Bailout, Recession, Depression.....Oh My!

So now it's done...finally. The $700 billion bailout package in the USA is done. It went from a three page document to over 100 pages but at least it's in place. Will it work? The jury is still out on that. As I have written in previous articles, it will take some time to see if it was enough. Hopefully, it will start to put some confidence back into the credit market. In case you haven't followed the details, this package has a few interesting wrinkles.


First, the package comes in three stages. The first releases $250 billion to purchase debt securities that have no market. It covers mortgages, credit card debt and auto loan, to mention a few items. The second stage is a second $100 billion that can be authorized by the President. The third stage of $350 billion must be authorized by congress.

Secondly, any financial institution using these funds must issue stock warrants to the government. Warrants are a financial item that allows an investor to purchase shares at a fixed price in a future period. The idea is that if the financial institution makes money by shedding their bad loans, the US government will be able to make some money on their shares.

A third provision raises the FDIC deposit guarantee from $100,000 to $250,000 as a temporary measure until December 31, 2009. This is designed to assure depositors that their fund are guaranteed to help forestall a run on a bank.

There are many, many more items in this bill but these three items are the meat of it, in my opinion. Is this enough to stop the slide? By itself, no. But that is not all that is happening. Around the world, national banks are moving in to make sure that there is enough money to stop banks from failing. The US has also announced a measure that will help businesses acquire short term loans to cover their operating costs, when they are having a problem getting the funds from their banks. I am sure that there will be more to come to stay tuned to this.



Are We Going Into Recession?

Probably. At least, we are having a big economic slowdown. Until confidence is restored, the domino will continue to fall. But over the years, national economies have learned much from previous tough economic time and we may weather this one better than others. Recessions are a fact of the economy. We've had them before and we will have them again. Governments can only do so much. No nation is big enough to rule world commerce. So until the lemmings stop jumping off of the cliff, we are going to have problems. As I have said before, it's all about confidence.


Are We Going To Have A Depression?

I doubt it. That being said, there are a lot of things conspiring together to raise concern. The subprime mortgage crisis, the rising cost of oil and the world food shortage are merging together and could create the perfect storm. Let's hope that we can head this one off at the pass.


So Now What?

Now, we wait. For the small investor, I would suggest that you look at your portfolio, dump the dogs, hold the quality stocks and keep an eye out for bargains. There are a lot of undervalued stocks of quality out there right now. Keep your eyes open.

If you are just trying to keep your head above water, try keeping your debt load low. Right now, interest rates are low but a little bird told me that they may be going up again. The last thing you need in a tough economy is larger debt payments.

If you are a homeowner, don't sell unless you have to. The inventory of unsold real estate is driving prices down and probably will for the foreseeable future. If you have a low rate mortgage, if could be time to lock in.

And as I have mentioned before, become a valuable person at your place of work. If downsizing happens, you want to be one of the people left standing. Try doing a bit extra at your job and perhaps show your boss that you have skills in other areas as well as being very good at what you do. If you are a small business person, start a campaign to keep in touch with your existing customers as well as attracting new ones. It is far cheaper to keep an existing customer than find a new one. Keep close touch with your financial statements and watch for unusual increases in costs or drop in revenue. Finding problems fast will allow you the time to fix the problem before it overwhelms you.

For My Canadians Clients and Friends

No matter what you hear during the current election campaign, Canada is not having the same problems as the USA. We don't have a subprime mortgage crisis, our housing market is not in free fall and the Canadian banking system is strong and sound. Beware of politicians doing their Chicken Little impersonation, screaming the sky is falling and yelling "FIRE!!" in a crowded theatre. This is not the time to panic. Yes, we have a problem. Yes, we need to be vigilant. But please, don't let the economic problems become a self-fulfilling prophecy. Canada is a small nation in a big world and we can't change the habits or actions of other countries. Our fundamentals are sound and we are in better shape to take a hit then most. Shoveling money off the back of the truck is not the way to solve this problem.

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.

Subprime Mortgages and The Economy:...YIKES!!!

Since I started to write this post, a lot has happened with the US financial crisis and it's still playing out.

Lately, we've had a lot of questions about understanding what the heck is going on with the US economy and the subprime mortgage crisis. It's a complicated mess but i will try and give you a quick look at what happened and what is going on here. The whole thing is a tale of greed and stupidity.

Many of the problems are things fairly unique to the United States. Most Canadian mortgages are insured by CMHC. If we do have a problem, it would be people drawing down on their home equity. But that's not quite the same problem so what I will address here is the situation in the USA.

