Tuesday, September 23, 2008
Five Myths About the Financial Crisis
There are so many things swirling in the economy and the markets right now, it’s hard to keep track of what’s what. But there are a few ideas in particular that have bounced around in recent days that are simply incorrect.
Here are five myths you may have heard about the financial crisis -- and an explanation of what’s really going on.
Myth #1: The U.S. government’s Triple-A rating is in imminent danger.
It’s true that the federal government looks set to take on a lot more debt, with the economic rescue package, the bailout of Fannie Mae (FNM: 1.31, +0.52, +65.82%) and Freddie Mac (FRE: 1.32, +0.47, +55.29%), the loan to American International Group (AIG: 5.00, +0.28, +5.93%) and more. But even the immense dollar amounts being thrown around aren’t endangering the U.S.’s credit rating.
“I do not think [these actions] are going to cause our credit rating to shift. I wouldn’t even put it as a ‘low’ probability,” said David Ader, head of government bond strategy at RBS Greenwich Capital. “The expanding deficit is a situation we know about, and our ability to pay the deficit is something we know about.”
In a recent report titled “The Unshaken Foundations of the U.S. Government's Aaa Rating,” ratings company Moody’s outlined the reasons the credit rating is safe.
Pierre Cailleteau, managing director of Moody's Sovereign Risk Unit and author of the report, cited “the U.S.'s exceptional economic and financial resilience, its flexible and competent policy-making and its high level of balance-sheet flexibility” as reasons to maintain the rating.
“As a Aaa-rated government, the U.S. faces very limited liquidity risk and is therefore able to manage its balance sheet in the best interest of what matters the most from a rating standpoint: the protection of its power to tax. Allowing gross public debt to increase, even materially, poses less of a risk to the rating of a Aaa government than would an impairment in the vitality of the economy and ultimately the tax base," Cailleteau said.
Rival rating company Standard & Poor’s expressed similar sentiments recently. So, unless the situation gets a lot worse, it looks as though the rating is here to stay.
Myth #2: Money-market funds are unsafe.
Money-market funds, which are historically some of the safest investments, got a lot of attention last week because one of them -- The Reserve Primary Fund -- “broke the buck,” meaning that it was worth only 97 cents on the dollar.
That news sparked massive concerns about money-market funds overall, and the reaction may have been one of the factors that shocked officials into action on a rescue package. They certainly came through quickly with a plan to backstop these funds, estimated to be around $50 billion.
But the Primary Fund was one of the highest-yielding, and therefore one of the riskiest, funds. It encountered the problems because it had exposure to Lehman Brothers notes, and of course Lehman filed for bankruptcy protection. In addition, it had no parent company to help shore up its funds.
Peter Crane, president of money market fund data firm Crane Data, told FOXBusiness.com’s Dunstan Prial last week that the Primary Fund problem seemed “to be an anomaly,” and that “it’s hard to find anyone else who fits that profile.”
The fact that the Primary Fund was down a mere three cents on the dollar -- and that it was so exceptional in this loss -- is actually a pretty good testament to the stability of money market funds overall.
Myth #3: FDIC insurance is simply $100,000 a person.
Saying that bank deposits are insured up to $100,000 a person is the simple answer, but FDIC insurance actually has some complicated rules.
The good news is that the complexity is in your favor -- not only can you have $100,000 of your own insured at your local bank, but you can have up to $250,000 insured in an IRA, as well as money in living trusts.
Also, the limit is $100,000 per person per bank, so you can have money in different banks. If that sounds like it’s too complicated to arrange, check out the CDARS service, which spreads your deposits around to different banks and can get up to about $50 million insured by the FDIC.
Myth #4: “I can call the bottom in the stock market.”
Take it from longtime NYSE floor trader Doreen Mogavero, president and CEO of Mogavero, Lee & Co.: “It is very hard to call a market bottom or top.”
Study after study has shown that people who try to time the market almost always fail. It isn’t pretty to watch the value of your 401(k) decline, but unless you need to take money out of the markets right away, your best bet is just to hold on for the ride.
In addition, individual investors have a tendency to pull money out of the markets when they’re down, and to put money in when markets are high -- the exact opposite of what’s ideal -- because they’re reacting more emotionally than logically.
Bottoms are “typically done during periods of great uncertainty and stress,” said Alan Gayle, senior investment strategist at Ridgeworth Investments. “That’s assuming you have tremendous foresight and can sense the bottom when it’s there… if you really don’t want to spend the time playing that game, you should maintain a diversified portfolio and stay fully invested.”
Myth #5: Short sellers are inherently evil.
Short sellers are kind of the “Debbie Downers” of the markets. They bet that stocks will go down in price, when most investors just want stocks to keep going up. But even if it’s hard to love the short sellers, they also provide an important balance in the system.
For one thing, short sellers are often the ones who spot frauds and other problems at companies. The firm founded by famed short seller James Chanos, Kynikos Associates, was one of the first to raise questions about Enron.
Chanos wrote recently in The Wall Street Journal that “short sellers act as ‘safety valves.’ Their transactions help to bring share prices to levels supported by the fundamentals, decreasing the likelihood of price bubbles. Short selling also improves market quality and efficiency by narrowing spreads, improving the speed of price adjustments based on new information, and pumping liquidity into the market.”
“When the markets aren’t functioning well, short selling can add to the down pressure,” said Ridgeworth’s Gayle. “But typically, short sellers are trying to find value, just like the long buyers.”