We saw today the effects that a tsunami in the south pacific can have on a civilization, which can be devastating. My heart goes out to these people and I pray that the people affected will be ok. Much like this tsunami has had a crushing and devestating impact on people’s lives in Samoa, the financial tsunami now known as the great recession is currently upon us all. The factors that caused this recession were like the earthquake that caused the tsunami. Once the earthquake happens, that wave is coming at you no matter what. And there is nothing anyone can do to stop it.
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.
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.
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.