Archive for the 'financial crisis' Category
Having just settled in to the reality of ScrapperMom’s layoff, we learned this week that our tenant for the last year will not be renewing his lease. Assuming that ScrapperMom gets no new work and that it takes us at least a month to rent the apartment, this leaves us with 38% less income in December than in November. The only thing keeping us even next month will be the raise that I got last month. This means that all of our savings and discretionary spending has gone to zero in the upcoming budget month.
Thankfully, we have planned well, and have an emergency fund that can get us by for quite a long time under the present circumstances. Having just received that raise, there is no reason to expect that my job is not secure for some time to come. Though with a paying down low interest debt in favor of boosting our savings and emergency fund. We are still overpaying a couple of our loan accounts, and while it’s not by much, I may still have to bring these down to the minimum payment until our income rises again.
I’m glad that I have resisted the urge to invest given the down market. While a great long term opportunity, this would have tied up cash that we may need to have available in a long term investment.
I wish that we had made it a priority to increase our savings sooner, despite the fact that we still have some debt. This would have given us more confidence and breathing room in the current economy to know that we can weather the storm.
I wish that we had not bought an alligator. We’re now feeling more stuck than ever, and I’m amazed out how quickly our fortunes have turned.
We’re not ruined yet, so we’re going to be looking for new ways to trim our expenses. Many of our recurring expenses, like our Netflix or DirecTV plans can be trimmed by $5 or $10 per month. Two months ago I would not have thought that this would make much difference, but now that every dollar matters so much more it may be worth doing. On the flip side, we’ll be looking to stir up new business in the form of a new tenant, as well as looking for ways for ScrapperMom to bring in some new engineering work, or perhaps investigate some new opportunities.
Have you or your families been affected by the economic downturn? Do you have any ideas for us to trim our expenses or boost our income? Let us know what you think in the Comments Section below!
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With the recent market turmoil, there has been a lot of talk in the press and even around the water cooler about the nature of risk. Most people seem to understand that investing in the stock market is risky. They also understand that the more risk one takes, the greater the possible upside and downside of the investment. What many don’t seem to understand is what, exactly, is risky about investing in the stock market as well as how risks can be mitigated.
A great book on this subject is A Random Walk Down Wall Street by Burton G. Malkiel. This book details, for example, why a well diversified stock portfolio is less risky than a single stock. Malkiel shows that it takes a minimum of 20 to 30 stocks across a number of asset classes to provide sufficient diversification for a typical investor. For example, if one holds the 30 companies in the Dow Jones Industrial Average, a typical market cycle might have Coca-Cola announce a new product offering which boosts its stock price, while 3M announces layoffs. These types of stock movements are offsetting and are generally the reason why a diversified portfolio is less risky than individual stocks.
A diversified portfolio is still exposed to “systemic” effects on the market — effects that are spread across the whole market. This is most easily observed in the current market turmoil. Clearly it’s not possible for every company to be doing poorly right now — somebody must be making money in a Bear market. But the market average is down, and as a result, many good companies are getting hit hard on their stock prices simply because of the financial crisis.
Another aspect to risk, and the one about which I have been trying to remind my coworkers and friends, is the time factor. When purchasing an investment, one has to be aware of both the time one can afford to tie up money in the investment, as well as the typical time for the investment to achieve the kind of return being sought. This is fairly easy to see with a Certificate of Deposit: you buy a CD that pays a certain percentage yield and that has a limited lifetime of months or years. There are penalties for withdrawing money early. The equation is less well defined when it comes to investments such as houses, stocks, or tulips. The risk with investments such as these (well, not the tulips as much…) is not that the investment won’t hold value or yield a return, but rather over what time period the investment will pay off.
Conventional wisdom suggests investors be prepared for minimum investment times to substantially reduce the chance that the investment will depreciate while held. The purchaser of a house, for example, should be prepared to hold the house for 5 years or longer to have a high degree of certainty that the money invested can be recovered in full. Diversified stock portfolios are more like 10 years of holding time. In fact, (according to Malkiel) there has never been a 10 year period since 1926 in which the stock market has returned a negative yield, and there has never been a 25 year period in which the return was less than 8%.
The point in all of this is that you should not panic about the volatility of the current market. In fact, the less you pay attention to it the better off I expect that you’ll be. If you are investing for retirement and you have ten years or more left to invest, you shouldn’t even sweat during this crisis. If you have less than 20 years until retirement, or are retired already, you should have made and be making annual or semi-annual changes to your portfolio to reduce your risk exposure by locking up your stock gains in less risky vehicles like bonds. This is what’s known as rebalancing your portfolio. If your time horizon for a certain pile of money is shorter than 10 years, then your exposure to the stock market should be minimal.
