’s Response
Early on, BWFA recognized that the real estate market was overvalued, and sold several of its investments, which were closely tied to the real estate market (primarily REITs). More recently, we queried the managers of our short-term fund selections to ensure that our clients had no direct exposure to these troubled securities. As of this juncture, we do not believe that our clients have any exposure to troubled money market funds which have been prevalent in the news.

In addition, some months ago we began raising the cash positions in our client portfolios to the highest level in our firm’s history. For clients who are drawing money from their investments (retirement), we did this a while ago; for clients still accumulating assets, our shift has been more recent. This will help in two ways: it will reduce our clients’ market exposure, and it should provide cash to take advantage of extremely low valuations in good quality securities which are occurring now.

We often say that managing risk is even more important than managing returns for our clients. While we prefer to stay fully invested over the stock market cycles, always seeking strong companies that merit long-term investment, we recognize that the markets are now in a highly unusual situation. We want you to know that we are taking a prudent approach by focusing our attention on market risks, given the current circumstances.