Financial Crisis HelpLine, Part 3

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November 18, 2008

QUESTION: Over the past 11 months, my 401(k)'s value has been cut in half. With the way the market is today, does it make sense to withdraw my 401(k) funds and pay off the $62,000 I still owe on my home, as well as other outstanding bills? Once we've paid off our debts, I'd start investing in the 401(k) again.

—Al Gaskins

ANSWER: Withdrawing money from your 401(k) can prove to be a big mistake. Not only will you get hit with a 10% penalty, but you'll also have to pay taxes on that amount. Say you're in the 25% tax bracket and you decide to withdraw $62,000 to cover the remainder of your mortgage. By the time the penalty and taxes are paid, you'll only have some $41,000 left — nowhere near the amount you owe on the house, says Kim Snider, CEO of Dallas-based Snider Advisors, an SEC-registered investment advisory firm.

And while it's scary to watch the Dow lose hundreds of points in a day and your 401(k) balance get decimated, there is an upside: By continuing to contribute money into that account, you're now buying shares at much cheaper valuations. This is known as dollar-cost averaging and it can prove very beneficial in beaten-down markets. Once the market rebounds you will have more shares in your account to take advantage of those gains. Pull out now and you'll lose out on them, says Snider.

One last thing: While most people like the idea of living a debt-free life, paying off the mortgage may not be the best choice. For the most part, mortgages are considered "good debt" since they tend to carry lower interest rates than say, credit cards or auto loans. It's best to concentrate on those higher-interest obligations first.

QUESTION: I need to rebalance and increase my exposure to bonds/Treasurys. Some bond funds have done well this year. Is it too late to invest in these funds?

—Jim Stafford

ANSWER: Investing in bonds can be tricky. Are you interested in government or corporate? High yield or investment grade? Taxable or tax free? The list goes on. That said, it's wise — and never too late — to rebalance a portfolio. Assuming you have straightforward savings goals and are buying to hold, low-cost and diversified bond funds offer a practical counterweight to stock holdings. One of the best mutual funds of its kind is Vanguard Short-Term Bond (VBISX), up 3% year to date. (Compare that to the 40% plunge in the S&P 500 index.) It's dirt cheap, best in its class over the past decade, and holds a mix of high-quality Treasury, corporate and government agency debt.

If you're confident enough to try your hand at individual bonds, a good place to start is TreasuryDirect, a government-run web site that allows individual investors to purchase Treasury bonds, Treasury Inflation-Protected Securities (TIPS) and savings bonds. Prices for all manner of bonds, from munis to corporates, can be researched at the web site of FINRA, a nongovernmental securities regulator. In most cases you'll need to contact a broker to purchase individual bonds trading on the secondary market. While not for the faint of heart, columnist James B. Stewart recently made the case for investing in the bonds of Goldman Sachs (GS), which are yielding 8% or more, a reflection of the added risk that they carry.

November 17, 2008

QUESTION: My husband was transferred for work, and we're having a difficult time selling our old home. We've tried everything — from reducing the sale price to offering it for rent. We qualified to hold both mortgages, but realize that our home may take months or years to sell/rent and the money for the old home payments will eventually run out. What are the most serious ramifications of foreclosure? And if we end up in foreclosure, will it impact our ability to get college financial aid for our kids when they go off to school?

—Anonymous

ANSWER: If you can, try to avoid going into foreclosure. On average, a person who forecloses on their home will see their credit score drop by 300 points, says Danielle Babb, a real estate analyst. And that black mark won't be wiped off their credit record for seven years, she says.

Also, going into foreclosure will make it very difficult for you to take out any new loans, say, for a car or a home equity line of credit or home equity loan. In most cases, lenders will deny you outright and the offers you do get will almost certainly come with high interest rates and fees. Credit-card issuers, too, will jack up your interest rates, or worse, discontinue your account.

