Credit Crunch: It's Not Just For Breakfast Anymore!

In my last article, I discussed the subprime mortgage problem and how we got into this global credit mess. And now that we are actually here, let's examine what governments are trying to do about it, whether it will work and what might happen if it doesn't. I know, this is all very depressing but knowledge is power so you should know what is happening.

A Crisis of Confidence

First, credit is all about confidence. People and businesses loan money if they believe that they are going to get paid back. You must have confidence that the borrower has the ability to repay the loan. And here lies the root of the problem. The banks have been badly burned with their mortgage loans. They are owed large amounts of money. They also own large amounts of assets that are decreasing in value very quickly...ie. houses they can't sell.  Banks have not only stopped or reduced lending to businesses and individuals, they have also stopped lending to each other. 

Traditionally, when a bank has their cash tied up in loans, they have more value in their assets than in the loan. Also, they are usually getting cash by way of their mortgage payments. When a bank is short of cash to loan out or meet their current obligations, they will borrow the money from a bank than has cash available. Investment banks on Wall Street, such as Lehman Brothers, Bear Sterns, etc., often fill this roll, either loaning the money to the bank, buying the assets from the bank or even buying the loans. Right now, this is not happening. At least, not happening as much as is needed to keep the system functioning smoothly. The system has lost confidence due to the large amount of bad mortgage loans.

Even banks that are in good shape are afraid to loan out their money. They have lost confidence in the ability of the borrower to pay them back. The system is structured that when this happens, a chain reaction follows:

1. A business can not get a loan
2. The business can't pay their suppliers or employees
3. To reduce costs, employees are laid off.
   
4. The supplier doesn't get paid so they can't pay their employees.
5. People without jobs can't buy goods and services.
6. Businesses don't sell good and services, so they go out of business.
7. More people are without jobs and can't pay their bills.
8. Businesses that have failed and people without jobs don't pay taxes.
9. Public service employees are laid off. Government projects are put on hold.
10. More people lose jobs and more businesses fail.

Recession,  Depression and The Bailout

This is how an economy get into recession and eventually, depression. Governments right now are desperately try to stop this before the dominoes start to fall. In Europe, governments have been nationalizing banks and financial institutions, trying to stop failing institutions  from causing a ripple effect. The USA has done the same thing with Freddie Mac and Fanny Mae, that nation's two largest guarantors of mortgages. And then there the big $700 billion bail out in front of the US Congress right now. The idea is that these funds will be used to "buy up" the bad debt so that banks will again start lending money to each other.  

At this writing, the first congressional vote on this package had failed. The main reason for this is political. Members of congress have been getting an earful from the voters. There is a theory out there that many congressmen believed that they had to vote against the package so that their constituents would see what would happen. What happened was the stock market had one on its biggest one day falls in history. I, for one, believe that some kind of package will go through, probably this week.

Naturally, the question is, will it work? That will remain to be seen. The other question would be, is it enough? Probably not, but it might be enough to put confidence back into the system and oil up the credit system gears. Let's all hope so because this is as much about Main Street as Wall Street. Who caused it and why it happened are questions for a later date. When the house is on fire, you put the fire out before you try to find out why it happened.

In his work, "A Life of Reason", George Santayana wrote, "Those who cannot learn from history are doomed to repeat it". This is what appears to be at work here. At the beginning of the Great Depression of the 1930's, the stock market crashed in 1929, ruining the fortunes and lives of many individuals and businesses. One of the main reasons attributed to this was that too many people were into the market on margin, or credit. Many assumed that the market would keep rising forever. They would buy stock on credit and after it went up, they would sell their stock, pay off the broker and pocket the profit. Due to problems in the economy of those days, the market began to go down and people panicked, selling off their shares to pay the debt. That caused the market to fall even faster and the prices crashed. Replace the words, "stock market", with "real estate market", and your can see the similarities.
 

So Now What?

For the time being, there is not much to do but watch, and watch carefully. Sudden moves right now, before the current scenario has played out, could be disastrous for the small investor. One provision of the US bailout package appears to be an increase in the FDIC limit from $100,000 to $250,000. This means that bank deposits are guaranteed by the US federal government to $250,000. Hopefully, this may cool the idea of everyone pulling their money out of their bank. That would make the problem even greater. So for now, here are three things I would suggest:

1. Keep your self as liquid as possible. Right now, cash is king. But if you own stock in major corporations and they have sunk like a rock, don't sell out too quickly.
2. Don't move. If you can, stay in your happy home. This is not a great time to sell. 
3. Stay out of real estate for now. I doubt that prices have bottomed out. However, if you can afford it, there are bargains to be had. But don't do it with big debt.
4. Be indispensable at work. Try and be the last person standing if your company is downsizing. Try and have more than one skill that your company can use.

One final note. We will be writing more articles on this and other financial subjects in the near future and if you like what you read, I would suggest that you subscribe to this blog. You can do this two way. If you are into RSS and have a reader, look on the right side of the page to subscribe. If you prefer, you can subscribe by email. Just put your email address in the box shown on the right side of the page and click on "Subscribe me!". Be assured that your email will remain confidential and not available to anyone else.