THE SUB PRIME MORTGAGE

Basically, what happened was that people who had no business getting a mortgage, got one. It is called a subprime mortgage. You could qualify if you had a pulse. Now this is all fine and dandy as long as the value of housing keep going up and people keep making money. But it didn't. Several things conspired at once to knock the pins from under this house of cards. First, many of these mortgages were based on interest only payments for the first year or so. As such, the new home owner could only build equity if the price of the house went up. None of their payments went into the principal. And even if it did, the amount of principal being paid in the first years of a mortgage is minimal at best. Secondly, interest rates started to go up. Not a lot, but enough to make the mortgage payment rise. And finally, there was the price of oil. As soon as oil stated to go up, so did the price of everything else. This meant less money available for housing. I suppose that we should add on to that the other things that many of these first time home owners didn't consider such as property tax, maintenance, utilities,etc, etc.

When it came time for the mortgage to be renewed, the mortgage payment was going to go up, and Mrs. and Mrs. Home Owner found that they just didn't have enough left over to make the new amount. First, they tried to sell their house but found out that a lot of other people were trying to sell too. As is the case with everything else, when there is more supply than demand, the price goes down. Suddenly, Mr. and Mrs. Home Owner have a $350,000 mortgage on a $275,000 house. If they sell, they lose $75,000. They don't have $75,000 so they just walk away and give the house back to the bank or mortgage company.

THE BANKS AND MORTGAGE COMPANIES

So now the banks and mortgage companies have a lot of unpaid mortgage loans and a big inventory of houses that no one wants to buy. Here are a few examples. In Cleveland, Ohio, there is a subdivision that as of two months ago, was 80% vacant. In Las Vegas, housing prices have dropped by 44% and they haven't reached the bottom yet. Very few places in the USA have not been touched by this crisis.

How did this happen? Well, there are several villains here and enough blame to go around. So here we go.

The Builders

It seems that everyone thought that the housing boom would go on forever. Housing prices kept going up so the builders kept building. Then, sales started to have a slight slow down in some markets. In some cases, builders actually set up their own mortgage companies. Where did they get the money to do that? Well, they sold their paper to the investment banks. Investment banks also loan money to other banks on the basis of their securities, such as mortgages. These baking names may ring a bell...Bear Sterns...Lehman Brothers..Citi Bank. Other mortgage companies got into the game like Countrywide. Things were going crazy. People who should never qualify for a mortgage were getting loans of 125% of the property's equity.

The Banks and Mortgage Companies, Especially Wall Street

Greed makes people make funny decisions. Once again, supposedly intelligent people ignored history. And this time, it was a world wide banking problem. Banks in many countries couldn't wait to get in on the gravy train and lap up some excess profits. But as the new home owners began to default, the mortgages were higher than the value of the housing assets that backed the debt. Several months ago, the news was all about the banks taking big write down on their bad mortgage debt. That means that they parked some of their money to cover their exposure to bad loans. Here's a list of some:

Company	Business Type	Loss (Billion USD)
UBS AG	bank	$37.7 bln [1] [2][3]
Citigroup	bank	$39.1 bln [4] [5] [6][7]
Merrill Lynch	investment bank	$29.1 bln [8] [9][10]
Morgan Stanley	investment bank	$11.5 bln [11] [12][13]
Crédit Agricolea>	bank	$4.8 bln [14]
HSBCa>	bank	$20.4 bln [15][16][17]
Bank of America	bank	$7.95 bln [18][19][20]
CIBCa>	bank	$3.2 bln [21]
Deutsche Bank	bank	$7.7 bln [22] [23][24][25][26]
Mizuho Financial Group	bank	$5.5 bln [27]
Barclays Capital	investment bank	$3.1 bln [28]
Bear Stearnsa>	investment bank	$2.6 bln [29] [30]
Royal Bank of Scotland	bank	$15.2 bln [31][32][33][34][35]
Washington Mutual	savings and loan	$2.4 bln [36] [37]
Swiss Re	re-insurance	$2.04 bln [38][39]
Lehman Brothers	investment bank	$3.93 bln [40][41]
LBBW	bank	$1.1 bln [42]
JP Morgan Chase	bank	$5.5 bln [43] [12][44]
Goldman Sachs	investment bank	$1.5 bln [45] [11]
Freddie Mac	mortgage GSE	$4.3 bln [46]
Credit Suisse	bank	$9.0 bln [47][48]
Wells Fargo	bank	$2.9 bln [49][50]
Wachovia	bank	$11.1 bln [51][52][53][54]
RBC	bank	$1.2 bln [55] [56][57]
Fannie Mae	mortgage GSE	$0.896 bln [58]
MBIA	bond insurance	$3.3 bln [59]
Hypo Real Estate	bank	$0.580 bln [60]
Ambac Financial Group	bond insurance	$3.5 bln [61] [62] [63]
Commerzbank	bank	$1.1 bln [64]
Société Générale	bank	$3.0 bln [65] [66]
BNP Paribas	bank	$0.870 bln [67] [68]
WestLB	bank	$2.74 bln [69][70]
American International Group	insurance	$11.1 bln [71][72]
BayernLB	bank	$6.7 bln [73]
Natixis	bank	$1.75 bln [74]
Countrywide	mortgage bank	$4.0 bln [75][76]
DZ Bank	bank	$2.1 bln [77]
Fortis	bank	$2.3 bln [78]
ICICI Bank	bank	$0.264 bln [79]
IKB Deutsche Industriebank	bank	$3.45 bln [80]
Aozora Bank	bank	$0.397 bln [81]
Dresdner Bank	bank	$3.49 bln[82][83]
HBOS	bank	$7.06 bln [84][85][86]
Lloyds TSB	bank	$1.32 bln [87]
Bank of China	bank	$2.0 bln [26]
ICBC	bank	$0.448 bln [88]