Foreclosure also makes parents ineligible for the Plus loan — a loan that can cover a year's worth of college costs. Undergraduate freshmen and sophomores whose parents are denied a Plus loan for any reason (including foreclosure) do become eligible for $4,000 more per year in unsubsidized Stafford loans, however. (Juniors and seniors can get $5,000 more per year.) But that's little consolation, especially considering that private student loan lenders will almost certainly turn you down as well. The only way a student will get approved for a private loan is if they can offer a creditworthy adult as a co-signer.

QUESTION: I own more than 8,000 shares of Wachovia (WB) common stock. What will happen to it when the merger with Wells Fargo (WFC) takes place? Will the dividend continue?

—Mariane Schaum

ANSWER: This merger's been a pretty brutal one, and it's not quite finished. It took a while for Wells Fargo and Citigroup to settle which of them would acquire the battered Wachovia, and Wells Fargo finally won the day early last month. Under the merger agreement, Wachovia shareholders will get 0.1991 Wells Fargo shares – about a fifth of one share — once the merger is approved by stockholders. That vote hasn't been scheduled yet, but a Wachovia investor relations representative says it will happen before the end of the year.

That means 8,000 Wachovia shares become 1,592.8 Wells Fargo shares, which isn't a great payoff for current shareholders. When weighed against Wachovia's huge losses and 87% drop in its stock price over the past year, it's still better than nothing.

The Wachovia dividend, now at five cents a quarter, will become Well Fargo's dividend, now at 34 cents. Morningstar analyst Jaime Peters calculates the future dividend at 27 cents a quarter on a pro-forma basis, once the dilutive effect of the Wachovia shares is factored in. That means the $400 quarterly payout for 8,000 Wachovia shares becomes about a $430 payout for freshly minted Wells Fargo shareholders. A special dividend, sometimes paid before a merger takes effect, isn't likely.

"You're actually a little better off," she says. "I hadn't thought of it that way yet, but it's true."

One thing investors should bear in mind is that Well Fargo has lined up with other banks to get federal bailout funds, a move most participating financial institutions felt they had to make. Peters reminds shareholders that by taking federal funds, Wells Fargo can't boost its dividend without government approval.

November 13, 2008

QUESTION: I have a variable rate mortgage that is due to reset at a fixed rate in April 2009. Currently, the mortgage is worth more than the property and I'm concerned that the fixed rate will result in substantially higher monthly payments.

—Anonymous

ANSWER: Unfortunately, there may be nothing you can do to avoid the switch to the fixed rate. You could try to refinance the loan. But, due to the credit crunch, banks aren't as willing to refinance — especially to homeowners who don't have any equity in their property.

Another possible solution is to ask the lender for a loan modification, which could lower the interest rate and principal and bring the monthly payments down. Banks, however, typically reserve modifications for consumers who've experienced a hardship, such as a temporary job loss or medical problem, and are already delinquent on payments, says Justin Pane, vice president of Amerimod Modification Agency, a Uniondale, N.Y., company that specializes in loan modifications. And, in some cases, lenders will rework the terms on a loan if the homeowner is at risk of falling into delinquency. Banks will not, however, modify a mortgage simply because a consumer doesn't want to make a higher monthly payment, even if the property has fallen in value, Pane says.

For more on mortgage solutions, read our story.

QUESTION: I own preferred stocks in Morgan Stanley (MS), Bank of America (BAC) and a few other companies. Do my preferreds come in line ahead of the preferred shares the federal government will receive from these companies in exchange for bailout funds?

—Walt Carter

ANSWER: This probably isn't the answer you were hoping for, but no. Under the terms of the Troubled Asset Relief Program (TARP), your preferred shares come in line after those held by the federal government.

But that doesn't necessarily make preferred shares, which function more like a bond than common stock because they pay fixed dividends, a bad investment. In the event something catastrophic happens to a company, preferred stockholders generally get paid off ahead of common stockholders, though there's no guarantee remaining assets will be enough to make anyone whole. But then again that's why preferreds pay higher fixed dividends: You're being compensated for the risk.

