The U.S. government had originally said it would loan AIG, once the world’s biggest insurer, $85 billion, but increased that to $122.8 billion on Wednesday as the company races to sell assets to pay off the loan before the credit turmoil makes buyers harder to come by.

When I read this it made me sick to my stomach. Not because of the staggering sums of money being lent to AIG, but because it is not a government loan. My initial thought was correct, as AIG has never received any government loans. Granted Reuters is a British based company, but you would think that if they are going to report on U.S. financial news, they would ensure that their reporters understand the Federal Reserve System.

Unfortunately I would seem that such errant reporting is not limited to foreign reporters. Earlier this week, the New York Times reported that the Fed is purchasing commercial paper to provide some additional liquidity to the credit markets (I came to learn of the NYT article from MyTwoDollars). Within the New York Times article the authors state:

While the move will put more taxpayer dollars at risk, it underscores the growing sense of urgency felt by policy makers in a climate where lending has virtually dried up.

I’m not exactly sure how it puts more taxpayer dollars at risk, because the Federal Reserve is independent within government, and generates its own revenue with Open Market Operations. If you look at the Federal Reserve’s 2007 income statement, you’ll see no line items that indicate income from taxes. If the Fed incurs any losses, they would be losses for the Fed not taxpayers.

With all of the recent focus on the Emergency Economic Stabilization Act of 2008 (aka the $700 billion “bailout”), the media finds it convenient to label everything as a government-sponsored act. It is sensationalistic and inaccurate to equate the actions of the Federal Reserve as actions of the U.S. government. The next time you see the Federal Reserve and the U.S. government mentioned within the same article, be sure to take what you read with a grain of salt. It is likely that the author may not really understand how the Federal Reserve System works.

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So why are the stock markets down in response to the passing of the bill? Although the bill has passed, the fact remains that credit markets are still failing and it is still difficult to borrow money. The credit markets really act as a fuel for the economy, as they make capital readily available that otherwise wouldn’t be. Capital allows companies to make capital investments (purchase of plant & equipment, i.e. long-term assets) for corporate growth which results in economic growth as well. Consumer credit also allows consumers to make purchases they may not otherwise be able to make if they could not repay them over time. This also helps to stimulate the economy. Without credit the economy suffers. The market value of stocks is fundamentally based on future cash flows (how much money companies are expected to make and grow), so when the economic outlook is poor stock prices will suffer.

It will take time before the situation in the credit markets improve and ultimately the stock markets improve as well. So what can you do to protect yourself? That of course depends on your overall situation and your tolerance for risk. If you are in it for the long haul and you have long positions on some stocks or exchange traded funds that you do not intend to sell, you might want to consider selling covered calls. The VIX (CBOE Volatility Index) is currently over 50, which means that huge premiums are being paid for options. This is premium you could pocket by selling covered calls.

However, one problem with this strategy is that if you are below your cost basis (very likely), you would be locking in losses by selling calls at strikes below your cost basis, if a miraculous recovery takes place before the expiration of the option you sell. If it takes a long time for the stock markets to recover (which I believe it will), you can sell slightly out-of-the money covered calls month after month and help to some of your losses and use your positions to generate income. Another problem with the strategy is that if the stock markets continue to fall rapidly, you’d just be better off liquidating your positions rather than trying to use covered calls for income. The income from the covered calls may not be sufficient to recover continuing losses.

If selling covered calls doesn’t sound like your cup of tea, but you are still in it for the long haul then you probably should simply do nothing. If you can’t stand watching your portfolio continue to fall, you may want to consider selling off and holding on to your cash in an FDIC insured account. If retirement is a long way off, you should continue to contribute to your 401k and IRAs. If you can afford it, you might even want to try increasing your contributions a bit. If you are approaching retirement, hopefully you’ve adjusted your asset allocation accordingly and your portfolio is not heavily weighted in equities. There is one thing I’m certain about and it’s that the stock market will eventually recover. Even in the worst of times, they always do. I take solace in that and you should too.

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I was watching the news last night and it was rather upsetting to listen to a member of Congress speaking about the issue in terms of what was taking place in the stock markets.  He spoke as if the purpose of passing the bill was to increase market value and restore losses experienced in 401k accounts.  Most politicians blaming are Wall Street for the woes in the credit markets, when in fact Wall Street has very little to do with it.  It is unsettling when those drafting legislation of such magnitude do not appear to understand that the securities markets and credit markets are two separate markets.

Politicians are quick to blame lack of oversight and immoral CEOs for what has transpired, when in fact it is really no one’s fault.  When capital becomes available as easily as it did over the past several years, one should expect a lot of lending to take place to the point where even unqualified individuals are receiving substantial loans that they are incapable of paying back.  If anything is to blame, it is the monetary policy of the Federal Reserve from several years ago.  If any government oversight should be put into place, it should preside over the actions of the Federal Reserve Board, not the banks.

