Turning Point Financial

The Perfect Storm – Part 2

This is part 2 of a 3 part series on a discussion the contributing factors to this major recession that we are currently in.  Personal financial planning is all about understanding the risks that you face, and then taking steps to avoid or protecting yourself against those risks. You can read Part 1 Here.

In the previous post I discussed Globalization, Low Savings, Cheap Money, and Deregulation.  In this post I will cover Derivatives, National Debt, Declining Dollar, and Bank Leverage.

Derivatives

A derivative is a financial instrument that is derived from some other asset, index, event, value or condition (known as the underlying asset). Rather than trade or exchange the underlying asset itself, derivative traders enter into an agreement to exchange cash or assets over time based on the underlying asset. A simple example is a futures contract: an agreement to exchange the underlying asset at a future date.

Derivatives are often leveraged, such that a small movement in the underlying value can cause a large difference in the value of the derivative.

Wall Street geniuses came up with a way to use derivatives to trade almost anything.  They came up with derivatives for all these mortgages that were flooding the market, and people started trading them like crazy.  The investment banks who were creating these instruments were making money hand over fist, and so were the investors who were buying them.  At least for a time.  One problem was that most people didn’t really understand how they worked, and how risky they really were.

National Debt

Under President Reagan our National debt reached the $1 Trillion mark, which seemed pretty scary at the time.  Today it’s just over $11 Trillion.  Most people can’t even comprehend how big a Trillion dollars is.  Just to put it in perspective: $1 billion dollars is a thousand millions.  $1 trillion is a thousand billions.  It really is hard to put your mind around how big that really is.  Our country produces enough goods and services that our national debt is not unaffordable.  But we can afford it right now because interest rates are so low.  China currently owns about 20% of that debt (in the form of T-Bills and other U.S. Treasuries) and Japan owns another 20%.  46% of it is owned by Americans.  So it’s not really the size of the debt that concerns me, becase relative to our income as a country, we can currently afford it.  But if interest rates were to jump up, the interest alone on that debt could crush us financially.  The interest alone on our national debt currently makes up about 20% of our country’s budget.  If interest rates went back up to 6%, our interest payments would double!  This is like an individual having an adjustable rate mortgage on their house, and they are at the mercy of current market rates, and they can’t really refinance!  Now think about this, if you own stock in a company and you see that the company is starting to amass a lot of excess debt, what will you likely think?  You will become concerned that they may not be able to pay back all that debt, and you may consider getting rid of that stock.  Right now, China and Japan are looking at our situation and saying, “I wonder if they are goign to be able to pay back all that debt?  Do we really want to hold onto this debt?”  And what happens when everyone starts selling or trying to get rid of something?  That’s right, the value of it goes down.  And when the value of a bond goes down, the interest rate goes up.  So our level of national debt has us in a very precarious position.

Declining Dollar

A weak dollar does have some positive things that can help stimulate an economy.  When the US dollar is weak, it costs less to buy things here in the US.  This can stimulate the purchase of US goods, foreign tourists coming here,  and people coming here to go to college.  But there are downsides too.  Oil is traded in US dollars, so having a weak dollar is likely to make the price of oil go up as other countries buy up the oil with their more valuable currencies.  It also makes businesses here vulnerable to hostile takeovers by foreign buyers.  But the biggest risk ties back in to our interest rates.  A weak dollar and low interest rates go together.  If the dollar stays weak, eventually foreigners are not going to want to buy our debt at such low interest rates.  This will mean that interest rates will have to go up so that they will buy our debt.

Bank Leverage

With all the money being made by the banks writing all those mortgages, they got greedy.  They started to over extend themselves by writing more mortgages than they should have written, and even lending out their reserves.  As we already discussed, many of these loans were NINJA loans (No Income, No Job or Assets).  Real estate appraisers got in on the NINJA loan action by appraising houses for more than they were really worth so that even people with bad credit could get 100% financing to buy houses.  Some banks would pressure the appraisers to appraise a house at a certain value or else they wouldn’t send them any more business.  When things started to turn south in the real estate markets, speculators just walked away from properties.  They owed the bank more than the property was worth, so they would just leave the keys on the counter and walk away.  Many banks have already gone under.  As of today, 94 banks have failed in 2009 and been taken over by FDIC, with many more on the way.  Commercial real estate loans haven’t even hit the fan yet.  Credit card defaults are still growing.  And car loan defaults will be the last thing to bring up the rear.

Come back soon to see the last part of this 3-part series!

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