November 12, 2008

QUESTION: My house went into foreclosure this June. I had a second mortgage that was transferred to a debt collection agency that is still calling me. What are my options?

—A. Singh

ANSWER: Before you do anything, consult a local real estate attorney. Foreclosure laws vary greatly by state so it's difficult to provide exact advice.

Generally speaking, many consumers are not responsible for paying the difference between the balance on their mortgage and the amount their home sold for in foreclosure. In California, this is also the case if the homeowner took out two mortgages (a first and a second) to buy the house, says Gabe del Rio, vice president of lending and homeowners for Community HousingWorks in San Diego, a nonprofit housing and counseling agency. If a loan balance was wrongly sent to collection, a real estate attorney can help remedy the situation.

However, in some states, consumers are responsible for what's called a "deficiency judgment," or the difference between what a home sold for and the outstanding balance on the mortgage. So if a homeowner took out a second mortgage — say you refinanced the home or took out a home equity line of credit — then the lender often has the right to go after at least some of the money that is still owed them, even after the foreclosure process, says Stephen Elias, author of "The Foreclosure Survival Guide."

QUESTION: I'm a 22-year-old with a small amount of savings and am dying to invest ASAP! I hope to invest in mutual funds like Vanguard 500 Index (VFINX). What discount broker would you recommend?

—Michelle Tsao

ANSWER: SmartMoney's annual broker survey is the place to shop for a discount broker. It compares everything from commissions and fees to research and trading tools to customer service offered by a wealth of brokers. Once you've settled on the best broker for your own personal situation, SmartMoney's mutual fund center can help you craft an intelligent, efficient investing strategy.

Meanwhile, you might be burning to invest your stake immediately but going all in at once isn't necessarily the best idea. While you might get lucky and time the market perfectly, odds are you won't. Putting money to work a little at a time at regular intervals, a strategy called dollar-cost averaging, is a better bet because it reduces the risk of buying at a market top.

November 11, 2008

QUESTION: In June I invested $450,000 in a balanced portfolio. As of recently I'm down to $307,000. I don't live off this money and it's strictly an investment. However, my concern is this rate of loss. My advisor said I can move to ultra-conservative or conservative portfolios; however, he would advise against that, since my recovery period would take longer and yield less. Thoughts?

—Shirley Chitjian

ANSWER: Your alarm is understandable. A big chunk of money you invested in June has shrunk by nearly a third in five months. That's the kind of result one expects from a casino, not from something as prudent-sounding as a "balanced portfolio." Now you're agonizing over two seemingly bad choices: selling, and thus finalizing a giant loss, or holding on, thereby taking a chance that the loss will worsen.

This is likely little consolation, but your June investment was merely unlucky, not unwise. Nothing in your question suggests you picked bad investments. Your returns match all too well with those other investors have experienced. Stocks, on which your balanced portfolio is partly based, really do produce handsome returns over long time periods. Over short ones, they can and sometimes do lose value. Rarely, perhaps once in a few generations, they produce the kind of stunning loss you've just experienced.

Consider a couple of things before deciding what to do next. First, it's never a good idea to hold an investment just because you want it to "come back." June's price matters far less than whether the things you own today are worth today's price. Historically speaking, stocks are fairly priced right now relative to measures like company profits, company asset values and dividends. That's not to say stocks can't go lower or stay cheap for a long time. They can. But if your stocks resemble the broad market, they're likely paying a dividend yield of more that 3.5% right now that you can reinvest, since you don't live off the money. That's as much as a bank certificate of deposit pays, with the added potential for long-term growth once world economies improve. Ask yourself, if you had started with $307,000 in a savings account, and had avoided the market's recent plunge, would you now invest in the portfolio you own with the thought that you're buying low? If so, stay put.

Second, your advisor's "ultra-conservative" portfolio likely keeps your principal ultra-stable in the near term but offers an ultra-skimpy return over the long term. Such investments can be called safe only if you hold them for a short time. Over many years they can be risky, the risk being that your money doesn't grow as fast as the rate of inflation, and that your buying power is gradually reduced.

