The Dollar Stretcher : Economic Crisis

Lessons from an Economic Crisis - part 2

Gary — Mon, 13 Oct 2008 14:50:00 GMT

Last time, in part 1 we looked at 9 lessons we could learn from sub-prime mortgages. Those lessons centered around the bad mortgages. Fortunately the overwhelming majority of us didn't take out one of the now toxic sub-prime mortgages. But, that doesn't mean that we won't be affected by the economic fallout from those mortgages. And, there are lessons that all of us can learn from this experience.

Lesson #1. You don't need to borrow lots of money just because everyone else does. This seems like the kind of advice that you'd get from your mother ("Just because Billy's mom let's him play in traffic..."). Typically mom's advice was pretty good. It's not so long ago that you and I were listening to people brag about how they bought a house with no down payment. About how they were able to find a lender who could get them the home of their dreams. At times I even wondered if I was so smart to not borrow as much as I could. Thankfully, I chose not to. Even better, most of you chose not to either.

Lesson #2. No job is ever completely secure. There was a time that you could go to work for a big company and pretty much be guaranteed a lifetime of work and paychecks. Not true anymore. Even if your union contract says that they can't fire you. In today's worldwide economy innovation and competitiveness are key to success. So bigger isn't safer. And, a company can look like it's doing well just before it crumbles. Don't get fooled by the fake front. And, union contracts that make it hard to fire employees may just means that it's more likely that the entire business will go bankrupt (study the domestic automakers for more details). Bottom line? You can be a great employee and still find yourself suddenly unemployed (especially if you ignore Lesson #3 below).

Lesson #3. What your employer believes in matters. Your CEO takes a multi-million dollar salary and a bonus besides. Should that concern you? Yes. It points to the fact that the CEO (and presumably their main subordinates) believe that it's ok to take as much as they can from the company. That's the same mindset that approves shenanigans in accounting and treats customers poorly. To put it simply you can't trust people who are that greedy. Especially with something valuable like your future. You may be making a good buck today, but you better have a plan in place in case the roof caves in on the business. (just in case you were wondering I have no use for people like those that lead Fannie, Freddie, Countrywide, or a host of other companies)

Lesson #4. Check your assumptions before borrowing. Any time you borrow money you are assuming that you'll have the future income to pay it back. And, typically that means that you expect to be able to work to earn those payments. So unless you have an emergency fund, you're assuming that you won't lose your job before the debt is repaid. You can choose to live debt free. Or you can recognize how important it is to have an emergency fund. (an FYI: if you say that you can't afford to save an emergency fund that just points out that you're exact the type of person who's most likely to need it in a crisis)

Lesson #5. Debt makes any economic situation harder. In good economic times debt can be managed. Debt is never good, but at least you can keep up with the payments. But, in bad times debt can become a very cruel master. Losing a job if you have credit card debts is especially tough. In just one month things can go from bad to critical. The answer for someone who isn't in trouble today? Pay off any debts (especially credit cards) as quickly as possible. Even if it means working overtime or taking a second job to do it.

Lesson #6. It takes two to tango. You don't have to be a dance partner. A few years ago mortgage companies were climbing all over each other to offer you a mortgage. Even if your credit wasn't so good, or you didn't have a job, or the loan was too big for your income. This won't be the last time that people are willing to lend money foolishly. It will happen again. That doesn't mean that you have to join the dance. Many smart people said "no" to mortgages and other loans that they knew they couldn't afford. Those are the folks who are not losing their homes or counting on a government bailout now.

Lesson #7. We'll all pay for the economic bailout. To avoid panic the government is flooding the market with dollars. That's probably something that they have to do now to keep the panic from spreading. But, all of those new dollars are still subject to the law of supply and demand. We're going to have more dollars chasing the same amount of goods and services. That means that you'll see prices go up. Actually we've already started down that path. The Federal Reserve has been pumping money into the economy for awhile now. Expect inflation to become a problem in the next few years.