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I will agree that the situation is poor, but I do not think it has yet reached cataclysmic proportions. Many say that the financial system is breaking down, but I say that it is a free market that is working just as it is supposed to. The cost of interbank borrowing has risen, but for good reason. If a bank wants to borrow from another to meet reserve requirements, but there is more risk than there is under normal circumstances, the lending bank needs compensation for that risk.

Unfortunately, the media has made the situation even worse. I believe that is a big reason why Washington Mutual has collapsed. People begin to panic that their bank is going to close its doors (even though more than likely, the deposits those people have are well below the FDIC insurable limits), so they take out all their money. When the deposits drop, the bank needs to increase reserves so it has to borrow. With the cost of borrowing high and sources of capital diminishing, it becomes impossible for the bank to maintain solvency. I think the media had a big effect on sending people to their branches to take out all their money and stuff it under their mattresses.

I was actually pleased to learn this morning that talks on the bailout package are breaking down. I believe that the vast majority of Americans do not want such a bailout to take place. Everyone I hear talking about this issue around the water cooler says they do not want it to happen. Let’s hope that Congress will lend an ear to constituents, and not pass legislation that will cost us for generations to come. A breakdown in the democracy in which this great nation was founded would be far worse than failure of the financial system.

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Before

After

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In addition to AIG seeking to resolve its problems, things were much worse for Lehman Brothers who is seeking chapter 11 bankruptcy protection.  LEH fell over 90% to 20 cents yesterday.  The other top story of the day was Bank of America’s buyout of Merril Lynch in an all-stock deal.  Bank of America shares were down over 20%.  The fed will continue to meet today and  a decision is expected around 2:15.

Through last week, there was no expectations of a rate cut.  However, yesterday sparked some hopes that the fed may decide to drop the federal funds rate to alleviate concerns surrounding the financial sector.  Interest rates may have to hit rock bottom to help those struggling to find capital.  I think that ultimately, the fed will have to allow some inflation to take place to help resolve many of the problems with credit and the economy.  If the fed doesn’t cut rates today, they may need to in the near future.  It has become exceedingly difficult for even large financial institutions to obtain capital, and without further reduction in interest rates these problems will continue.

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1. It will not help in the short run
   In the short term, gas prices will remain high. It takes time and tremendous capital investment to get a new oil platform up and running. It will take too long to build the platforms for it to impact gas prices this year.
2. In the long run, increased production will lead to increased consumption
   As a modern industrialized nation, we need to work towards developing and utilizing cleaner sources of energy than petroleum. Just as individuals and corporations poured money into developing the petroleum infrastructure many years ago, this needs to take place with renewable sources of energy. Increasing production to lower the price of oil will delay the evolution of better methods for harvesting energy. As limited resources continue to be consumed, it will need to happen anyway. It is better that this happen sooner than later, otherwise the effects it will have on the global environment could be catastrophic.

Fears of the Greek malady spreading to the UK grow

What do you do if you’re on a road trip and your battery is running low on charge? Even if battery technology improved to allow for a five-minute full recharge, where would you go to recharge? You can recharge at home for intracity commuting, however, you still need a recharging station when you travel further distances. Unfortunately, there will be no incentive for entrepreneurs and corporations to build recharging stations because electricity is so much cheaper than gas. It would take pennies to recharge your electric car so it will be up to the government to provide public recharging stations. There would be significant capital investment and there would never be a return on that investment. I think the cost to put an electric car in front of every house is much higher than Philip has calculated.

Although there won’t be anyone rushing to build recharging stations, there is definitely a bright future for improvements in battery technology. It will be the key to improving hybrid vehicle technology as well as fully electric vehicles. The electric double-layer capacitor is one type of technology that shows a lot of promise. Eventually someone will start to mass produce a highly efficient energy storage device and it will change the world. When this happens electric cars will be much more viable and it will open up new markets. At a minimum, the majority of vehicles (if not all) will be hybrids that incorporate the new technology. Only then will we be able to wean ourselves from our addiction to petroleum.

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As mortgage rates began to fall towards all-time lows early in 2004, real estate prices skyrocketed. Thus began an insatiable appetite for home ownership, and lenders began to offer all kinds of mortgage products that would allow consumers to finance as much as possible for as low a monthly payment as possible. It was a snowball effect that caused a housing bubble that eventually popped.

Unfortunately, a lot of time and money will now be spent with investigating lenders. Time and effort will also go into the development of new regulations to prevent such a calamity in the future. At this point there is little that can be done to rectify the problem, other than to simply let the markets take their course. The reality is that the banks have already paid the penalty with the increasing number of defaults they are experiencing. Most of the new regulations will probably be unnecessary, as the banks have learned their lesson and have become very restrictive with their lending practices in light of what is taking place in the real estate market and lending market.

If you still insist that someone should be to blame, you could point the finger at the Board of Governors of the Federal Reserve and former chairman Alan Greenspan. Although mortgages do not directly follow the Federal Funds Rate, they do tend to trend along with the Federal Funds Rate when it experiences rapid and drastic changes. From January of 2001 to June of 2003, the Fed Funds Rate dropped from 6.5% all the way down to 1%. They remained at 1% for a year, until the Fed began raising rates again in June of 2004. There are others that also share my view that Greenspan is partially to blame for the credit crunch.

