I love my dad :)
Hi Sarah,
We’ve certainly got interesting times we are living through. These really are major upheavals in the financial system, on a scale that the country hasn’t seen since the Great Depression.
That said, I don’t think there is huge reason for you to worry, and you certainly don’t need to go pulling money out of the bank. Bank accounts in the US with balances up to $100,000 are all insured by the government under a program called FDIC (Federal Depositors Insurance Program— started after the Great Depression). This means that even if the bank goes under, the government guarantees you’ll be able to get your money from your account.
Our family’s (and your) stock investments will doubtless plummet for awhile with this situation. But these are all just paper losses— what is going down is the price we *would* get for it if we sold the stock, which we’re not going to do. The best thing to do in such situations is to resist the temptation to sell off stock in a panic, but instead to hold onto it (maybe buy more at the low prices!) and wait for the market to go back up, which it will eventually. The only situation where this strategy doesn’t work is if the company whose stock you have goes bankrupt— then you lose your money. That’s a problem these days for people who have lots of stock in the banking and financial companies. But we have very careful, conservative brokers who steer clear of the popular, get-rich-quick trends that roil the market from time to time, and as a result we are in pretty good shape.
For you personally, I think the biggest danger is that if congress can’t come up with a workable rescue plan, the economy could go into a fairly serious recession for the next two or three years. That means money would be tight, businesses would tend to circle the wagons and lay off some workers, unemployment would go up and jobs would be harder to find. This could make things more difficult for new college graduates.
Some background on the situation to help you understand a little better what is happening— Stock and other financial markets are subject to “bubbles” from time to time: Sometimes when one part of the economy starts growing, people see it and get all excited and start pouring investment money into it, which in turn makes stock prices go up even further, making more people get excited about it, and pour more money into it, etc. etc. Eventually such bubbles burst when people start to realize that the price of the investments they are holding is supported by nothing more substantial than people’s excitement about it— the underlying value of the actual companies involved doesn’t come close to matching what the stock is actually selling for. When this happens the result tends to be a stampede out of the sector, with everyone trying to sell that particular kind of investment, and this causes the value of it to plummet. This kind of bubble happened in the 1990s with technology industry stocks. People got all excited and were buying stock in tech companies that kept going up—yahoo, for example went up to around $250 a share. Then came the crash—when the bubble burst I believe yahoo went down to about $14 a share, which means if you had put all your money in it, you lost nearly everything.
We are currently experiencing the effects of a bubble that has burst in the real estate market, the effects of which are hugely magnified by some very unwise practices in the mortgage and banking industries. A lot of banks and real-estate companies were loaning people money (mortgages) for houses who probably weren’t going to be able to make their payments. They lowered the standards they used for judging whether people would be able to qualify for loans (this was in part mandated by the democrats in congress, who passed laws saying that a certain percentage of the mortgages financed by banks had to be for low-income housing). They also were pushing things like balloon mortgages, which start out with low payments and interest rates, but then increase dramatically after five or ten years. For gullible people, this led them to buy great big houses without thinking about how they’d be able to afford the payments when they hit the “balloon” part of their mortgage! The general term for these kind of sketchy mortgage arrangements where it’s a little uncertain whether the people are going to be able to make their payments, is “subprime” mortgages.
The subprime mortgage market didn’t seem like such a bad deal to the banks, because the way a mortgage works, if people can’t make their payments, the bank assumes ownership of their house. And all these subprime loans were being made in an environment where house and real-estate prices kept going up (the bubble!), which meant if someone defaulted on their mortgage payments after five years, say, the bank got their house and could turn around and sell for much more money than it had loaned the people in the first place. The banks made money on defaults just like they did on mortages!
With mortgages looking like such a good investment to the banks, they started getting creative with them— they would bundle bunches of mortgages together and create a little holding company that would be the recipient of payments, say, for 1000 family’s house payments every month. And then they would sell shares in that holding company, so I could buy into the deal and receive a proportion of the money that was coming in. And because real estate prices were rising, these bundled mortgage investments looked like a good deal and everyone bought lots of them and the price of shares in the holding companies consequently went up.
This was only one layer of complication they built into the mortgage-investment markets, there were other even more abstruse ones— like mini-insurance policies that in exchange for a fee would guarantee to make up the monthly payments to a mortgage holder if the people couldn’t make their payments (called “credit default swaps”). I won’t go into all the details, but suffice to say there are lots of very complex investments floating around the economy that are based ultimately on home mortgages.
