Today saw several “cracks” opening wider in a number of our large financial institutions. While still, I would say, unlikely, these cracks could literally lead to a meltdown in our financial system.

Those who have been clients for many years know that I do not usually seriously entertain such dire thoughts. There are always a group of investors and economists who see impending doom right around the corner. But I avoid hype, and I am an avowed skeptic when it comes to believing economic extremes are going to occur. This means I only believe such ideas when I begin to see hard data and some proof that the serious problems may indeed come to pass. They rarely do, usually occurring perhaps 1-3 times a century.

However, in the last few days, and today in particular, I began to see signs that our financial system may be in more jeopardy than I ever thought I would see in our economy. There is a reasonable chance that a number of large financial institutions could go under, possibly including Lehman Brothers, the fourth largest brokerage firm in the U.S., AIG, the largest financial company in the world, and Washington Mutual, one of the largest banks in the U.S. There is a chance that this could also bring down, at a minimum, a number of other companies: potential candidates include J.P. Morgan, Merrill Lynch, and Morgan Stanley. It is possible that this could happen quickly. Should this occur, our economy and markets would almost certainly plummet.

Four years ago I began to study the complex financial securities the major investment banks were creating out of pools of mortgages. At the center of the transactions were something called “Collateralized Debt Obligations,” consisting primarily of large groups of mortgages. The investment banks took these pools of mortgages and created a massive number of derivative investments. These are impossibly complex instruments linked in various ways to the mortgage (and other bond) pools. For every pool of mortgages, dozens or even hundreds of the linked derivatives were also sold.

While I cannot explain all this here, the short story is that these investments are in the process of exploding, i.e. becoming dangerously close to worthless. This is a huge problem, as the Wall Street firms hold massive numbers of them. For example, when Bear Stearns essentially went under a few months ago, they had up to 750,000 of these derivative contracts on their books. Even worse, if one of the major firms in this market goes down, they could bring down all the other players in this ill-advised scheme, as many of the firms are inextricably connected to each other through these derivatives.

The good news is that our economy will end up much stronger if many of our largest financial firms fail. In a free market economy, we actually need to get rid of companies so poorly managed that they would engage in such stupidity. And these companies will be replaced by those who have done and continue to do a good job. So while this is terrible news for those who own Lehman Brothers’ stock, which went down 45% on Tuesday, this may be great news for their competitor Goldman Sachs, as Goldman did not engage in any of the ill-advised activities Lehman undertook. As a result, coming out of this mess, Goldman will be able to grow and take over much of the market share left behind by inferior companies such as Lehman. The same can be said of a company like Bank of America, which most likely would not mourn the loss of Washington Mutual! But while the best companies will indeed profit by the turmoil we are experiencing, in the short term our economy may be in for some very difficult times.

As you might expect, at Secure Retirement we are taking action to make our portfolios safer at this time. Even though our investment accounts begin with safety at their core, this is indeed an unusually dangerous time that requires additional care and caution.

Richard Morey
President, Secure Retirement