Lesson #8. We'll see more bailouts. Bailing out the banks and homeowners is not the end. We'll see more. And why not? We didn't want to let people with a too-big mortgage go under. Couldn't handle letting banks go down. Will we be more willing to get the automakers and autoworkers fail? Or perhaps the airline industry and it's employees? Or maybe whole states (can you say California)? The key point for you and I to recognize is that this isn't over. Not by a long-shot. There is more economic uncertainty to come. Hopefully not as bad as this latest round, but instability none-the-less. It's time to imitate the boy scouts and be prepared! (btw, you'll notice that those who need to be bailed out typically spent money they didn't have or made promises that they couldn't keep)

Lesson #9. It seems foolish to play by the rules. Let's be honest. Some good, hardworking folks who chose to buy a house they could afford are going to be helping pay for someone who bought and financed a house that they could not afford. Your tax dollars are going to be paying part off part of their mortgage. Bottom line? People who chose to live beyond their means are not paying for their mistakes.

Lesson #10. It really is not foolish to play by the rules. Those folks who are getting mortgage help are not out of the woods yet. Their credit score will still be hurt. In trying to keep up with an unaffordable mortgage they were probably late in making credit card payments. That means penalty rates up to 30%. And, most importantly, they didn't learn that it was wise to live within your means. So, they'll probably continue to try to spend money that they don't have. They'll get out of this crisis. But, not the one after that...or the one after that. Sooner or later they'll end up in trouble again. And sometime it won't be politically expedient to save them.

Lesson #11. There are no economic islands. We're all affected by those around us. As the world becomes more complex, it becomes more interdependent. I may not have co-signed on your mortgage, but if you fall behind a number of people will be hurt. It might not be fair, but it is true. And, it means that I need to be even more prepared for the unexpected.

Lesson #12. Smart investors don't panic. It's likely that your 401k has taken a hit (OK, a clobbering) this year. But it was a generation ago that the Dow Jones was at 1,000. Today we're complaining because it dropped below 10,000. So owning shares in American companies is (at least on average) a good thing. If you'll need your money in the next few years you might have to sell now. But, if you won't need it for awhile now is not the time to sell your stocks (unless the company is being run by one of the greedy CEOs - see Lesson #3).

Life is full of lessons. Some are inexpensive and not too painful. That's not the case this time. So hopefully all of us (borrowers, lenders, CEOs, regulators, politicians) will learn a lot from this one. Because if we don't we sure have wasted an awful lot of money and the price next time will be even higher.

Keep on Stretching those Dollars!

Gary

Lessons from an Economic Crisis - part 1

Gary — Mon, 29 Sep 2008 14:46:00 GMT

Lately the economy is big news. As someone who discusses personal finance I'd have to say that the discussion is good. But, if you add up all the news reports (print, radio, television, internet) you wonder whether Jane and Joe Consumer are really learning anything. So much of what is being reported has no practical value for folks like you and I. So let's see if we can learn something from the turmoil all around us.

Lesson #1. "Zero Down" mortgages can be dangerous. "No money down" - sounds like every would-be homeowner's dream offer. No need to struggle saving a down payment. No need to wait until you do. Just sign on the dotted line. Only one problem. You're upside-down in your home as soon as you close on it. Yep, you owe more than it's worth. Unless you managed to keep all the closing costs, origination fees, attorney's fees, etc out of the mortgage. And, that doesn't typically happen (because your goal was to show up at closing with nothing but your ball point pen).

So maybe being upside-down in your home isn't so bad. Guess again! You can't sell your home (unless you can afford to bring a check to the closing). Yep, you're stuck. And, you'll stay stuck until the house appreciates to the point where it's worth more than the balance of your mortgage.

Lesson #2. "Interest Only" mortgages can be dangerous. Interest only mortgages were sold to help keep your payments "affordable" (oh, how I hate that phrase - it means we've done something to your loan that'll hurt more later so that it doesn't hurt now). Yes, it's true, you won't have a pay a portion of the principal you owe each month. So your payment will be lower. But, because you're not paying any principal the amount you owe doesn't go down each month. That means that the only way that you'll actually own more of your house is if the value of your home increases. If home don't appreciate? You could end up owing more than the home is worth (see "zero down" mortgage comments).

