Financial crisis! What to do …

We are in the midst of a financial crisis. Not a downturn. Not a slump. Not a blip. This is a full-blown meltdown. The causes?

Too much housing speculation: The Federal Reserve pumped the economy full of easy money after the tech bubble burst. That money found its way into the housing market, fueling a speculative bubble like no other in modern U.S. history. Now that bubble is popping, too … and the fallout is spreading throughout the financial markets.

Too much stupid lending: Residential mortgage lenders gave loans to anyone with a pulse during the boom. Now, delinquencies and foreclosures are surging, and so are loan losses.

Stupid lending wasn’t confined to home mortgages, either. The commercial mortgage and leveraged buyout markets have seen their fair share of excesses. Concern over these higher-risk loans is now hammering Wall Street.

Too much financial leverage: Hedge funds, Wall Street firms, everyday speculators — they all borrowed huge amounts of money to boost returns. But what happens when the investments head south? All that leverage enhances LOSSES.

So, in a nutshell, reckless investors, lenders, and borrowers gambled with easy money and lost.

The result is the unfolding meltdown you’re seeing in the corporate bond market … the mortgage bond market … the stock market … virtually everywhere.

It’s not pleasant. It’s not fun. And, from everything I see, it’s not over. But you shouldn’t be surprised by any of this.

The Tell-Tale Signs of Financial
Panic Began Weeks Ago

On August 3, I told you that we were in the midst of the “worst environment for banks, mortgage lenders, and the general U.S. financial industry” since 1998.

Since then, I’m sad to say, things have only deteriorated further. Almost every single day, we learn of another mortgage company facing funding problems or another lending market getting roiled.

For example, the largest mortgage lender in the U.S., Countrywide Financial (CFC) recently experienced a bout of funding turmoil. The company reportedly had trouble selling a form of short-term debt called commercial paper. It tapped into an $11.5 billion credit line to raise money instead.

Countrywide’s bond holders are worried about a potential default. I can see why: Fitch Ratings and Moody’s Investors Service both cut Countrywide’s credit ratings. And one Merrill Lynch analyst went so far as to say the lender could be forced into bankruptcy.

The stock has plunged as a result, leaving it down about 55% year-to-date!

Countrywide’s shares tumble as credit crunch fears surface …

Meanwhile, a Canadian firm called Coventree Inc. announced that the market turmoil has prevented it from selling asset-backed commercial paper (ABCP). This ABCP is a form of short-term debt backed by things like car loans, credit card receivables, and mortgages.

How important is the Coventree news? Well, the company is the biggest non-bank issuer of this kind of paper in Canada. It needed more than $700 million in emergency funds because of the problems. And other firms — at least 16 according to Canadian ratings company DBRS — are having similar issues. That’s a sign of a real liquidity freeze!

There are signs of massive financial stress everywhere you look.

Heck, the three-month, British pound-based, London Interbank Offered Rate, or LIBOR, just surged to its highest level since 1998. As I explained last week, this kind of move indicates that banks are scared to lend each other money even on a very short-term basis.

At the same time, yields on three-month U.S. Treasury bills plunged almost three-quarters of a percentage point (72 basis points) at one point yesterday. That was the largest decline in any one day since the stock market crashed in October 1987!

Even in the immediate aftermath of the 9/11 terrorist attacks, yields fell only 39 basis points. That means the financial panic we’re seeing now — according to this one measure — is even worse than we saw in September 2001!

And the underlying fundamental problems aren’t going away anytime soon …

Clearly, the Housing
Market Is Still Slumping

The National Association of Home Builders just released its latest monthly survey of builder sentiment. The overall index sank to 22 in August from 24 in July. That was below the 23 expected by analysts and the worst reading in any month since January 1991, when the index touched an all-time low of 20.

Builder Sentiment Index Plunges!

Moreover, all three subindices declined. The index measuring present single-family home sales dropped to 23 from 24. The index measuring expectations for future sales fell to 32 from 34. And the index measuring prospective buyer traffic dropped to 16 from 19.

As for home construction, it dropped yet again in July. Housing starts fell 6.1% to a seasonally-adjusted annual rate of 1.381 million from 1.47 million in June. The issuance of building permits — an indication of future construction activity — fell 2.8% to a rate of 1.373 million.

Starts haven’t been this low since January 1997, while permits haven’t been this low since October 1996.

Housing Starts Have Cratered!

How to Protect Your Wealth
In These Turbulent Times

The markets are fraught with risk right now. There’s no way around that fact. Fortunately, there are several things you can do to protect your wealth:

First, you can take more profits off the table. We’ve been telling you to do this repeatedly over the past few months. Hopefully, you were able to get out with some nice gains. Why not bag more now, wait out this period of chaos, then look to buy when the coast is clearer?

Second, consider using stop losses. Stop loss orders are an essential tool for risk management. They instruct your broker to automatically sell a position once it drops below a predetermined price. That protects you from even bigger losses.

Stop losses aren’t perfect. You could get stopped out of a position only to watch it reverse and head higher, for example. But these orders take the emotion out of your trading decisions.

Third, don’t forget about inverse ETFs. Martin and I have been talking for a long time about inverse and double-inverse exchange traded funds. These ETFs RISE in value when the underlying indices FALL. You can target broad indices, like the S&P 500, or you can target specific sectors, like Real Estate Investment Trusts (REITs). Our favorite ones have surged in value during this recent market decline.

Fourth, use options to hedge if you can. How can you protect yourself against a real crash for a relatively small cost? By buying put options. Put options give you the right — but not the obligation — to sell a stock, ETF, or other investment at a specified price before a specified expiration date. The value of that right surges in value when the underlying investment falls.

Naturally, the opposite is also true — if the markets rally sharply, the value of those put options will decline. So would the value of any inverse ETFs. But as I said at the outset, I think we’re in for a 1998-style rout … and that means further declines are likely.

Bottom line: These are dangerous times — and you should take steps to protect yourself.

Until next time,

Mike

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