EP 9 | PROTECTION IN A FINANCIAL MELTDOWN

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Hosted by
ANDREW LANOIE

Hey everyone, before we start today’s episode, I just wanted to give a heartfelt thank you to everyone who’s been following the show and reaching out with your questions. If you have any specific topics or questions that you’d like covered, please send an email to team@theimpatientinvestor.com.

Here’s a few questions for you. When a public company suffers a financial meltdown, what are the ripple effects? What are the different levels of exposure among the varying investors in holders of financial instruments? To predict the impact of a future financial meltdown you only have to look back at some of the recent financial disasters to have an idea of how the next debacle will play. Possibly the most high-profile fallout from the financial crisis of 2008 or the subprime crash was the bankruptcy of Lehman brothers at the time, the fourth largest investment bank in the US. Lehman brothers had been around since about 1850 and was assumed to be too big to fail or so we thought. Lehman’s financial meltdown was the direct result of its heavy involvement in subprime mortgages. A subprime mortgage is a type of loan. Typically granted to individual with poor credit scores, let’s say 640 or less, and often below 600. As you can imagine, there’s a large amount of risk associated with any subprime mortgage. As a result of their deficient credit histories would not be able to qualify for a conventional mortgage often with better interest rate in terms, there’s some great movies out there that cover this crash, including the big short margin call and too big to fail. The ripple effects from Lehman’s failure were not local, but global in scope. And were largely credited with kicking off the global financial crisis. The only parties who got paid from Lehman’s carcass, were its creditors. With assets worth $639 billion, and debts totaling $768 billion employees and shareholders were left with nothing.

The personal and emotional toll from Lehman’s meltdown was catastrophic. From the 26,000 employees who lost their jobs to Lehman’s investors who shares literally bottomed out to everyone else who saw the retirements and net worth plummet with the market. Unlike the emotional toll, the impact on the global financial markets was way more quantifiable. The collapse affected the public in a broad spectrum of ways, depending on the types of financial instruments they held. Let’s look at the various instruments, held by consumers that were affected to get an idea of how each group was impacted.

The first is public equities. The public equity markets are based on public securities that stocks, derivatives and hybrid securities. Equity derivatives, including futures, options, and warrants facilitate hedging transactions. Hybrid equity securities include convertible bonds and bonds with equity warrants. Besides the various classes of equity, derivatives and hybrids directly issued by Lehman, that became worthless, the effects on the general public equity markets were far reaching. Lehman’s failure shook wall street to its core. Immediately the Dow plummeted 504 points. The equivalent of over 1300 points today. Some $700 billion vanish from retirement plans and other investment funds. Credit markets dried up affecting cash strapped companies like GM, who couldn’t even get short term funding. In 2009, general motors and Chrysler corporation declared bankruptcy.

In March of that year the Dow Jones plummeted to its lowest level of just under 6,600, the decline of more than 50% since 2007 and the unemployment rate hit 10%. Retirement accounts tied to the financial markets fell sharply. Lehman is not the only recent high-profile bankruptcy. Before Lehman there was Enron and WorldCom. What the stockholders received in those cases was the same thing Lehman stockholders received, absolutely nothing, not even an apology from the CEOs and CFOs that ran those businesses into the ground and those guys went to prison.

Now let’s look at debt securities. Debt securities, including commercial investments and treasury instruments offer a fixed rate of return, often touted as a safer investment than equities. Commercial debt instruments can include bonds and bond derivatives such as bond futures. Options on bond future, interest rates swaps, interest rate caps and floors and interest rate options and government offerings, including treasuries short and long-term. Like annuities guaranteed returns on commercial bond offerings are only as good as the companies backing them. During the financial crisis many cash strapped companies unable to obtain credit from a restricted market were unable to meet their obligations under these instruments. Because government treasuries are largely uncorrelated to the broader market, investors flocked the safe returns offered by treasuries.

In the best-case scenario, bond holders from failed public companies would get a portion of assets since the company secured creditors and creditors with priority liens would have first dibs. In Lehman’s case corporate bond holders received 10 cents on the dollar. In the worst-case scenario, bond holders receive nothing. Mutual funds, which are professionally managed investment funds, including open-end funds like ETFs, unit investment trusts and closed end funds pull money from investors to purchase securities and are directly tied to the public equity markets. 401ks in public pension funds heavily invested in public equities, mirrored the downward spiral of the public markets.

