Dominos keep falling. It started with Bear Stearns, then Fannie and Freddie got bailed out. Then came Merrill Lynch and Lehman, and then another bailout. This time AIG, followed by rumours of other merger deals.
It’s strange to watch one of the most laissez-faire administrations in U.S. history resort to hard-core Keynesianism to prevent a key economic sector from falling. But that’s what the situation calls for. At the very least, liquidations must be orderly. Pragmatism trumps.
Who could have predicted such a sea change in a few short months? A lot of people, actually. Not the specifics, mind you, but the trend.
Alan Greenspan’s infamous comment on irrational exuberance is nearly a decade old. Five years ago, central bankers started expressing concerns about excessive housing price gains, and that people who didn’t seem creditworthy were being given mortgages on high-cost homes. A year ago, the warnings about dodgy mortgage-backed investment vehicles emerged—with everyone in the financial sector forwarding a YouTube link of a British comedy routine mocking the investments’ architects. Nobody’s laughing now.
Plenty of advisors have also been calling for a correction, with a figure of 20% being tossed around. The only question, once the mortgage-backed securities and ABCP news broke, was when the other shoe would drop. We got our answer.
In the early light of the aftermath, I talked with some advisors about what the shifts mean to their practices. First and foremost, they say it calls into question the metrics used to determine client risk tolerance. As one fee-planning veteran put it, "A lot of people who confidently said they could take a 20% hit without freaking out, are now freaking out."
So, what’s the solution? It’s clear, regardless of what they say on account opening forms, that investors really want a 10% return and no risk—or at least no capital loss.
That fundamental reality contains the key. When push comes to shove, everybody needs a cushion. Banks are living to fight another day, and buying some of the world’s oldest investment houses at fire-sale prices, because they have the capital.
Your clients need the same thing, so start bulking some cash into their portfolios in the event a third shoe drops. It’s the pragmatic thing to do.