What's happening in the stock market?

With the stock market down almost 10 percent since the beginning of the month, Lehman going bankrupt and the "bail-out" people want answers, but nobody is explaining what's happening in a way that makes sense. Understanding these unprecedented events will help you plan the future financial needs of your business. To understand what's happening you have to understand what financial institutions (banks) like Lehman and AIG were doing during the real estate boom and bust cycle. The real estate boom was driven by the creation of complicated financial instruments that were supposed to reduce the risk of lending money for banks. These financial instruments we're going to call "stuff" because the how and why of their creation is too complicated for this article. Because this "stuff" was supposed to reduce the risk of lending money, banks started lending money like crazy. Without much surprise this led to an increased demand for housing and the creation of a lot of this "stuff". Basically, underlying all this "stuff" is mortgages. Mortgages are pretty simple financial instruments, a bank lends someone money to buy a house and in return gets a stream of payments to repay the loan plus interest. Usually banks are happy to lend mortgages because underlying mortgages are houses, so if you stop paying your mortgage the bank can sell your house and get their money back. Unfortunately, when the housing market slowed down the banks suddenly couldn't sell the houses to get their money back. Eventually, banks realized this "stuff" was no longer worth the original amount of the mortgage and started the write-down process at the end of 2007. A write-down means they had to change the value of the loans on their books to reflect the current value. If they had a $300,000 loan on a house worth only $280,000 they wrote the loan value on their books down from $300,000 to $280,000. This could have been the end of the financial crisis except for two things; mark-to-market accounting and greed. If banks just accepted facts and took whatever was offered for their "stuff" they would have lost money, but probably would have survived. Instead they refused to accept the prices offered to them because underlying this "stuff" is mortgages and most are still receiving payments. Let's go back to the house example, maybe by now you've realized your house isn't worth $300,000 but think it's worth $260,000 and wish you had taken the $250,000 a year ago. Plus, now you're renting the house for $2,000 a month but the best offer you get is only $60,000. What would you do with an offer four times less then you think the house is worth when the house is generating $24,000 a year in rent? This is the decision faced by financial institutions. They collectively owned so much of this "stuff" that no one was willing to pay anywhere near what they wanted (not to mention there aren't that many buyers with $2 or $3 trillion to pay their prices). They could have made the tough decision and sold as much of this "stuff" as they could at .20 cents on the dollar ($60,000/$300,000=.20), but who would do that. Instead they thought they could hold out until they got better prices, but there was no one left to offer them better prices because everyone was in the same situation. Now they can't pay the bills with just the mortgage payments coming in and they can't sell this "stuff", even at 20 cents on the dollar, because everyone who can buy it knows they have to sell it or go bankrupt. Banks are left without any choices accept to go bankrupt or take whatever price someone is willing to offer. The good news about this situation is all this "stuff" still has value. Remember, underlying all this "stuff" is mortgages and underlying all the mortgages are houses. Whatever these houses are worth is what all this "stuff" is worth. Unless the houses are worth 20 cents on the dollar from a year ago or a $300,000 house is now worth $60,000 whoever buys this "stuff" is going to make money. However, the only way to make the money is to hold the "stuff" until all the mortgage payments are made or the market returns to normal and you can sell it. You have to have enough cash that you can just hold the "stuff" without having to sell it. That's where Lehman and AIG and all the others got into trouble...they had to sell it to meet cash flow needs but didn't so now they are forced to sell in bankruptcy. Much like if you didn't pay your mortgage for a few months, but the house was worth more then the mortgage...the bank would still come in and sell your house out from under you for whatever they could get for it. And this selling would lower the prices of all the other houses in the neighborhood. Just like the selling by these financial institutions is lowering the prices of all the other stocks. The ripple effect of the selling spreads to all aspects of our economy and affects your business. This credit crunch extends beyond the real estate market and small businesses need to know that just like homeowners who can no longer get loans to buy the same houses they could a year ago, business can't get the same loans to finance their daily operations or growth. During these times you need to verify you can get financing for your business before you make decision that require financing. It's no different then home buyers during the real estate boom; they didn't need preapproval for a loan before finding a house because almost anybody could get a loan for almost anything. Now, you have to get preapproved just to have an idea of who much you can get. Small businesses in particular need to be proactive in finding out how much financing is available to them and in securing that financing as early as possible. Banks are still in the lending business and need to make loans to make money, but you need to better anticipate your needs and get the money early. Big business is going as far as maxing out their lines of credit to raise cash in case those lines of credit are not available in the near future. Small businesses that are financed through lines of credit or home equity loans (HELOCs) may want to consider doing the same thing. Many of these types of loans are being frozen so no additional cash can be withdrawn. If you have access to any types of credit that you regularly use or are planning to use it may be a good idea to take what cash out you can now. Make sure there are no big penalties or ridiculous interest rates. Ideally you want opportunities like a HELOC costing 4.99 percent a year where you can take the money out and put it in a savings account paying 3 percent so you're actually cost of holding the cash is only 1.99 percent a year (less then inflation and in real dollars it's a free loan). 2008-09-24T15:22:59Z

2008-09-27T20:45:07Z