by Archie M. Richards, Jr.
November 12, 2007

What happens when companies write off bad loans, as they're doing now?

Nothing happens. The write-offs are just bookkeeping entries.

Here's what has happened: The federal government set policies intended to help low-income people own homes. Thus encouraged, mortgage companies didn't work too hard checking whether applicants could handle the debt. Homeowners took out second loans to cover the downpayments. For the first two years, the mortgages required payments of interest only at enticingly low rates.

With these mortgages in place, the mortgage companies sold them to investment bankers, like Morgan Stanley. The investment bankers created bonds by bundling together many similar mortgages, and they sold the bonds to financial institutions worldwide.

With homeowners paying interest only, the mortgage balances increased. But the home values declined, pulling the values down below the mortgage balances.

The interest rates on these mortgages are now rising substantially. For this and other reasons, many (not all) homeowners can no longer handle the payments. The mortgage companies are foreclosing and putting thousands of homes on the market.

The defaults mean that portions of the bonds held by the financial institutions won't be paid off. But with so many foreclosed homes still unsold, no one knows what the bonds will eventually be worth. Therefore, no one is willing to buy them now. The buying and selling of mortgage bonds has come to a halt.

The investment bankers and financial institutions are conservatively estimating the eventual losses on their mortgage bonds and writing off the estimated losses against current earnings.

But good news is buried amid the bad:

• The total losses won't be nearly as bad as the Savings & Loan crisis of the early-1980s. (That crisis was also brought on by the federal government encouraging banks to lend. Financial crises are almost always caused by faulty government policies. The actual long-term results of big-government policies are usually opposite to the intended results.)

• Eventually, the losses on the mortgage bonds will probably be less than current estimates. Future earnings will therefore be higher than expected.

Okay, but meanwhile we're seeing panic selling of stocks with high trading volume. The market is telling us something: Panic selloffs are the only occasions when you can be reasonably sure that the next move will be up.

If you have cash for investing, buy stocks now. If you're already invested, hang on.

We're probably in a recession now. But recessions aren't officially identified until after they begin. Sometimes, they aren't identified until after they've ended!

The news be damned; panic selloffs are the best time to get in (or stay in) the market.

An investment company analyzed twelve down markets from 1945 to 2004. During the first year of recovery on each occasion, the S&P 500 Index (not counting dividends) gained an average of 32.5 percent.

• When investors waited in cash during just the first week of recovery, the gains for the entire first year fell from 32.5 percent to 24.3 percent.

• When investors waited in cash for three months before getting back in, the first-year gains fell to only 14.8 percent.

Cutting your return from 32.5 percent to 14.8 percent (17.7 percent reduction) is too much profit to forfeit.

Stock prices move before the reasons for the move become known. By the time you become aware of bad news, the prices have already fallen. By the time you become aware of good news, the prices have already risen.

Say the news turns bad, as it's been doing. You sell, and you breathe a sigh of relief when the prices fall a little more.

But while in cash, the losses you prevent when the stocks fall are less than the profits you don't earn when the stocks subsequently rise. In other words, the profits lost on the upside are greater than the losses prevented on the downside.

Hold stocks throughout. You're better off.

During panic selloffs like the one occurring now, hang on to your stocks. If you have cash, buy 'em.