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The crisis in the U.S. financial industry and the plunge in the U.S. dollar is a combination far more damaging than either alone. U.S. stocks and bonds and the dollar are being pummeled by a perfect storm -- and the damage is far from over.
Here are the problems investors face and five strategies for riding out the turbulence.
By themselves, the huge financial-industry write-offs would be enough to send those stocks plunging and the stock market reeling. Each day brings new bad news. On Nov. 7, for example, Morgan Stanley (MS, news, msgs) announced it had lost $3.7 billion on just one subprime investment.
Financial stocks are in a full-scale bear market: Sector Select SPDR-Financial (XLF), an exchange-traded fund based on the stocks in the Standard & Poor's Financial Index, dropped 21% from May 31 through Nov. 8. Any loss greater than 20% puts you smack-dab in bear country.
By itself, the plunge in the dollar would be enough to send the U.S. financial markets reeling. Against the euro, the dollar is down 9% this year, through Nov. 9, and down a startling 19% against the euro since the beginning of 2006. The story against the currencies of other U.S. trading partners is just as bad or even worse. For example, the U.S. dollar is down 19% against the Canadian dollar just this year. That kind of plunge has made overseas investors and central banks think twice about holding U.S. dollars and hesitant to invest in U.S. stocks and bonds.
Why investors are wary
What's going on? Two things, both deeply unnerving to investors.First, because the debt securities that Wall Street constructed out of the raw materials of buyout loans, mortgages, and credit card and auto loans are so complex, it is taking a long while for everyone to figure out exactly who is on the hook for what. Wall Street banks made loans to other Wall Street companies so they could buy debt paper from still other Wall Street investors who had borrowed money from still other Wall Street players to buy that debt in the first place.
Unlike the stocks and bonds that you and I buy, most of the debt instruments involved in these transactions were structured just for those particular deals. So each one differs on such currently critical issues as who has to extend financing and to whom when trouble strikes.
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And second, since much of what everyone bought and sold doesn't trade very often, if at all, there are no established market prices for these derivatives. They've been carried on Wall Street's books at prices calculated by internal computer models that give the owners a great deal of discretion about what their portfolios are worth.
When an investor is forced to sell, however, there is suddenly a market price for that piece of financial paper, and portfolio after portfolio across Wall Street has to mark that paper to market -- almost always these days at a huge drop from the price calculated internally.
- Discuss with Jim Jubak: What's the best way to profit from the falling dollar?
Under the circumstances, no one wants to buy or sell these debt derivatives. Buyers don't want to buy because they don't know what the derivatives are worth. Sellers don't want to sell because any sale will trigger a markdown in the value of any part of the position that remains in the portfolio.
The Fed to the rescue, sort of
With nobody buying and nobody selling, whole sections of the debt markets have seized up. Investment and operating companies can't roll over their short-term commercial paper. Banks can't sell debt derivatives to raise money to lend. Mortgage lenders and home builders can't find buyers in the debt markets for the mortgages they've made, so their money remains tied up in existing mortgages.The Federal Reserve has to ride to the rescue by injecting new money into the financial system -- so that lenders will have money for borrowers to borrow -- and by lowering interest rates so that some of the pressure comes off hard-pressed debtors, ranging from homeowners facing foreclosure to hedge funds that had borrowed to buy debt derivatives.
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Jubak's Journal: Invest like the ChineseLooking to make some money in a falling stock market without too much risk? Follow the flow of dollars from Beijing as China invests in commodities, says MSN Money's Jim Jubak.
Though the Fed can't really fix the problem by making money cheaper and more available, it can buy time for buyers and sellers to regain confidence in the accuracy of the prices for these packages of debt.
Continued: What's driving the dollar down
TAGS: U.S. DOLLAR - BEAR MARKET - DEBT MARKETS - TIPS FOR INVESTORS
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