The last two days the stock market has recovered some of the lost ground. On Friday it recovered thanks to the action of the Fed to reduce the discount rate. Much has been said about this, but what does it really mean? It means that banks can borrow money from the Federal Reserve at a reasonable market rate that hopefully allows them to invest and make a profit. This helps with liquidity. However, it does not address the more fundamental problems facing the market, unless it results in a general reduction in interest rates along the yield curve.
Let me explain this to you. The basic problem with the subprime crisis is that liberal lending rules have resulted in large pools of assets that investors of all stripes have bought at relatively low spreads over 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, investors are not being fairly compensated and investments in those bonds are not worth what they paid for. for them. While we cannot predict the future, it appears that this will be the case. Mortgage default rates are rising, home values are declining, and the likely result is that more losses will accumulate in those portfolios and bonds will be worth less than full value.
Now let’s say you are a hedge fund. If you bought many of these bonds and leveraged those bonds by borrowing against them to increase the return on the principal invested in your hedge fund, 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 that the risk is much higher and therefore 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 cancel them at a loss.
Although the Fed has provided liquidity to holders of these investments, allowing them to hold them longer rather than sell them, this does not affect the value of the actual investment in the long term.
So until the market establishes a new value for all of these mortgage-backed investments, we won’t know the extent of the losses that various players will incur. Just know this, there will be a constant stream of loss announcements coming from the financial sector. We haven’t even begun to see this.
So how do you invest? Good question. The value of the shares has fallen considerably. So it may be time to buy for the long term. On the other hand, the market could react negatively to these earnings announcements and stock values could be affected. The economy in general is strong. The people who lose money are the ones who should lose money. They provided funds to a mortgage market without adequate risk protection. Your losses will be someone else’s gain.
My suggestion is that you expect more backlash in the stock market for certain companies. This will create some volatility in the stock price. However, in the long run, the economy will produce positive returns for most companies, including financial companies. Virtually all companies have been punished in the declining market, although some will not be negatively affected. Choose your investments. Know if you can stay long term or not. Evaluate the balance sheets of the companies you have invested in to see what your potential exposure to loss is and reallocate or not based on your findings.
He neither overestimates nor underestimates what the Fed can do. If you can reduce all interest rates, the value of the bonds will increase and losses will be minimized. But the Federal Reserve can only control short-term interest rates, and the policies it applies can have additional effects on the value of the dollar and future inflation, which can shift long-term interest rates in the opposite direction, lowering the value of long-term bonds.