QUESTION: I've been noticing that the U.S. equity markets can be having a good day, then during the last 10 minutes they plummet. I've theorized this is the result of some sort of computerized trading that kicks in late in the day so as not to influence the market prices until they are ready to trade. Am I right?

—Jim Pierce

ANSWER: The late-session plunges that now characterize so many trading days begin around 3 p.m., when brokerage houses send out their margin calls. That means traders who've bought stocks with borrowed money have to come up with the cash, or sell off in order to pay up. Recently, Merrill Lynch cut the interval for its margin calls from five days to two, shortening the window for a trade to be profitable. It's a normal feature of stock trading, but this isn't a normal market, says Ed Yardeni, president and chief investment strategist at Yardeni Research. "I think it's that simple, though you also get a lot of wishful thinking at the beginning of the day," he says.

Barry Ritholtz, chief executive and director of research at FusionIQ, says that while margin-call rules vary from firm to firm, the unwavering attitude of margin clerks does not. Traders get calls once the value of their positions drops below a certain percentage of what they've borrowed — say they bought $200 worth of stock, putting up $100 of their own money and borrowing $100. A 30% drop would prompt a margin call, and no amount of explaining will change the margin clerk's question: "Did the money hit?" When he worked at another brokerage, Ritholtz overheard one clerk's timeless response to a trader's tale of woe: "You've confused me with someone who cares."

Yardeni says market jitters mean the 3 p.m. to 4 p.m. window will see more activity. "When people are this twitchy, they don't want to be worrying about their positions overnight. I think that last hour is when key decisions are made."

November 10, 2008

QUESTION: With the cost of housing so low, I am considering refinancing and potentially buying rental property. I have an excellent credit score and no debt besides my home. My questions are: Why are 30-year mortgage rates increasing so rapidly? And will this trend continue?

—Larry Athens

ANSWER: Mortgage rates remain fairly stable despite the Fed’s rate cuts and diminishing yields on the 10-Year Treasury. The 30-year fixed rate, for example, recently averaged 6.20%, as reported by Freddie Mac — down from 6.46% last week, but slightly higher than rates were a month ago. A number of factors are keeping mortgage rates high, the most salient being the high risk still involved in making and investing in mortgage loans, says Keith Gumbinger, vice president at mortgage information company HSH Associates. The economy is flagging, home prices are continuing to decline, and the asset quality of many existing loans are questionable at best. All that, combined with residual concerns about inflation, has long-term rates trending higher. Whether they’ll continue to climb and for how long is uncertain. But Gumbinger predicts that the 30-year rate will be in the upper-5%- to mid-6% range six months from now.

As for your prospects of landing a decent mortgage for an investment property, the risks that mortgage lenders take on with financing non-owner-occupied homes are somewhat compounded in this market: Since you don’t live there, lenders think you’re more likely to walk away if you can’t manage the mortgage, says Gumbinger. So be prepared for more restrictive loan conditions and terms.

November 7, 2008

QUESTION: I am interested in investing about $240,000 cash into some type of investment that would generate interest, which I could use to augment my income for the next five years or so. I want to preserve the principal yet use the income to eliminate some credit-card debt. Do you recommend any particular type of investment in order to accomplish this?

—David Dean

ANSWER: There's a wide range of income-generating investments including corporate, municipal and Treasury bonds, money-market and savings accounts, dividend-paying stocks, mutual funds and exchange-traded funds, and certificates of deposit. Since the return of your principal in five years is your biggest priority, stick to only the safest guaranteed investments. That eliminates corporate bonds, stocks, ETFs and mutual funds. (Money-market mutual funds are safe, but you can find higher yields elsewhere.)

Treasurys are rock-solid, as are savings and money-market accounts backed by the FDIC, but like money-market mutual funds, you can do better on yields. (The Federal Reserve's target on short-term interest rates currently stands at 1%, and it wouldn't come as a surprise to see that target lowered even further in a bid to spur economic growth.)