The other very stupid thing the banks and financial houses did was to heavily leverage their investments. This means that they borrowed the money they were using to invest in the mortgage-backed securities. Suppose, for example, I put $1,000 into a particular investment that returns 10% in a year. That means at the end of the year I have made $100. Now instead of that, suppose along with my own $1,000 investment I borrow another $9,000 of “leverage” and invest that money for the year, too. That means at the end of the year, I’ve received 10% of $10,000, or $1,000— doubling the amount of my own money I put in! This kind of leveraged investing was made possible because the government under the Bush Adminitration has been willing to lend the banks basically all the money they wanted at very low interest rates, so they had access to large amounts of leveraged capital for their investments— some of them were borrowing 30 to 40 times the amount of their own money they were investing, and reaping huge returns as a result.
The thing about leveraged investments, though, is that the multiplication factor can work against you if the investment loses value. If I borrow $9,000 to add to my $1,000, and the investment *loses* 10% instead of gaining, I have now lost 10% if $10,000—or the entire $1,000 I had to begin with!
So what has happened currently is that the banks and big investment houses made heavily leveraged investments in the mortgage security markets, which was a hugely profitable enterprise so long as housing and real estate prices kept rising. But the bubble has burst in that market and prices are now falling rapidly, which means the banks are losing their shirts on these leveraged investments, and some of them are actually going under as a result.
This situation has led to another problem that poses a danger not just to the banking industry, but to the entire economy. These bundled mortgage investments were so complicated, it became impossible to tell how risky they were: If I have a piece of a holding company that receives payments from hundreds of mortgages, it is nearly impossible for me to now find out how many of those mortgage holders are likely to actually default, which means I have no idea how risky this investment is. This was not a problem when real estate prices were rising, because everyone knew this investment would keep making money even if people defaulted on their mortgage payments. But now with real estate prices falling, defaults mean huge losses for the mortgage holders, and nobody knows how many such losses there are going to be.
The result has been that the banks and investment houses have no idea how much money they need to keep on hand to cover potential losses from these mortage securities. As a result, they are keeping as much money on hand as they can, and this means they have way less money to lend to other people.
This situation, where the banks stop having money they are willing to lend, is called a “credit contraction,” and it threatens the entire economy. Nearly all businesses rely on being able to get short-term loans at reasonable interest rates in order to finance their day-to-day operations. (My business might get an order for a shipment of widgets, for example, and not get paid until it is delivered to the buyer. So I would rely on loans to pay my workers to make the widgets, and then pay back the loan when I receive the money for the shipment). If businesses can’t get short-term loans, then *they* have to keep lots of cash on hand in order to keep operating, and the only way to make this happen is to do things like lay off workers and cancel expansion plans. Businesses that are already stretched financially will probably go bankrupt if they can’t get credit. So the credit crunch threatens to plunge the whole economy into a serious recession. That is why stocks are going down across the board— people are worrying that even the non-banking companies will have a rough time for a few years if we get hit with a large recession.
The bailout plan that the government has proposed (it’s not the most accurate name for it) would authorize the government to buy up the sketchy mortgage investments from the banks and hold onto them. That way the banks could get their money out of these investments whose risk they can’t determine, and this would put them in a position where they would know how much money they needed to keep on hand to cover their investments, so they could start lending the rest like banks are supposed to do again. The result of this would be to free up credit, make loans avilable again, and hopefully prevent a recession. The government would obviously assume some risk with this, but it’s not just pouring money down a hole— when the real estate market bottoms out and starts rising again, if not too many people have defaulted on their mortgages in the meantime, the government could actually wind up making money in the long term from these investments!
If the government does *not* take this or a similar action to free up the credit markets, the entire economy is probably going to take a serious hit until the bulk of th subprime mortgage defaults work their way through the system and real estate prices start going up again, whenever that might be.
We will doubtless see a major political debate along with all this about what the best way to prevent such a situation from developing again might be. Democrats tend to favor regulation, passing laws that will make it illegal for the banks to do the kind of things that got them in trouble to begin with. The Republicans tend to favor free-market solutions: they will point out that the banks who did stupid things have gone bankrupt because of it, and only the smarter ones are left—problem solved! But in the short term, the immediate problem they need to deal with is how to prevent the credit contraction and recession that are looming.
One other thing to say if you’re tempted to be frightened by this situation— there’s a certain sense in which it’s only money. When I was at Duke and after we first came to Dubuque, I was making very little in the way of salary and your Mom wasn’t working at all. And it was very easy to get consumed by worry over finances and what was going to happen. I learned in that situation to ask each night whether any of you kids was going to go hungry the next day. The answer was always ‘no’— we were never even close to that situation— and that helped me worry a lot less. So maybe an uncertain economy can be a helpful reminder of what’s really important in life.
Love, Dad
