Personal Finance Advice

Financial institutions are in a mad dash to raise capital in an effort to avoid the fate that befell Bear Stearns when it ran out of cash and nearly collapsed.  Many of them have had to issue new stock at bargain basement prices which has angered existing stockholders because it will dilute their earnings per share for years. 

While some of this capital is being hoarded in anticipation for more write downs from additional sub prime defaults. another area that has many of them concerned is their exposure to credit default swaps(CDS).  One of the many financial innovations that came about in the last decade, the notational value of the fast growing market is estimated at over $62 trillion.

CDS are basically insurance polices sold by financial institutions to protect purchasers of bonds against the risk of default.  Many parties use them as hedges against their positions but because the only money that changes hands initially are the premium payments, it’s also a very popular tool for speculation.  Reconciliation payments take place only when a certain credit event is triggered like a ratings downgrade or default.

CDS were very popular during a booming economy when the default risk was low because it was basically free money for  the sellers of these instruments.  Now with credit markets in shambles, CDS have become an albatross around the neck of many financial institutions.

Warren Buffet spoke out against CDS as early as 2002 saying that they were a disaster waiting to happen.  Since it was pretty much an unregulated market, much of the risk exposure to sellers of CDS was unfunded.  Some analysts believe that it would only take one large financial institution to default on a CDS to cause a catastrophic chain reaction in the entire credit market.

CDS spreads ballooned during the height of the sub prime write downs and although they have recently tightened somewhat, they are still nowhere near their normal levels.  Some believe this may be an indication that credit markets are starting to improve or that at least financial institutions are now less pessimistic than they were a couple of months ago.

Nonetheless any money that’s being hoarded isn’t being loaned out, which serves to exacerbate an already tight credit market.

While the stock market is going through a rough period at the moment, it should still make up the bulk of your investment portfolio.  Despite the current love affair some analysts have for commodities, that market should only be used as an inflation hedge and not as the backbone of a sound investment strategy.

So what if commodities are riding high while the stock market has fallen from grace.  Does that mean you should reallocate your portfolio?  Let me put it to you this way, when has it ever been a smart idea to buy high, sell low?  I hate to say this, but if you didn’t already have some of your funds invested in commodities as an inflation hedge, you probably missed that boat already.

Panic selling can be one of the worst things you could do in the current economic situation.  If anything, shrewd investors will be looking out for potential bargains in the stock market that could be the springboard for hefty gains when the economy recovers.

While no stock is recession proof, some do better than others when a downturn comes along.  I have long been a fan of tech stocks due to the high global demand for such products.  Large cap stocks also tend to weather an economic downturn better than small cap stocks.  For investors like retirees who need to live off their investment income, stocks that offer strong dividends could also be a smart alternative.

Smart investors that have a well diversified portfolio with proper asset allocation should just stay the course as they should already be well equipped to ride through the storm.

Recent economic data shows only a slight slowing in consumer spending but those numbers are misleading.  Higher prices are to blame for this, so while Americans may be spending the same amount of money, they are getting much less for their dollars than they did a year ago.

While some of it’s inflation, the weakness in the dollar also plays a large part in this because of the American consumer’s propensity for purchasing imports.  With the Fed forced to slash interest rates to cope with the growing credit crisis, the situation is not expected to improve anytime soon.

Americans are feeling the strain, especially in states like California and Florida.  With foreclosure rates at three times the national average, the housing bust has hit these regions especially hard.

Consumer confidence is at the lowest its been in years and we aren’t even technically in a recession yet.  People are having to spend a larger percentage of their disposable income on necessities like food and energy, whose prices have soared over the last year.

Many retailers are struggling as more and more Americans grow worried about inflation and job security.  While the economic stimulus package will provide a little relief, it is becoming increasingly unlikely that we will be able to spend our way out of this economic downturn.