That brings us to CDs and munis. Banks, desperate for fresh deposits, are offering yields in excess of 5% on some CDs. Munis, meanwhile, are offering some staggering yields and in many cases have very low rates of default. However, munis are not risk-free, as their prices fluctuate on the secondary market and they require careful due diligence before purchase.

That makes CDs sound like a good option for you. The FDIC will back your CDs up to $250,000, but that coverage extends only until the end of 2009, at which point it returns to $150,000, so buy your CDs from more than one bank. One advantage to CDs is that your yield is locked in even if the Fed cuts rates, but since we're talking about a five-year time frame, you should consider laddering your CD portfolio. Similar to dollar-cost averaging, laddering offsets the risk of changing interest rates. It also lets you maintain access to some of your cash without incurring an early withdrawal penalty.

November 5, 2008

QUESTION: Like most Americans, my home's value is a lot less now than it was when I first bought it. Most bank web sites I've visited state that I'm not eligible to refinance because of the decrease in the value of my home. Is there something in this $700 billion bailout to solve this problem? Are banks willing to take a "pay cut" and work with us?

—Artur Topolszki

ANSWER: The government has taken some strides toward helping homeowners in the past several months. The aptly-named HOPE for Homeowners Act, which was passed by Congress in July, encourages lenders to refinance mortgages of borrowers who are at risk of losing their homes to foreclosure. One criticism of the plan: Lender participation is voluntary. However, according to HUD, more than 80 lenders have signed up for the program since it began on October 1.

Separately, the government is using part of that $700 billion rescue package you mentioned to buy bad mortgages from lenders and incite them to work with troubled borrowers through HOPE for Homeowners or other housing programs. In the case of a residential mortgage loan, these modifications may include a reduction in interest rates or of loan principal.

November 4, 2008

QUESTION: I am 56 and typically wait until the beginning of the year to decide how much to put into my Roth account for tax purposes. I know I can contribute up to $6,000. Do you think I should contribute now while the market is down, or wait and see how the market does after the beginning of the year?

—Bob G.

ANSWER: Deciding to go all in at once, be it now or at the beginning of 2009, is called market timing, a strategy that usually doesn't pan out. No one knows when the market will bottom. Investing everything in one big chunk only increases the risk that you'll buy high. In the past week alone the Dow Jones Industrial Average has swung 1,400 points. If you bought last Monday you would've gotten the Dow below 8200; today the Dow is above 9500.

A better strategy is dollar-cost averaging, an approach that calls for investing a set amount at regular intervals. For example, you could invest $1,000 in your Roth on the 15th of every month between now and April 15, the deadline for 2008 contributions. That way, even if you buy on a “high” day, the odds are you’ll also buy on a “low” day, which will even things out over time. Stick to that plan and you'll lessen the risk of buying at the top of the market.

QUESTION: What are the differences between money market funds and stable value funds?

—Gary Thorburn

ANSWER: Money market funds and stable value funds are among the most conservative savings options available to investors. The difference lies in how they are constructed.

Money market mutual funds are a regulated class of funds that hold "very high quality, very short maturity securities that can be easily liquidated," says Morningstar's Eric Jacobson. The rules that govern money markets allow sponsors to maintain them at $1 per share on their books, although as we saw earlier this year a money market fund can "break the buck" when it encounters a credit or liquidity problem. Some money-market deposits now carry the backing of the federal government. (Note that money market mutual funds are different than money market deposit accounts, which are offered by banks and brokerages and insured by the FDIC.)

The term stable value, says Jaconson, refers to investment pools "that seek to provide a relatively high level of income while maintaining a stable net asset value." The offerings pull this off by using guaranteed investment contracts, or GICs, that lock in a certain rate of return over a time period without price fluctuation. GICs are typically sold by insurance companies.