If you hold mutual funds invested in a failed company, the value of the mutual fund will undoubtedly plummet. That’s why in the case of 401ks and pension funds invested in mutual funds that were in turn invested in failed companies like Lehman and Ron and WorldCom, employees took a huge hit to their retirement accounts. Despite being touted by the insurance industry as a secure investment, annuities are not immune from economic meltdowns. Variable annuities are tied to market indexes and during the great recession, these annuities were pummeled by the markets, even fixed annuities, which offer guaranteed rates of return are only as good as the insurance company issuing them.

The guaranteed returns are worthless if there is no insurance company around to pay them. If not for a government bailout, just weeks after the Lehman bankruptcy AIG, one of the nation’s largest insurers would have certainly followed in Lehman’s footsteps.

In the worst-case scenario, you would receive nothing if the insurance company behind the annuity went bankrupt. Similar to savings accounts, certificates of deposits or CDs are insured money in the bank in virtually risk-free, but only up to the maximum FDIC insured amount of $250,000. Like annuities and commercial paper, CDs are only as good as the bank offering them. Did you know, Lehman brothers operated Lehman bank that offered CDs? With the collapse of Lehman, any CD over a $100,000, which was the FDIC limit at the time were paid pennies on the dollar in the bankruptcy. Today in the worst-case scenario, if a bank failed, the most you would recoup is the $250,000 insured amount.

Money market accounts offered by banks for interest earning savings accounts are often used as safe havens during a recession. These accounts have a higher rate of interest with a higher minimum balance, typically ranging from about a $1,000 to $25,000. Like CDs, money market accounts are FDIC insured and are generally considered safe investments up to that FDIC limit. In the worst-case scenario, you would be able to recoup up to $250,000 or the FDIC insured amount.

Unlike the accounts I’ve just discussed, money market funds are not FDIC insured. A money market fund is kind of a mutual fund, but only invest in highly liquid cash and cash equivalent securities that have high credit ratings. Also called a money market mutual fund. These funds invest primarily in debt-based securities, which also have a short-term maturity of less than typically 13 months and offer high liquidity with a very low level of risk. Although they sound relatively safe, money market funds are not immune to crisis. Money market fund aims to maintain a net value of at least $1 per share, in any excess earnings that get generated by way of interest received on the portfolio holdings are distributed to the investors in the form of a dividend payment. Occasionally a money market fund may fall below the $1 net asset value, a condition which is described by the term breaking the buck. This occurs when the investment income of a money market fund fails to exceed its operating expenses or investment losses, if any.

In the history of the money market dating back to 1971 less than a handful of funds broke the buck until the 2008 financial crisis. In 2008
However, the day after Lehman brothers filed for bankruptcy, one of the market funds, the $62 billion reserve primary fund felt a 97 cents after writing off the debt it owed that was issued by Lehman. This created the potential for a bank run in the money markets. As there was fear that more funds would quote unquote, “break the buck.” if not for government intervention, the financial pressures from the great recession would have caused a run on the financial markets. There is no guarantee that absent government intervention, a run will be prevented in the future causing money market funds to lose value. Because money market funds are not insured in the worst-case scenario, you would lose all of your money.

FDIC insured savings accounts are considered one of the safest investment options to consumers. In the case of a bank failure, in the worst-case scenario like CDs and money market accounts, you would recoup the FDIC insured amount of up to $250,000. An investor can get an idea of their level of protection from future financial meltdowns, simply by comparing the type of financial instruments they’ve invested in and how these instruments fared in the last financial crisis. Public equities in the various institutions invested in public equities like 401ks and pension plans are the most exposed and offer the least amount of protection in a meltdown. In the worst scenario, you can lose everything. At the other end of the spectrum of protection are government debt instruments like treasuries that are considered to be the safest form of investment backed by the full faith and credit by the United States government. In the unlikely scenario that the government goes bankrupt your government treasuries are safe. Next to the government treasuries are FDIC insured bank products, which offer a fair amount of security, but not a 100% security. As these investments are only insured up to $250,000. In the worst- case scenario, you lose everything, but the $250,000.

Then there’s everything else in between including commercial bonds, annuities, and money market funds. The bottom line is without the backing of the full faith and credit of the federal government or government backed insurance, every other financial project has full exposure and you risk losing everything in the worst-case scenario. To prepare for the next financial meltdown, look no further than the most recent disaster.

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Episode 9