This morning a friend of mine shared an article titled: AIG borrows 57 percent of government loan. The very first thought that came to my mind was, “I don’t remember hearing anything about AIG ever receiving any government loans.” The article states:

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.

Related Websites

Weakonomics Economic Review of 2008

UK companies plan to rely less on banks for credit

Citigroup completes agreement with US government

Related Posts:

Will Democracy Prevail?

Democracy Prevails – Round 1

Revolving Debt and the Economy

On Friday, Congress passed the Emergency Economic Stabilization Act of 2008. Since its peak on Friday, the Dow has gone down as far as almost 1000 points, or nearly 10%. Asian and European markets tanked on opening Monday and the U.S. markets have followed suit. If you’re confused as to why the markets have not rallied in response to the bailout, it is because the bailout has nothing to do with the stock market. If you read my post on the initial defeat of the bailout, then you’ll see that the stock market and credit markets are completely separate markets.

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.

Related Websites

Free Online Technology Helps Manage Business Telephone Expenses

Stock market ramblings

Free From Broke November 08 Review

Related Posts:

Will Democracy Prevail?

Democracy Prevails – Round 1

Is the Worst Behind Us in the Stock Markets?

Last week I asked if democracy will prevail, and earlier this week it did.  The Economic Stabilization Act of 2008 was defeated in the House of Representatives by a vote of 225 to 208.  Although the Dow Jones Industrial Average suffered the largest point loss ever, I was pleased to see that the majority of House members listened to constituents and defeated the bill.  A lot of it probably has to do with the upcoming election, which is a big incentive for incumbent representatives to listen to constituents in order to assure reelection.  I suspect that eventually some sort of relief package will be passed, but it is good to see that Congress will take some time to draft a bill that makes sense.

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.

Related Websites

Personal Finance Review - Egg on My Face Edition

Credit Law Repair Hands You The 'SECRET WEAPON' To Annihilate Debt Collectors!

Text of President Obama's State of the Union Address

Related Posts:

Bailout Passes – Stock Markets Down

Will Democracy Prevail?

Due to massive losses, uncertainty, and loss of confidence, credit markets have seized up and it is becoming more difficult for banks to borrow from each other. Congress is working on putting together a purported $700 billion bailout package to assist firms that are in danger of collapse because they cannot find sources of capital to meet reserve requirements.

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.

Related Websites

How to Invest Now Without a Dime in the Bank

Brown and Darling face a dilemma.

$700 Billion Bailout - Is My Money Safe?

Related Posts:

Democracy Prevails – Round 1

Bailout Passes – Stock Markets Down

When it comes to personal finance, most people are very familiar with the concept of cash flow. They know that their monthly pay represents cash flow in and checks written and automatic draft payments each month are cash flow out. As long as cash flow remains positive (the more positive the better), everything is great. However, most individuals do not realize that improving cash flow does not necessarily equate to improving overall savings and increasing one’s net worth. This is because interest expenses can reduce the accumulation of wealth, even though financing purchases (at higher interest rates) may improve cash flow.

What exactly does that mean? Perhaps the easiest way to explain it and understand it is with a good example. Here’s an example inspired by a post David at MyTwoDollars made in which a reader asks whether to pay off a car loan or increase the down payment on a new home:

My husband and I are selling our house and will be netting a profit of $52,000. We are building a $300,000 house and were wondering if we should pay off a Tahoe for $12,000 so we can get rid of a $600 payment or should we put all $52,000 into the new house. I guess I’m asking what the pros and cons would be. Thanks

Unfortunately the reader did not include additional information necessary for my example, namely the interest rates on the car loan and mortgage. I will take the liberty of fabricating the interest rates and some other information. Here are the assumptions we will make for the first part of the example:

• Auto loan balance: $12,000
• Auto loan interest rate: 0%
• Total monthly auto loan payment: $600
• Auto loan total term: 36 months
• Auto loan remaining term: 20 months
• New home purchase price: $300,000
• Down payment on home: $52,000
• Amount borrowed for home purchase: $248,000
• Interest rate on mortgage: 6%
• Mortgage term: 30 years
• Total monthly mortgage payment (principal and interest): $1,486.89
• Auto loan is paid off and money is not used for down payment on home purchase
• After auto loan payoff, monthly cash outflow is $1,486.89

