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Rising Debt

But there are some signs looming out there that indicate that all the trouble may not be over.  One of the biggest signs of trouble is the amount of debt that the United States is accumulating at a rapid rate.  In the next year, the total debt held by the US government will rise to $12 trillion.  All the economic stimulus and the war in Afghanistan continues to fuel this burden.  As the trend continues, our dollar is worth less and less (because we keep printing more and more of them).  The largest holders of all this US debt (which is in the form of treasury bonds) are Asian and European countries.  Once these investors get tired of our fiscal irresponsibility and the low rates that our bonds are paying them, they will start heading for the exits.  As they start selling bonds, the values of the bonds will drop, and interest rates will rise.

How Soon Could This Happen?

The United States has a very large credit limit, so this is not likely to be something that happens very quickly.  But in the next three to five years, this scenario is very possible.  When it does happen, stock and bond markets will take a tumble, and interest rates, inflation and unemployment will rise to levels we haven’t seen in a few decades.

What Can I Do?

Fortunately there are some steps you can start taking to protect yourself from another financial meltdown, and it doesn’t involve putting your money in the mattress.  Stay tuned in the days to come for some personal financial planning ideas that could help you stay afloat if the economy starts to sink again.

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This is the last of a 3-part series in discussing the factors that have contributed to this great recession we are in.  You can view Part 2 Here. and you can view Part 1 Here. 

When doing personal financial planning, you have to take steps to prepare yourself for these types of economic situations.  They are sure to happen again in the future, and you can start preparing yourself now for it.  I would welcome any comments you may have about this topic.

Today I will discuss the last 3 factors that I feel have contributed to this current recession, which are:  Credit default swaps, unemployment, and the stock market.

Credit Default Swaps

This is something that most of you had probably never heard prior to this mess.  In my 15 years of personal financial planning, I had never heard of them until a few years ago.  A credit default swap is similar to an insurance policy that is supposed to protect the buyer from losing money.  A credit default swap (CDS) is a swap contract in which the buyer of the CDS makes a series of payments to the seller and, in exchange, receives a payoff if a credit instrument (typically a swap or loan) goes into swap (fails to pay). Less commonly, the credit event that triggers the payoff can be a company undergoing restructuring, bankruptcy, or even just having its credit rating downgraded.

There are some differences between a CDS and real insurance though.  With insurance, the buyer of the policy typically has some insurable interest such as owning the debt that he is insuring.  With a CDS, the buyer doesn’t even have to own the security.  Sellers of CDS’s do not need to be regulated entities, and do not have to keep reserves to pay off buyers.  However, major CDS sellers are subject to bank capital requirements.

One of the largest sellers of CDS’s was AIG, and they were selling a lot of them that were designed to insure against losses in mortgage securities.  When the mortgages started to blow up, everyone was coming to AIG to get paid, and they couldn’t pay them.  They didn’t have enough money to pay everyone they had sold them to.  You all know how the government stepped in to bail them out and cover their losses with tax payer dollars.

Unemployment

This is always a part of a recession, as businesses struggle and close up shop, people lose jobs.  As they lose jobs, they have less money to spend.  Since most of our economy stands on the back of consumer spending, more businesses start to struggle.  Then more businesses start to make cutbacks, and more jobs are lost.  It’s a downward spiral that won’t stop until things finally hit bottom and equalize.  In August 2009, the unemployment rate rose to 9.7% with 14.9 million people being unemployed.  Since this recession started in December 2007, the number of people who are unemployed has risen by 7.4 million and the unemployment rate has risen 4.8%.  So this is obviously affecting a lot of people, and you can see why there is so much less money being spent by consumers.

Stock Market

Some people may think that the stock market crashing causes recessions to start, and that recoveries make them end.  While there is definitely a correlation to the performance of the stock market and the economic cycles, the market doesn’t really cause recessions to start or end.  I would say that instead, the stock market is a good indicator of where we are at in an economic boom or recession.  There is certainly a relationship between the two.  The stock market peaked in November 2007.  When markets near high points, you might be surprised to know that those are the times that more people are adding new money into the market.  Stock mutual fund in-flows usually peak at about the same time that the market is peaking.  And when the market bottoms out, that’s when most people are taking money out of the market.  That’s just the time that you should be putting money back in.  But psycologically, it’s very difficult for someone to sell their stocks when they’re hitting highs, or buy them when they’re hitting lows.

This peaking out of the stock market in late 2007 was just another sign that a big correction was coming.  And there was nothing that anyone could do to stop it.