The absolute worst thing that you can do right about now is to get scared and change the way you are investing because of the market fluctuations. Selling off stock now is the opposite of what everyone knows is the key to investment success: buy low, sell high. Selling now is “selling low” and locks in your losses. I have not lost any money in the current market, and I say this because all my losses are on paper so far. I still own the same number of shares this week as I did last week. Only by selling shares now can I be sure to lose money in this market. History tells us that some of the greatest days in the stock market follow some of the worst, and Monday’s stock market performance is certainly evidence of this. Selling when the market is low takes your money out of play and eliminates any chance of regaining the value lost in your portfolio as the market rebounds.
Are you concerned about the loss of value in your 401k plan? Have you made any changes to stem your losses, or are you just gritting your teeth and bearing it? Do you find yourself checking the value more frequently or less frequently because of the volatility? How much risk can you stomach? I’d like to read your perspective on the situation in the Comments Section below.
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On Monday of this week, I had to leave the office early to visit the home of one of my company’s customers. On the car ride, I listened to story after story on National Public Radio about the Financial Crisis, and more specifically the fact that despite the passage of the rescue bill over the weekend, stocks were falling through the floor. The Dow Jones Industrial Average was set to close below 10,000 points for the first time in years. And all the time I couldn’t think of anything else but to call ScrapperMom, who would likely be near a computer, and ask her to move some of our cash into equities.
Thank goodness I didn’t, because the market has lost almost 15% since then. But now I’m just salivating more at the prospect of picking up some market index funds at such low prices. Am I crazy? I’m not sure. Everyone is reacting to the market — and all in different ways. But the truth of the matter is that the rational me knows that I probably should not change my long term investment plan based on what the market did today. So it really requires me to take another look at my investment plan and then act accordingly.
Here’s where the problem comes in: I don’t really know what my long term investing plan is. We’ve written here before about many of our financial goals and priorities. Since visiting a financial planner for a free consultation about a month and a half ago (Side story: The planner at the time had hinted at the suggestion of bonds issued by Lehman Brothers since they were paying something like 7% interest… I wonder why I haven’t heard from the planner since our meeting…), we finally decided to reduce the aggressive paydown of our low interest debt in favor of other priorities.
Saving for retirement is certainly one of those priorities, and given this, the current market is the perfect time to invest in order to capitalize on the “buy low” strategy. Sure, the market could go lower still, but the rebound, whenever it does occur, will almost certainly end up higher than the current market within 20 to 30 years, and therefore money put into the market now should be a good investment.
However, building a substantial emergency fund is also one of our priorities, and given the current state of the economy, cash is probably not the worst position for our money. While both of our jobs seem fairly secure over the next year or so, the truth is that anything could happen at any time. I actually have no idea whether my paycheck is dependent on the ability of our parent company to borrow money, and if so, what will happen if it becomes unable to do so. ScrapperMom works in a field that caters to higher-end tastes, and so far the only effect the slumping economy has had on her line of work is the choice of whether to build the garage to the vacation home now, or hold off until the market rebounds a bit.
I have considered our income position a number of times over the last year or so, and the diversity seemed to pretty much assure that we would continue to have at least 1 out of 3 major incomes at any given time. I think that is still true, but I’m not as sure as I used to be. It is unfortunate that it has taken a serious financial crisis to finally drill into my head the need for a substantial emergency fund.
To that end, I think that I will hold off on moving from cash to equities, at least for now. But, if the market starts to rise quickly, soon, I know I’m going to feel a bit sick over not taking advantage of it when I had the chance. What’s interesting is that people are often told to take on as much risk such that they will still be able to sleep at night. For me right now, I feel like not taking on sufficient risk is going to keep me up nights…
What about you? Are you hanging on tight to the roller coaster ride? Did you get out of the market already? Are you plowing cash in? What would you do in our situation? Let us know in the Comments Section below!
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Editor’s Note: Introducing guest poster Matt. Matt and I have been close friends since our first days of college — we and our wives were in each others’ weddings. Matt has been a bond market professional for the last ten years, and I strongly value his insight into the current economic/political crisis. Despite the expected settlement by Congress, the American public still needs to understand and ultimately accept it. I’ve gone back and forth on this all week, and Matt’s assessment below has certainly swayed me back the other way.
I would like to share some insights on the pending economic bailout package and perhaps clear up some confusion that seems to be circulating through political sound bites and media commentary. To be clear upfront, as I’ve dedicated my career to them, I am a strong proponent of capital markets and believe in the model. Also worth noting, I have never been in a role to participate directly in any mortgage lending or borrowing that is relevant to the issue at hand.