In order for my example to work, I had to make the rather outrageous assumption that the vehicle was purchased with 0% financing. So if the auto loan is paid off the monthly cash outflow will be $1,187.11. Now let’s see what happens if we keep making payments on the vehicle for the remaining 20 months, and use the $12,000 to increase the down payment on the new home:

• New home purchase price: $300,000
• Down payment on home: $64,000
• Amount borrowed for home purchase: $236,000
• Interest rate on mortgage: 6%
• Mortgage term: 30 years
• Total monthly mortgage payment (principal and interest): $1,414.94
• Auto loan monthly payment: $600
• Monthly cash outflow: $2,014.94

Most people would tell you that paying off the car loan will help save $528.05 every month and over the course of 20 months would save a total of $10,561. However, I say that paying off the car loan will actually cost a total of $1,188.30 in terms of overall savings and accumulation of wealth. Certainly I will agree that cash flow will improve by $525.05 every month. However, by reducing the down payment on the new home by $12,000, it will actually cost more to pay off the car loan:

• Total interest paid on a 30-yr. loan for $248,000 @ 6% over 20 months: $24,558.27
• Total interest paid on a 30-yr. loan for $236,000 @ 6% over 20 months: $23,369.97
• Difference: $1,188.30

Keeping the car payment results in a higher net worth after 20 months, because the interest rate on the car payment is lower than that of the mortgage (now you see why I made my outrageous assumption of 0% financing on the vehicle). In terms of accumulating wealth, keeping the car payment is the more prudent decision. However, the majority of people would prefer to improve their monthly cash flow and pay off the vehicle. More often than not, individuals will sacrifice accumulating wealth in order to improve cash flow. Consequently this is the reason why most people never achieve financial independence.

The bottom line: if you ever have the opportunity to pay down loan balances, you should pay balances with the higest interest rates first. You may be tempted to pay off the balance on a loan with a lower rate if the monthly payment is higher than the payment on a loan with a higher rate. Afterall, it would result in better cash flow to do so. However, it would not result in the most favorable net worth to pay off a lower rate balance first. Let’s look at another example with some smaller numbers:

• You have a 36-month personal loan @ 10%
• Monthly payment on personal loan is about $260.
• Original personal loan amount was for $8,000.
• Remaining balance on personal loan is about $3,000.
• Remaining term on the personal loan is 12 months.
• You have another credit card with a $5,600 balance @ 18%
• Credit card has a monthly payment of $120.
• Total monthly payment for both loans is $380.
• You receive $4,000 for your annual bonus. Which balance do you pay off/pay down with the $4,000?

I contend that most people would probably opt to pay off the personal loan, because it would result in a better cash flow improvement. However, paying down the credit card instead would result in a higher net worth. Let’s compare the difference in interest paid over the next 12 months (the remaining term of the personal loan):

	Paying Off Personal Loan	Paying Down Credit Card*
Personal Loan Interest Accumulated	$0	$161.46
Credit Card Interest Accumulated	$969.82	$180.17
Total Cost	$969.82	$341.63
Remaining Credit Card Balance	$1,121.77	$249.48

As you can see, by paying the lower interest balance first ends up costing more in the long run. Although cash flow improves over the next 12 months, you pay more in interest expenses and are left with a higher debt balance in month 13.  A higher debt balance means you have a lower net worth. Not only do you pay less interest in months 1-12, but you will pay less interest in subsequent months and debt will be eliminated faster.  So remember, if you can afford to do so, pay down your loans with the highest rates first.

Related Websites

New Loan Funded — payoff current loan and new invest on business — $25,000 at 29.00% — E Credit — DTI 37%

How Do Credit Card Companies Charge Interest on Your Balance?

The Horror of Just Paying Monthly Minimum Payment to Credit Cards

Related Posts:

Prosper Days 2008 Videos

Having Trouble Refinancing? Borrow from a Rich Friend or Family Member

Preparing to Refinance