People ask me all the time, “Mark, why is it that when I buy something it goes down, and when I sell it, it goes back up?”  It’s really very strange how this happens to almost all individual investors.  This is one major benefit to hiring a professional money manager to help you manage your investments.  That person can take a lot of the emotion out of the investment process which helps them to do the opposite of what your gut tells you to do.  As the market hits highs, your advisor can take profits and rebalance your portfolio to protect money that you have made.  Then, when the stocks decrease in value, he or she can add more money to them at the the time when you should be buying more.

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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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Globalization

The North America Free Trade Agreement (NAFTA) went into effect on Jan 1, 1994.  This was an agreement between the United States, Canada & Mexico that was meant to open up trade between these countries.  The idea of this globalization was that if we bought products from Mexico we would raise their standard of living, and eventually they would all start buying more products from us.  While this agreement did increase trade between the countries, the long term effects have been somewhat damaging to us.  Currently we buy as a country about $1 Trillion in goods per year from other countries, and we sell about $200 Billion of our good to them.  That’s a trade deficit of about $800 Billion per year.  Why is this?  Because we don’t really have anything to sell to them.  Everything is now made in other countries like Mexico, China & India where labor costs are so much cheaper.  Why would they buy things from us when they already have it, and they make it, and it’s cheap.  This has made our country very dependent on other producing countries for goods that we need.  It has also weakened us financially.

Low Savings

Currently the United States is the richest country in the world, but we have the lowest personal savings rate in the world.  In China the personal savings rate is 30%, in Japan it’s 16%, and Germany saves about 12%.  Up until 1989 our savings rate was 11%.  Today we are at -1%.  That’s right, people are spending  ALL of their income and then some every year.  Because of inflation, today’s wages are the same as they were 20 years ago.  Yet our standard of living has increased dramatically.  How is that possible?  Today about 90% of couples under the age of 50 have both spouses working.  We’ve also been using home equity, credit cards, and our savings to maintain our standard of living.

It used to be that people set up sinking funds to pay for purchases like new cars, vacations, Christmas, etc.  They would set aside a little money into their separate sinking fund account each month so that when it was time to go on the vacation the money was there.  Today, people just put it on the credit card or get a loan for it, and then make monthly payments on it (with interest).  This lack of savings has made our country very vulnerable to financial crisis.

Cheap Money

The Federal Reserve started making it very easy to borrow money when they reduced interest rates to near zero levels.  This was an effort to “prime the pump” and get money flowing, and it worked.  Banks were able to borrow money from the government at 1% interest rates, and then lend it back out in the form of home mortgages at 5 – 6% rates.  They were making money hand over fist, and Wall Street was getting flooded with mortgages.  So many mortgages in fact, that something had to be done to deal with all of them.

Deregulation

During this same time there was much less reguation going on in the banking industry.  With a lack of regulation, many banks got greedy and started giving loans to people who really shouldn’t have had them.  People got really good at falsifying loan documents in order to get a loan.  This is where the NINJA loans started to run wild.  NINJA stands for No Income, No Job or Assets.  Here’s how they worked.  Lets say a person comes in looking for a loan to buy a house and they have an income of $5,000 per year.  The mortgage officer might have said something like, “Well lets just put an extra zero on the end of that income and make it $50,000, since a zero isn’t worth anything anyway.”  “And you don’t have a job, you just watch TV all day?  Let’s put down that you’re an entertainment executive with Dish Network.” and so forth.  These were the kinds of people who the banks were lending out cheap money to on a daily basis.  Can you see how this was setting us up for the big crash?

Look for “The Perfect Storm – Part 2″ for more on this topic.

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I agree that there are a lot of things about the current health care system that need to be changed.  There are currently not many incentives in the system to keep costs in check. 

Example #1.  Doctors today are scared to death of being sued, and for good reason.  Because of that, they practice defensive medicine to protect themselves.  They prescribe extra tests and proceedures that are not really medically necessary, but will cover their rear ends in the event of a future law suit.  This makes sense to me.  But on top of that, the more tests and proceedures they perform, the more money they make.  So it helps them in two ways to practice defensive medicine. 

Example #2.  A mother goes in to the doctor to get my child’s ear ache checked out.  She pays her co-pay of $15 or $30, and that’s all she has to pay.  Her affordable health insurance plan pays for the rest of it.  Or at least it’s now between the health insurance company and the doctors office to work out how much they will pay.  But to that mother, she really doesn’t care what it costs because it doesn’d directly impact her.  She just wants to make sure she gets good care for her sick child.  In the long run it does impact her as the health insurance premiums go up every year based on everyone’s claims.  But for today, she’s not having to pay anything but her co-pay.

