Today at TILE… Tight Markets

March 9th, 2009

Today at TILE we talked about what happens when credit markets “tighten” – when investor fear leads to a “downward spiral”. A healthy economy is characterized by investors who trust the information they receive and want to “put their money to work” (or invest money rather than hide it away). In contrast, in a “seizing” or “frozen” market, investors don’t trust what companies say, aren’t sure of the rules of the game, and are afraid surprises will decrease value. All of these characteristics and fears are in the market right now.
Wall Street Journal: New Fears as Credit Markets Tighten Up

Here are some examples:

- Lack of Trust in Information. In order to make good investment decisions, you need to know the information you are using is good information. For example, if a Company said there was $10 in cash on the balance sheet, but then says, “oops, we really only have $2 in cash on the balance sheet” you would think twice about whether the company is a good investment. Similarly, when credit rating agencies change their mind about the credit ratings (or measure of the ability to repay debt) they publish, it makes investors question whether they can trust the information necessary to make investment decisions. If you can’t trust the information, sometimes there is a preference not to make any investment – or “Freeze”.

- Questioning the Rules of the Game. Investors are also questioning the rules of the game. Some basic “rules” mentioned in the article include: 1) bond holders have first claim on the assets (e.g. they get first dibs over equity holders if something goes bad); and 2) the government has protected bondholders. If those rules change, either in practice by the government or in courts, it would create a lot of confusion. For the most part, investors like consistency, not confusion – otherwise could choose to do nothing/not invest.

- Watching Values Decrease. When investors are uncertain and choosing not to invest, this sends prices or values down. For example, GE’s bonds are trading at 63.5 cents on the dollar because people don’t know whether the bonds will be paid back – the more uncertainty about the health of the company, the lower the price. Another way to think about it, the more uncertainty, the higher the interest rate an issuer/company must pay. That is what the article refers to as a “spread” – the greater the spread between Treasury bonds (which are considered risk free because they are guaranteed by the US Government)or LIBOR rates (a well known benchmark) and the bond (e.g. Junk Bonds have a 19 point spread) the greater the perceived risk.

So what does it mean for the TILE Community? Well, the concern is that the viscous cycle will impact you in different ways. First, it can hurt the value of your portfolio. If you bought a GE bond for 100 cents on the dollar and now it is trading at 65 cents on the dollar, your portfolio is worth less. What you thought you bought may be different than what you own. Second, continued fear will make investors less likely to invest in the market. If you are trying to get a loan or a mortgage, banks or lenders will be less likely to trust you (e.g. they are risk adverse). You are still a great person but people just trust you less.

What can be done? As the article points out, it is important for the government to set the “rules of the road” and NOT change them. At present, it feels like there are new rules every week. While the intentions are good, investors and business people need consistency so if the rules constantly change they are more likely to sit on the sidelines (e.g. freeze up). How would you feel if you played soccer and every time you ran down the field the referee changed his/her definition of a foul? At some point you may just stop playing!

Relative to TILE, go to GROW and take a moment to look in the Fixed Income or Bond portion of your portfolio. Do you recognize all the names? If you do a news search on them what does it tell you? If you look at a price chart of the yields are they moving quickly in one direction or another? If you have any concerns about any of the names, Ask Your Advisor their opinion. The more you know about what is in the portfolio the more informed investor you will be!

- Amy

Amy Butte is a co-founder of TILE Financial. TILE stands for The Investing Learning Environment – an online community where young people go to develop their financial identity around Spending, Growing and Giving their money.

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