Why It's Time to be Concerned

Are you concerned about the economic news we're hearing lately ? Do you understand what's going on in the economy and what the implications/long-term effects are? I'm betting that most people don't. People get bogged down in Dow Jones Averages and Interest Rate Cuts and tune out. Most people are not economists or bankers and, thus, don't really even understand what that stuff is. Now - I'm neither an economist or a banker. I do follow this stuff with interest, however, and I'm going to attempt to give you my explanation of what's happened to get us where we are and what we may be in store for

The Housing Boom - we all heard about it and people rushed to get in on it. Home flipping shows, what can you buy for $XYZ shows, etc. started popping up all over cable. The real estate market has been hot for about the last 5 years. People lost money in the dot com bust and were looking for a place to invest and real estate was where they landed. As a result, builders built more houses & lenders lent more money.

Mortgage Backed Securities - when banks lend you money for your home, they rarely keep the loan. Typically banks pool a bunch of mortgages together and create what's called a Mortgage Backed Security. This essentially is a big pool of mortgages that they sell off in pieces - just like a mutual fund is a big pool of stock shares that is sold off in pieces. This helps diversify the risk - if someone defaults, all the shareholders are impacted a little instead of one lender being impacted a lot.

Lowering of Standards - as the real estate market got hotter, more people wanted in. Banks started issuing loans to less credit worthy individuals - these are the now famous "Subprime Loans". Now you've got people that aren't very solid financially taking out loans for homes and often times they don't even understand what they owe. They take out adjustable rate loans that allow the lender to up the interest rate every so often and suddenly there's a whole bunch of homeowners that can't pay the money back.

Ripple Effects - so...people can't pay back loans and go into foreclosure. Banks now have a lot of bad loans on their books that nobody wants to buy (when they're turned into securities). Securities buyers (most of whom, in this case, are European and Asian banks) now hold securities that are worth less than they paid for them since people aren't paying back the loans. Suddenly the impact of the subprime market starts being felt around the world. Now a bunch of countries have loans/securities that aren't worth what they paid for them. Companies start writing off losses. Stock prices go down. Investment portfolios lose value. Around the world. Remember the adage - When America sneezes, the world catches a cold.

Government Response - banks get scared and start setting higher standards for loans. Many people can't borrow money or can't afford to repay what they've got, so in response, the government cuts interest rates to make debts cheaper to repay. When interest rates go down, foreign investment leaves because they can get a better/higher interest rate elsewhere. The dollar goes down in value against foreign currencies. Americans pay more for imported goods (which we have a ton of in this country).

Right Now - So, in a nutshell, that's where we are right now. Now - one of the big problems that remains to be resolved is the fact that banks aren't good at figuring out exactly how much bad debt they have on their books. If they could've modeled who wouldn't repay loans, they wouldn't have issued the loan in the first place! So now they're trying to figure out what losses are going to actually be. And those numbers are going to be higher than they are right now. Markets are jittery as financial institutions go through this. We're seeing bank runs in some countries and people leaving markets in others. All of these activities serve to make the problem worse.

What's Next - We're in for a rough ride at least in the short term. Oil will definitely be more expensive because the dollar is weak and we have to pay more to bring it into the country. Food prices will go up because it takes oil to transport and manufacture food. Home sales will be next to impossible - you're not going to get what you want to get for your house because there's a glut of new construction (200,000 - 300,000 homes!) that still need to be sold and aren't moving. Interest rates will go down more - the government will continue to lower interest rates to try facilitate borrowing/repayment so that the whole system doesn't freeze up. That means your investments in things like CDs and Savings Accounts become worth less. Consumer confidence will drop - people will spend less, manufacturers will lower output to meet reduced demand, stock prices will slide.

What Should We Do? - This is a big mess. I think the election next year will have some positive effects as consumer sentiments usually change with a change in leadership. One thing we can all do is pay close attention to the Presidential race and vote somebody in with some good ideas on resolving this crisis. Make a plan now for what you'll do if gas prices go WAY up (ride the bus, carpool, etc.). Work with your financial adviser if you're nearing retirement age and can't afford to take a big hit in your portfolio in the short term. It may be time to switch into some different types of investments with lower, but guaranteed, returns.

That's my opinion on where we are, how we got here, and where we're going. Sorry it's not super positive. The good news is that we all have disposable things in our lives that we could cut out without much impact to our lifestyle and we live in a country that has seen this stuff before (the Depression, Inflation in the 70's, stock market crash of 1987, etc.) and we've got some measures in place to prevent a total economic collapse. That said, get ready for some choppy waters!!