Protection in a Financial Meltdown

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When a public company suffers a financial meltdown, what are the ripple effects?

What are the different levels of exposure among the varying levels of investors and holders of financial instruments? To predict the impact of a future financial meltdown, one only has to look back at some recent financial disasters to have an idea of how the next disaster will play out.

Perhaps the most high profile fallout from the Financial Crisis of 2008 was the bankruptcy of Lehman Brothers, the fourth largest investment bank in the U.S. at the time. Lehman Brothers had been around since 1850 and was assumed to be too big to fail – so we thought.

Lehman’s financial meltdown was the direct result
of its heavy involvement in subprime mortgages.

The ripple effects from Lehman’s failure were not localized but were 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 immeasurable – from the 26,000 employees who lost their jobs to Lehman’s investors whose shares bottomed out to everyone else who saw their retirements and net worth plummet with the market.

Unlike the emotional toll, the impact on the global financial markets was more quantifiable. The collapse affected the investing public in a broad spectrum of ways, depending on the types of financial instruments they held.

Let’s look at the various financial instruments held by consumers that were affected by the meltdown to get an idea of how each group was affected.

Public Equities

The public equity markets are based on public securities (stock, 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 equities market were far-reaching.

Lehman’s failure shook Wall Street to its core.

Immediately, the Dow plummeted 504 points, the equivalent of 1,300 points today. Some $700 billion vanished from retirement plans and other investment funds. Credit markets dried up, affecting cash-strapped companies like G.M. who couldn’t even get short-term funding.

In 2009, General Motors and the Chrysler Corporation declared bankruptcy. In March of that year, the Dow Jones plummeted to its lowest level of 6,594, a decline of more than 50 percent since 2007, and the unemployment rate hit 10 percent. Retirement accounts tied to financial markets fell sharply.

Lehman is not the only recent high-profile bankruptcy. Before Lehman, there were Enron and Worldcom. What the stockholders received in those cases was the same thing Lehman stockholders received – nothing – not even an apology from the CEOs and CFOs that ran those businesses into the ground. Those guys went prison.

Debt Securities

Debt securities including commercial instruments and treasury instruments offer a fixed rate of return often touted as safer investments than equities. Commercial debt instruments can include bonds and bond derivatives such as bond futures, options on bond future, interest rate swaps, interest rate caps and floors, and interest rate options.

Government offerings include 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 to the safe returns offered by treasuries.

In the best case scenario, bondholders from failed public companies would get a portion of assets since the company’s secured creditors, and creditors with priority liens would have first dibs. In Lehman’s case, corporate bondholders received 10 cents on the dollar. In the worst case scenario, bondholders receive nothing.

Mutual Funds

Mutual funds, which are professionally managed investment funds including open-end funds (e.g., ETFs), unit investment trusts, and closed-end funds, pool money from many investors to purchase securities and are therefore directly tied to the public equity markets. 401(k)s and 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 is why in the case of 401(k)s and pension funds invested in mutual funds that were in turn invested in failed companies like Lehman, Enron, and Worldcom, employees took a steep hit to their retirement.

Annuities

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.

Certificates of Deposit

Similar to savings accounts, CD’s are insured “money in the bank,” and thus virtually risk-free up, 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 CDs over $100,000 (the FDIC limit at the time) were paid pennies on the dollar in 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

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

Money Market Funds

Unlike money market accounts, money market funds are not FDIC insured. A money market fund is a kind of mutual fund which invests only 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 have a short-term maturity of less than 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. A money market fund aims to maintain a net asset value (NAV) of $1 per share. Any excess earnings that get generated by way of interest received on the portfolio holdings are distributed to the investors in the form of dividend payments.

Occasionally, a money market fund may fall below the $1 NAV, a condition which is described by the term “breaking the buck.” The situation 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 money market fund, the $62 billion Reserve Primary Fund, fell to 97 cents after writing off the debt it owned that was issued by Lehman. This created the potential for a bank run in money markets as there was fear that more funds would 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 could lose all your money.

Savings Accounts

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 $250,000.

An investor can get an idea of their level of protection from future financial meltdowns by comparing the type of financial instruments they’re invested in and how these instruments fared in the last financial crisis.

Public equities and the various institutions invested in public equities like 401(k)s 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 the safest form of investment backed by the full faith and credit of the United States government. In the unlikely scenario that the government goes bankrupt, your government treasuries are safe.

Next to government treasuries are FDIC-insured bank products, which offer a fair amount of security but not 100% security as these instruments are insured only up to $250,000. In the worst-case scenario, you lose everything but $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 product 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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