Not only did the Fed’s monetary policy help fuel the fire for the spike in home prices, but remarks by the Fed chairman did as well:

American consumers might benefit if lenders provided greater mortgage product alternatives to the traditional fixed-rate mortgage. To the degree that households are driven by fears of payment shocks but are willing to manage their own interest rate risks, the traditional fixed-rate mortgage may be an expensive method of financing a home.

I think it is outrageous for the Fed chairman to make such remarks when fixed rate mortgages are at an all-time low (that remark was made on February 23, 2004). Certainly the banks were more than glad to oblige him, and they offered all sorts of exotic products to allow borrowers the highest mortgage balance possible for the lowest monthly payment. If you combine a high mortgage balance, an interest rate that is adjusting upwards, and little (or negative) home equity, you have a high probability that a default will take place.

Not only will a homeowner have a difficult time with the higher monthly payment on an adjusting rate, but with little or negative home equity, they may not be able to refinance into a fixed rate mortgage. Even if a borrower somehow manages to pass the strict requirements that lenders now have, the new fixed rate is very likely to be higher than the rate they had previously. The new payments are likely to be higher because of the higher rate as well as the principal component, which may have not been present in their prior mortgage if they had an interest-only loan.

The Fed may have prevented a recession in 2001, but the housing and lending markets are paying for it now. Now the Fed is lowering the Fed Funds Rate again, in hopes to prevent a recession from taking place. Sound familiar? Fortunately, this time there won’t be another housing bubble since the last one is still deflating. I think this time the actions of the Fed will result in the cheapening of our currency. It has already begun to happen, and is likely to get worse. Because the U.S. economy depends so much on foreign exports, the current actions of the Fed will most likely result in inflation.

Adding insult to injury, the bursting of the housing bubble has also contributed to the decline of the dollar. Foreign investors hold trillions of dollars in mortgage-backed securities. The problems with the housing and lending markets have led to a huge sell-off in these securities, lowering the demand for the U.S. dollar. If it wasn’t for foreign monetary policy, the decline of the dollar would probably have been much worse than it has been.

I think some moderate inflation will be necessary to allow household incomes to catch up with home prices. Even with the deflation of the housing bubble, home prices are still very high relative to incomes. If one is to purchase a home today with a traditional fixed rate mortgage, either their income needs to rise, the price of real estate must fall further, mortgage rates need to come down, or some combination of the three. Rising incomes will also help to lessen the blow of the problems with foreclosures and defaults. Lower foreclosures and defaults will improve the problems with the secondary mortgage markets, which will restore some confidence with foreign investors in that market. Eventually when things settle down the U.S. dollar should stabilize as well. It will certainly be interesting to see how things play out.

Introduction to Mortgages pt 3 of 5

Supplement to Weakon 231: What Went Wrong

is it our moral duty to carry on building debt to keep the economy alive?

I don’t know about it being our moral duty to carry on building debt, but it is definitely a part of the economy that is here to stay. The practice of financing spending isn’t limited to consumers. Year after year, the U.S. Federal Government operates with a budget deficit, and on very rare occasion ends the year with a surplus. The amount of consumer revolving debt pales in comparison to the federal government’s. Of course, being the analytical type that I am, I decided to take a look at the numbers.

U.S. consumer revolving debt increased from $850 Billion in December of 2005 to $902.3 Billion in December of 2006. An increase of $52 Billion or 6.15% (Source: Federal Reserve Board G.19 Release – Consumer Credit). By comparison, the U.S. federal debt increased from $8.17 Trillion in December of 2005 to $8.68 Trillion in December of 2006. An increase of $510 Billion or 6.24% (Source: U.S. Department of the Treasury, Bureau of the Public Debt’s Debt to the Penny History Search). The U.S. consumer does have an appetite for credit, but it’s not nearly as big as Uncle Sam’s!

U.S. consumers do love their credit cards, but credit card spending is actually quite minimal in terms of its contribution to the economy. In 2006, personal consumption expenditures were $9.2 Trillion (Source: U.S. Department of Commerce, Bureau of Economic Analysis). That means that credit cards only contributed about 0.57% towards the gross domestic product (GDP) in 2006. The federal government contributed $2.5 Billion to the GDP in 2006, so the increase in federal debt from 2005 to 2006 represents 20% of the government’s contribution to GDP in 2006.

As demonstrated by the huge amount of debt it has taken on, the federal government has supreme confidence in the sustained growth of the U.S. economy. The debt of the federal government represents a huge portion of its spending, but contributes less to the U.S. economy than consumers do. Although consumer revolving debt does seem like a huge problem, I think we are just fine as it relates to the overall economy. However, I didn’t mention non-revolving consumer debt. As you would expect (since it includes mortgages), it is much higher than revolving debt. At the end of 2006, it stood at about $1.5 Trillion. If there is any trouble with the economic outlook it lies therein, as many Americans have adjustable rate mortgages that are adjusting. But that is another story for another time.

German leader Merkel goes from glories to disgrace