From the November 2007 issue of Wealth Manager Web • Subscribe!

Panic Prevention

If any economic environment could put the theory of the "rational economic man" to the test, surely this would be one. At the end of the second quarter of 2007, the rate of loans entering foreclosure had jumped 41 basis points from a year earlier to 1.40 percent of loans outstanding, according to the Mortgage Bankers Association (MBA). Much of the increase was due to borrowers who were unable to handle reset rates on adjustable-rate mortgages, the MBA indicated. What's more, according to the National Association of Realtors, the index of pending home sales dropped 16 percent between July 2006 and July 2007. As upsetting as these statistics are, have they affected widespread investing behavior?

According to theory, rational economic men (and women) would not let the volatility in the housing and mortgage markets unduly influence their investment strategies. Instead, they would continue to prudently buy, hold and sell based on their long-term financial goals and the opportunities available.

So, has the theory held up? At first glance, it might not seem like it. After hitting 14,000 in July, the Dow Jones Industrial Average fell below 13,000 just one month later. Many investors appear to have been spooked by the mortgage mess and the money troubles besetting Countrywide Financial Corporation, one of the country's largest mortgage lenders.

To be sure, while well-heeled investors are unlikely to default due to adjusted mortgage rates, it would be hard for anyone to completely ignore the upheaval in the mortgage market. Even deep-pocketed individuals who are seeking new mortgages--particularly jumbo mortgages--have encountered some bumps in the road, says Cal Brown, vice president of planning with The Monitor Group in McLean, Va. "They're having a little more difficulty getting jumbo mortgages or trying to structure loans so that they qualify for conforming loans."

Some lenders are requiring down payments hefty enough that even larger mortgages come in under the $417,000 limit for conforming loans, or those that can be sold to Fannie Mae or Freddie Mac, Brown notes. To make the down payments, some clients liquidate portions of their equity portfolios which, of course, can lead to capital gains and higher tax bills. Or, if they sell fixed income assets, most have to rebalance their portfolios to return to an optimal debt-to-equity split. "You look at the alternatives and see what's more palatable," says Brown.

A few lenders are changing loan terms right up to the closing date, says David Michael, a mortgage banker with American Mortgage in Minneapolis. "Until then, they can say that they're not doing the loan under the (previous) terms."

At the same time, some wealthier individuals are concerned about any exposure they may have to the sub-prime debacle in their investment portfolios, Brown notes. (He adds that Monitor restricts its short- and intermediate-term bonds to AA or better). Others are worried that the crisis will dampen stock returns for the long term.

The potential for greater familial obligations comes into play as well. "Some clients are wondering if they'll have to support their kids' mortgages," says Ross Levin, president of Accredited Investors in Edina, Minn.

For the most part, however, wealth managers say that their clients are taking the mortgage upheaval in stride. "We've been impressed with how they're handling this," says Steven W. Medland, partner and principal with TABR Capital Management LCC in Orange, Calif. "For now, fortunately, clients see this as a temporary issue."

For most clients, the tried-but-true advice of "stick to your plan and don't react to bumps in the market" is appropriate, says Karen Altfest of L.J. Altfest & Co., in New York. In August, Altfest sent each client a letter, noting that she and her colleagues were watching their accounts, and that their portfolios were on "solid ground." Calls from worried clients eased up.

Of course, some clients--in truly rational fashion-- are looking at the opportunities available as a result of the mortgage upheaval, Levin points out. For instance, those who had been considering the purchase of a condominium or vacation home are finding some great deals now, given the inventory currently available and the attractive prices. "For clients who are thinking about second homes and vacation property, I think it's a better time (to buy) versus a year ago."

To be sure, not all investors have been able to put their concerns aside. One particularly worried client of Medland's wanted to sell his entire portfolio. While Medland and his partner talked at length with him, reinforcing the idea that he needed to take a long-term view, he was adamant. In the end, they significantly reduced his stock holdings. While that wouldn't work for most people, he had extensive assets, yet led a frugal lifestyle. "This was an exception," Medland says. "But, it was affecting his health."

In most cases, however, wealth managers are countering any inclination their clients may have to panic and act rashly--exactly the opposite of what "rational economic man" would do. "Some of our greatest value comes in preventing clients from doing certain things, versus convincing them to do certain things," Medland observes.

Karen Kroll, a former financial analyst, has written extensively on a variety of business topics.

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