Lesson #3. The 30 and 15 year fixed mortgages have advantages. Both the lender and homeowner benefit. Because the interest rate is fixed, both know how much the payment will be. For the entire life of the loan. No worry that increases in the interest rate will outpace the borrower's income.

Plus, with every payment a portion of the mortgage is paid off. In small amounts at first, but increasing as time goes on. That means that every payment check is just a little more efficient than the one before. And, the homeowner's equity increases each month. Even if house prices fall, a portion of the monthly payment will help increase the amount that the borrower owns.

Lesson #4 Not everyone can afford the home that they want. We'd all like it if everyone could afford a nice, spacious home in a good neighborhood. After all, that's the American dream. But, the truth is we're not there yet. When you want to own a home badly enough you'll be tempted to believe anyone who will lend you the money to buy your dream palace. Don't be fooled. You won't find them anywhere nearby when you struggle to make the payments. They won't even recognize you on the street. They sold your mortgage to Freddie Mac or Fannie Mae and you are so yesterday. They're busy working today's deal. Don't place all the blame at their feet. If you buy a house and take on a mortgage without thinking about how different future situations (like a falling housing market) will play out, you have no one to blame but yourself. (and ignorance is no excuse. You don't have to be too smart to ask for help from someone who knows more)

Lesson #5.Just because the government says it's ok doesn't mean that it really is ok. Back in 2004 Congress held some hearings. Problems were identified at that time. You can read what the NY Times reported here Shortly thereafter the head of Fannie took early retirement as reported in USA Today At the time some in Congress said that there was nothing seriously wrong and let business go on as usual.

If you took out one of these mortgages since the fall of 2004 you might want to do a little research and see what your representative was saying about Fannie and Freddie back then. They could have prevented you from falling into this trap. It's sad, but you trusted people for good financial advice and didn't get it.The rest of us should also check the voting record. Instead of solving a $9 billion problem, now we're going to have to pay to clean up a $700 billion problem.

Lesson #6. Assuming that house prices will go up is dangerous. Back in 2004 housing prices had been increasing for 25 years. No one knew for sure what the future would bring. History said that prices were going up. But, there was no guarantee that it had to continue without a break. In fact, from about 2002 on many people were predicting that housing prices had to retreat.

Homeowners who bet the house on a rising market are doing just that. Betting their house. Shame on the people who promised them that prices couldn't drop. And shame on the borrowers' who believed them.

Lesson #7. Accumulating a down payment before buying a home is a good thing. Sure it's nice to be able to buy your dream home today even if the only thing you have in your pockets are your hands and some credit cards. But, it's not a good idea. Here's why. When you save for a down payment you're forced to live below your income. So you get used to sacrificing. You also limit your standard of living. Then later when you've saved the down payment and buy your home you've created the habit of controlling your finances. Not so if you buy with no money down.

Lesson #8. Americans had too much of their wealth tied up in their homes. For the last 25 years housing prices went up. So we didn't need to do anything to become wealthier. Just stay in our house. That would be ok, but during the same time we've been spending just about every dollar we earned. In fact, it was very tempting to use the newly created home equity loans to tap into that new wealth to buy cars, vacations, pay off credit card debt or anything else that came into our little noggins. It also caused us to think that we were wealthier than we really were.

Lesson #9. Just because someone will lend you the money doesn't mean that you should borrow it. You'd think that if a bank or mortgage company were going to lend you $250,000 that they want to be fairly sure that you'd be able to repay it. Only seems logical. But, in this particular case you'd be wrong. The reason is that the bank/mortgage company was only going to own your mortgage for a short period of time. They sold the loans to Fannie and Freddie. So beyond the first few months they didn't care whether you could afford the mortgage payments.

In our next installment we'll look at some lessons that can help people without problem mortgages from being sucked into the crisis.

In the meantime, keep on Stretching those Dollars!

Gary