Despite my strong belief in free markets and my opposition to an RTC-like (Resolution Trust Corp as in the early 1990s Savings and Loan bailout) solution to this problem from the beginning, the recent bankruptcy of Lehman Brothers has pushed us to the breaking point and we now have no option but to pass this plan in one form or another. This is not particularly evident by looking at the the widely tracked equity markets, but is painfully clear in the bond markets. This is where all individuals, institutions and corporations secure loans and therefore, the economy cannot function without liquid and orderly money markets (short-term lending in the bond market). The recent acceleration of this crisis of confidence occurred when Lehman Brothers filed for bankruptcy (as a result of a perceived weakening of financial strength leading to the loss of funding availability, the same effect that brought down Bear Stearns) and general creditors (people and institutions that loaned money to Lehman) will likely lose all of their principal. This did not happen with Bear Stearns, Fannie Mae, Freddie Mac or AIG where only the common shareholder was wiped out. Money markets were no longer safe and cash fled to safe haven FDIC insured bank accounts and US Treasury Bills, which briefly traded at slightly negative yields last week. This means investors were willing to PAY the government a small amount of interest to LEND it money for one month and know their principal was safe! The SEC ban on short-selling prevented traders from attacking the next weakest link via the equity market, but with many people unwilling to lend to banks, short-term interest rates surged and liquidity dried up. Direct borrowing from the Fed, the lender of last resort, has exploded, and the Fed’s almost one trillion dollar balance sheet has been mostly used at this point for collateralized short-term lending to financial institutions around the world. This is unsustainable and is a result of the inability of banks to fully fund themselves through the capital markets. It is the combination of lack of funding, reduced equity and being saddled with illiquid assets that is preventing banks from extending credit, and the negative feedback loop that exists between these factors will ensure that the problem gets worse until something is done to turn the tide.
One important point is that this is a bailout of the economy as a whole and not just of the financial industry. Most people do not realize how close we are to doing irreparable damage to the capital markets and how important that is to everyone in this country. This crisis will now become worse at an accelerated pace and we haven’t seen anything yet if we continue down the current path. This plan is the only way to restore confidence to the US banking system.
What are the reasons not to go ahead with the plan in some form?
1) Let’s not bail out a bunch of rich Wall Street people.
This is silly because they have already lost billions of dollars and over 120,000 jobs and are only one piece of the puzzle. It is an inaccurate simplification to only blame investment banks for this problem. Everyone from homeowners/spec buyers to mortgage brokers to foreign bondholders to the US government (a big part of it actually) share the blame and they have and will be punished in one way or another.
2) The taxpayer shouldn’t have to pay for this mess.
This needs to be clarified because the media is misrepresenting the facts in many ways. The taxpayer may very well have to pay something in the end, but here are the important points:
a) The government is not “writing checks”, it is making loans and investments. This goes for the AIG bailout as well. Nobody “spent” $85 billion on that deal. The government will receive LIBOR + 8.5% (London Interbank Offered Rate), which is currently more than 12% interest, on that loan and will own most of the equity upside of the future of the company. Could it lose money? Yes. But it could also make a lot.
b) The government is not using taxpayer money to make these loans. Think of the government as a giant hedge fund. It borrows money and makes investments. It will issue $700 billion of US treasury notes and bills and use the proceeds to buy the distressed assets. The interest rates on the assets far exceeds the interest rates on the US govt debt so it will net receive income. As time passes, depending on default and recovery rates on the underlying mortgages, it will make or lose money on the assets, and losses, if any, may or may not be covered by the positive interest rate differential that the government will earn. In the end, the taxpayer is on the hook for the losses, if any, and will receive the gains, if any. Either way, the gains or losses are unlikely to be anywhere near $700 billion. One other interesting point is that as soon as the government buys the assets, they will immediately become more valuable and private capital will most likely flow into the system again. For example, Warren Buffet just put $5 billion into Goldman Sachs. Would he have done that if he didn’t believe this plan would be passed? Not a chance.
3) If we start with $700 billion, what if we need three times that much, and are we going down a dangerous road where we keep throwing good money after bad?
This is a concern and only time will tell. It might need to expand at some point, and may or may not be approved in that event, but my feeling is the initial size will be sufficient.
This plan has more hair on it than the similar RTC-type plans in the past, but there is precedent for this. Again, I don’t like that it has come to this, but unfortunately we have no choice. The US economy, already effectively in recession in my opinion even though GDP growth has yet to go negative, will continue to weaken in the coming months. However, with the passage of this bill, we have a chance to repair the banking system and enable the Fed to inject credit into the economy in levered form as it always does at this point in the cycle (i.e. the Fed cheapens lending and reduces incentive to save –> banks borrow –> banks lend ten times as much also at cheaper rates –> economic activity ultimately picks up). Without the bill, we risk a serious disaster in the financial system and a dysfunctional banking sector will prevent the economy from operating properly. Unemployment will rise significantly, many businesses will fail, asset prices will continue to deflate, possibly at a faster rate, capital will retrench and we risk a deflationary environment, a depression or a Japan-like scenario (also generated by collapsing asset prices and the unwillingness to write down and remove bad loans from bank balance sheets). I think we can work out of this mess, but it’s time to take out the big bat and shock the system. Too bad politics are involved.
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photo figure credit: Nictalopen
