As the implosion of subprime mortgages and junk bonds causes uncertainty throughout the markets, advisors and broker/dealer executives may want to think about what’s in their clients’ portfolios. Whether sold to clients by you or another advisor, the impact of what’s happening in these markets will be felt the same way, and some would argue that it doesn’t matter if clients actually own CMOs or CDOs directly. Simply owning stock or bonds in a firm that owns, creates, services, or rates these securities may be enough to put a client at risk for portfolio damage. Certain bonds that are not directly linked to mortgage-backed securities or junk bonds could be affected as bond markets themselves are shaken. And what about mutual funds and ETFs? If financial services companies, banks, or insurance companies are an important sector holding, it would be wise to help clients understand exactly what their exposure is.
If clients own affected securities, directly or indirectly, because you have recommended them, it is your duty to mind the store. If a client holds them because of another advisor’s advice, and you help the client understand what she has, and what her options are, whether to sell, sit tight, or buy more, you will at the very least have a much better understanding of her overall holdings, and can be the hero for providing good guidance.
Part of the problem with the subprime markets is that the structures of the products are so complex and so opaque that even the experts don’t know how big the effects of this debacle could be. Robert Rodriguez, CEO of First Pacific Advisors (FPA), who has 36 years in the investment business, has a unique perspective on subprime because he runs both equity and fixed-income portfolios, and started vetting his bond portfolios two years ago for anything that was not “plain vanilla.”
In February, Rodriguez says, the Moody’s rating service requested new information to feed its models, which were not working; one of the new data fields is the borrower’s loan-to-debt ratio. Moody’s had not been using the fundamental loan-to-debt ratio in its rating models. He adds that on a March 22 conference call, the ratings agency Fitch said its model for rating subprime mortgage-backed securities depended on homeowners’ FICO scores and assumed continuing home price appreciation. When Tom Atteberry, a VP and portfolio manager at FPA, asked Fitch “What would happen to your model if housing price appreciation remained flat?” Rodriguez said Fitch responded by saying the model would begin to “break down.” And if house price appreciation went “negative 1% or 2%?” Rodriguez says in his March 31 shareholder letter that Fitch replied that its “model would completely break down.” As of press time Fitch had not provided IA with a recording of that call nor responded to IA’s request for an interview to verify that statement.