The only party in the health care realationship who does care what things cost is the insurance company.  They are doing everything they can to control costs every day.  If the doctor and the patient were also incented to do the same thing, this wouldn’t be such a big problem.  But in the current health care system, there is no incentive for anyone but the insurance company to control costs.

If you need to find an affordable health insurance plan for your family, visit www.TurningPointBenefits.com today.

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Today Washington announced that the U.S. will run a $9 trillion defecit over the next 10 years, $2 trillion more than it had forcasted earlier this year.  That’s a 28% increase in their estimate of a few short months ago!  Washington also predicted that our nations unemployment rate will rise to over 10% for a period of months and quarters sometime in the next year and a half.  Right now the jobless rate is at about 9.3%, so they expect it to climb somewhat higher.

While it is quite normal to let government spending balloon during economic recessions (in order to help stimulate the economy) these numbers are far greater than we’ve ever seen in our country’s history.  And it looks like it could take a while to climb out of this hole we’re in.   One major contributor to our huge deficit is the amount Medicare is spending each year for health care.  This administration hopes to help slow down Medicare spending with its health care overhaul, but many are concerned about the effects it may have on the quality or availability of health care that they recieve.  Cuts to Medicare means that doctors who care for Medicare patients will get paid less, or fewer proceedures will be covered.  This will cause doctors to no longer want to treat Medicare patients, and/or cause the patients to have to pay for more things out of pocket.  Many seniors are worried that they won’t be able to afford the care that they will need.  This is going to make having a good Medicare Supplement policy even more important.

To read more about this go to the Wall Street Journal online. 

If you haven’t changed your spending and saving habits already, now is a great time to start.  Since it could be a number of quarters before we start to see the unemployment numbers start to improve, we all need to be putting away some extra cash for a rainy day (or an unemployed day).  While spending less isn’t going to help stimulate the economy, we need to all worry more about taking care of ourselves and our families.  Our government is doing a fine job of spending plenty of money.

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By JON HILSENRATH

JACKSON HOLE, Wyo. — Central bankers at the Federal Reserve’s annual retreat in the Grand Tetons are breathing easier about the outlook for the global economy than just a few months ago.

As he spoke, the latest bit of good news was released: Sales of existing homes in the U.S. jumped 7.2% in July, the fourth straight rise. European Central Bank Chairman Jean-Claude Trichet echoed Mr. Bernanke’s remarks, saying it was “almost miraculous” that financial officials around the world moved as quickly as they did after the shocks of September.

But Mr. Bernanke cautioned that “strains persist in many financial markets” and that “the economic recovery is likely to be relatively slow at first, with unemployment declining only gradually from high levels.”

Stanley Fischer, governor of the Bank of Israel and a prominent macroeconomist, emphasized the uncertainty that lingers. “Much remains to be done, not least in bringing banking systems back to health, and there are good — though not conclusive — reasons to fear a substandard recovery,” he said.

Three economists from the Bank for International Settlements, the central bankers’ central bank based in Basel, Switzerland, said at the conference that it could take until the second half of 2010 before output in some of the economies most affected by the financial crisis returns to precrisis levels. Some economists at the meeting thought that too optimistic.

Signs of economic recovery put central bankers in a delicate position: They must pull back from their rescue programs and raise interest rates in time to avoid inflation but not so soon that they kill the recovery in its infancy.

The atmosphere in Jackson Hole was palpably less tense than the previous two years. Mr. Bernanke flew in Thursday and set off on a hike with Fed Vice Chairman Donald Kohn, Fed governor Kevin Warsh, a security detail and Fed staff.

Last year, Fed officials spent most of their time at Jackson Hole in a makeshift command center, plotting how to respond to the crisis. The command center is ready at this meeting but hasn’t seen much use.

Mr. Bernanke said the multitude of Fed programs launched since last year’s collapse of Lehman Brothers has diffused the panic. When finance ministers and central bankers from the world’s biggest economies committed to not allow any other big financial institutions to fail in October, he said, it proved to be a “watershed” event that helped to turn short-term credit markets toward recovery. He credited other programs — such as an effort to restore issuance of debt securities backed by auto loans and credit-card debt — with helping to revive some markets.

“History is full of examples in which the policy responses to financial crises have been slow and inadequate, often resulting ultimately in greater economic damage and increased fiscal costs,” Mr. Bernanke said. “In this episode, by contrast, policy makers in the United States and around the globe responded with speed and force to arrest a rapidly deteriorating and dangerous situation.”

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