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Evaluate Tight Credit-Market Risk

With the credit markets tight, if not stuck completely, it’s important to evaluate each of your stocks for credit risk. Here’s why.

As you probably know, the credit market problems stem from bad mortgage loans that were bundled and sold to all sorts of investors, including corporations. As a result, some corporations holding bad loans failed. The seeming unpredictability of those failures, in turn, made investors reluctant to lend money to anyone.

These events can affect your stocks in two ways.

First, they may hold risky investments on their balance sheets that will eventually have to be marked down. Such markdowns would, at the very least, sink a firm’s share price.

Second, the tight market will make raise the cost of borrowing for corporations as well as for individuals. The resulting higher debt servicing costs will pressure corporate profits. In the worst case, lack of available credit could force companies to cut back on expansion, or to even scale down current operations.

There is no website or report service available for looking up these types of risk for individual stocks. You are on your own. You have to do it yourself. Here are my ideas for checking on the risk of your stocks.

Industry Risk
You don’t have to consult a website to know that banks are still risky business. Although many have already been hit hard by bad credit write-offs, nobody knows how many shoes are left to drop. Further, the sagging economy will undoubtedly trigger credit card losses. Thus, U.S. banks are all inherently risky from a balance sheet perspective. Some, but not all foreign-based banks may be an exception. They are not as exposed to home mortgage and credit card issues as U.S. banks.

Insurance companies typically invest billions of policyholders’ dollars in the stocks and who knows what else. Since securities backed by subprime or otherwise risky residential mortgages were originally termed “investment grade” by the rating agencies, it’s reasonable to assume that many insurance companies put money there.

Debt Refinance Risk
Firms that rely on debt to finance their operations must eventually refinance that debt. As already mentioned, firms that refinance now will likely incur higher debt servicing costs. The resulting cut in earnings would pressure share prices.

The debt/equity ratio, which compares debt to shareholders equity (book value), is a widely used debt gauge. A zero ratio means no debt, and the higher the ratio, the higher the debt.

You can see the debt/equity ratio on many financial sites. On Yahoo (finance.yahoo.com), get a price quote and then select Key Statistics. Find “Total Debt/Equity MRQ” under Balance Sheet. You’ll probably be okay with ratios under 0.5, but lower is better (MRQ means as of the Most Recent Quarter).

Balance Sheet Risk
Firms that generate cash over and above what they need to run or grow their business usually put the excess cash into relatively safe investments such as money market funds or Treasury Bills. That cash typically appears as “cash equivalent” funds on the balance sheet.

However, some firms put excess cash to work in riskier investments that are listed on the balance sheet as short- or long-term investments. Most don’t specify those investments in much detail in those reports.

Since, as mentioned earlier, mortgage-backed securities were originally rated investment grade, it’s possible that short- or long-term investments listed on a corporation’s balance sheet may include problematic mortgage-backed securities. Such assets are likely to be marked down, which, as mentioned earlier, would likely to sink a firm’s share price.

Finding Balance Sheet Data
You can see your stock’s balance sheet on Yahoo by selecting Balance Sheet on the Financials menu. Select Quarterly Data to see the latest quarter’s numbers.

Compare the total of short- and long-term investments listed on the balance sheet to the current assets, which includes cash and items likely to convert to cash within a year such as inventories and receivables.

In most instances, not all short- and long-term investments listed will have problems. As a rule of thumb, consider balance sheets where the current assets exceed the total of short- and long-term investments as relatively low-risk. However, once short- and long-term investments significantly exceed current assets, you’re getting into risky territory.

To put these numbers in perspective, as of June 30, 2008, insurance giant AIG, which was taken over by the U.S. government, listed short- and long-term investments totaling $904 billion compared to only $95 billion of current assets. Investment banker Lehman Brothers, which recently filed bankruptcy, on its May 31, 2008 balance sheet, listed short- and long-term totaling $564 billion vs. $61 billion of current assets (not counting short-term investments).

Still Recession Risks
These guidelines will help you avoid stocks at risk of suffering from balance sheet meltdowns and from unexpected debt servicing issues triggered by tight credit markets. However, that doesn’t mean that you’ll make money on stocks passing these tests.

For instance, most tech stocks are cash rich and don’t access the credit markets. But that doesn’t mean that a recession-induced slowdown in computer or cell phone sales wouldn’t sink their share prices. Caution should be your watchword.

published 9/28/08

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