A more popular option, however, is to build a conventional bond portfolio that's coupled with an insurance "wrapper." The wrappers, says Jacobson, help managers maintain "a 'book value' price on the portfolio that remains consistent. If investors ask to have their money back at a time when the underlying holdings have fallen in price, the insurance companies stand ready to make up the shortfall upon redemption." Jacobson cautions that there were some controversies surrounding the accounting of these wrappers a few years ago. You can read his commentary here and here.

November 3, 2008

QUESTION: I am a "young" 77 years old and still working. Most of my assets are with a Merrill Lynch managed account. Investments are approximately 60% bonds and 40% stocks. Should I be selling stocks and reinvesting them in more secure assets? I worry about the tax hits if I do. At this time I do not need to withdraw Merrill Lynch money for living expenses but I do want to leave my children and grandchildren money. What should I be doing?

—Wilma Robins

ANSWER: Our first suggestion is to speak with your account manager at Merrill Lynch. You're paying a fee for his expert advice, and he should have the clearest picture of the specifics of your financial situation, including any unrealized gains and losses in your account that have tax implications. Even in a down market there are ways to get breaks from Uncle Sam on taxes.

Since you don't need the money now for living expenses, sitting tight rather than locking in losses is one option to consider. One reason stocks are falling is that large institutional investors are being forced to sell to meet redemptions and margin calls. That selling pressure will subside at some point. In addition many investors large and small are dumping assets based on fear rather than fundamentals.

Since you'll probably want to stop working eventually, ask yourself this question: Do you really have enough money saved up to last through retirement and leave to heirs? While moving into cash protects your principal, it doesn't guard against inflation. The 60-40 portfolio might not be the best fit for your goals, but it might just need a few tweaks vs. wholesale change. A good account manager can offer strategies for asset allocation and estate planning.

QUESTION: Will banks that receive government funds under the bailout plan have to cut their dividend?

—Susan Schweickert

ANSWER: The good news is there's nothing in the Treasury's Troubled Asset Relief Program (TARP) that requires banks to cut their dividends. The bad news is that many will have to cut them anyway.

Banks participating in the bailout are required to pay dividends on the government's stake before all others. Preferred and common shareholders have to get in line behind the feds. But that's not the biggest concern. "In my opinion the TARP money is not by itself going to lead to dividend cuts," says Jefferson Harralson, an analyst with Keefe Bruyette & Woods. "The recession is."

Banks vary greatly when it comes to cash flow and capitalization, but in general it's best to brace yourself for further dividend cuts. As Harralson points out, they were cutting them already. If you're counting on income from your equities, you might want to look beyond financial stocks. Start by checking out our recent stock screen looking for high, dependable yields.

October 31, 2008

QUESTION: A family member maxed out my credit cards to the tune of $55,000 in 2001. After trying to fight it out in the courts, I eventually stopped paying my balances. Now I only use one credit card and I pay the balance on it every month. Since it has been seven years since I stopped paying on all of the cards (except the one I keep current) how can I go about rebuilding my credit score?

—Jay

ANSWER: You'll need to tackle this in two parts. First, make sure those bad debts have disappeared from your report. Otherwise, they'll continue to weigh down your score. Under the Fair Credit Reporting Act, negative information falls off your credit report after 7.5 years, unless there's new information — say, one of your lenders sued to collect the debt — then the 7.5-year clock resets. (Check your state's statute of limitations to collect credit card debts here.) If there's data that should have — but hasn't – been wiped off your report, contact all of the major bureaus including Equifax, Experian and TransUnion, to request its removal, advises Gerri Detweiler, credit advisor for debt management site Credit.com.

With those bad debts near the end of their shelf life, rebuilding your score might not be as hard as you think. "Old information has less of an impact than recent activity," points out Detweiler. Aim to have four to five good accounts, either loans or lines of credit, reporting to the credit bureaus. Start with just one now, and then apply for another after six months or so. (Any faster, and you'll hurt your score.) If your score is already below 500 on FICO's 300- to 850-point scale, consider credit-building techniques like opening a secured credit card or applying for a small installment loan. As a final touch, sign up for a free account at CreditKarma.com to monitor your score's progress.