That's a lot of money folks and now the weight of it all had trickled down to the entire US banking system.

The New Home Buyer

Yes, Mr. and Mrs. America...you're to blame too. The entire culture of "I want it now" has played into this problem. No down payment, big loans, not thinking about other expenses..these have all sucked you in and ultimately, your should have known better. Sorry, but the big, bad world doesn't owe you a thing and the buck always stops with you. Sure, you had help. Sure, you were sold a phony bill of good. But at the end of it all, you are the ones that got sold on this pipe dream and you should know better. Because you didn't, you are paying the price.

THE WEIGHT OF IT ALL

Now, you may be wondering how all of this plays into the banking crisis happening right now in the States. It goes like this. The US banking system is quite unlike the Canadian system. All over the US are many small banks, some with only a few branches and localized to their own communities. There are also near-banks called Savings and Loans, or Thrift banks. Banks borrow money from other banks on their debt to pay for their day to day operations, etc. Inter-bank credit is the basis of all banking. It is not unusual for a bank to have loaned out ten times their deposit base, selling their loans or borrowing against them from other banks to finance their debt. Unfortunately, the value of the assets that is backing the debt has shrunk, as we noted earlier. Housing that is backing mortgage debt has fallen drastically in price so the value of the assets is less than the debt. This creates a liquidity problem. Banks need cash for their depositors, investment certificates etc when they come due. And right now, banks are afraid to loan money to other banks because of the mortgage debt on their books. Now, banks don't have the money to loan to their business customers for lines of credit. In some cases, banks have been calling in or reducing lines of credit for their smaller customer.

Most businesses need credit from banks to survive. They sell on credit and use a credit line from the bank to pay their bills until they get paid. So when they can't get credit and their customer can't get credit, it starts a chain reaction. Their clients can't pay them so they can't pay their bills, so the next guy can't pay his..etc. There's no money for supplies and payroll. Now, some guy can't pay his bills or his mortgage. And to top it all off, the skyrocketing price of oil has put up the price of just about everything.

THE US GOVERNMENT BAIL OUT PACKAGE

As of this morning, there is a tentitive deal in the US government to provide an emergency funding package to the tune of $700 billion. The principal is that the government will buy up the bad loans from the banks so that they will be able to ease their credit redtrictions. Will it work? Is it enough? No one knows for sure but without it, the entire US financial systems, and therefore the world system, is in very big trouble. This is all about confidence. Banks have to believe that they can get their money back if they lend it and the subprime mortgage loans are the sticking point in this mess. By getting a lot of these loans out of the way for now, the US government hopes that the money will start to flow again.

There has been some resistance to the plan in Washington as many congressmen and senators have been getting an earful from their constituents. They don't want the government to create more debt to bail out greedy bankers. I suppose you can't blame them, but there isn't much choice in the matter. Whether the US voter knows it or not, this problem, unsolved, will eventually trickle down to them and make their lives miserable. Main Street has to bail our Wall Street and America isn't very happy about it. This money is all supposed to be a loan but for now, the government debt will balloon and the US taxpayer is ultimately on the hook if the loans don't get paid.

THE CANADIAN VIEW

Can it happen here. Sure, but it's not likely. The Canadian banking system is smaller, more centralized and better funded than the US system. The conservative banking practices that many of us in Canada get angry about are now serving us well. By not having a subprime market of any size, the bottom is unlikely to fall out of the housing market. Right now, home prices are shrinking but not at the rate of our brethren to the south. We may see some pain from the US crisis but if the bail out works, we should get by relatively unscathed. If it doesn't, the whole world's banking system may have trouble so we shall see. For now, north of the US border is a better place to be for home owners. I would suggest that you don't draw down your equity. Watch your spending. And make sure that you can afford the payments for a long term before you get that equity loan.

Stay tuned...this one isn't over just yet