The Economic Crisis

My wife asked me a great question last night, "Are we really in an economic crisis, or are we only in trouble because the news is telling us we are in trouble?"  In other words, are all the layoffs, plant closings, and personal penny pinching going on around the country truly a reaction to the current economic condition, or are we just reacting to what we are seeing on the news (a self-fulfilling prophecy).  It is a little of both in my opinion, but you have to really look at what has happened to our economy to understand why I say that.

So what has happened?  In my understanding, there was a lot of bad debt out there, and it finally got called.  The ridiculous mortgage debt gets the lion's share of the blame because it was by far the most readily visible form of bad debt, but there was lots of other bad debt mixing around hidden in accounting books and financial forms not so readily recognizable to most folks.  What happened was that this bad debt that could never be recouped simply became too great.  Financial institutions were forced to realize that they were never going to be able to call those debts, so they had to write them off.  Unfortunately, there was often only a pittance of tangible assets to back those debts, if anything at all.  This means that when the financial institution wrote off the debt, they didn't have any collateral to recover.

Take the example of a home mortgage.  Let's say that the builder constructs a home and sells it for $100,000.  Let's say that this home is in an area with explosive growth.  The first owner then sells it to owner #2 for $200,000.  Owner #2 sells to owner #3 for $400,000.  Finally, owner #4 purchases the property for $1,000,000 by taking out a loan from his bank.  Owner #4 is not able to make a down payment, and elects to take on a interest only 2 year mortgage that will re-adjust to the current lending rate after two years and become a 30 year ARM.  On paper, owner #4 now has a tangible asset (the house) worth $1,000,000 and an outstanding loan of $1,000,000.  Let's say the interest rate was set at 6% so his monthly payment is $5,000.  Now, let's say owner #4 only makes $6,000 a month.  After a couple of months of being able to make his payments, he starts to fall behind.  After 6 months, he simply can't pay, so he stops paying his mortgage altogether.  The bank forecloses on the property and evicts the owner.  So now the bank has a (on paper) $1,000,000 property ready to sell in a hot market.  However, imagine that this happened for EVERY property in that neighborhood.  Or at least a majority of them.  Suddenly that $1,000,000 home isn't worth quite so much.  In fact, it may fall to the original builder price of $100,000.  This means that the bank is out $900,000.  Even worse, it is out that kind of money on every home loan that failed.  

The net result is that the lending institutions were incredibly cash short.  Without any money to spare, the lenders have to be very rigorous in determining who they will lend to, and have to increase rates in order to make any attempt to recover from this loss.  For some lenders, it is simply too much, and they fail altogether.  We saw this on a daily basis through much of the third quarter.  For others, they reach out for a government loan (that $700 billion dollars you've heard so much about) to keep them afloat long enough to start recovery.

Now comes stage 2.  The majority of businesses rely on some form of short term credit or debt to get by.  Whether it is a car salesman who needs short term debt to acquire inventory, or a small services firm that uses credit to fulfill paychecks, short term debt is a primary cog in the business machine.  With little money to lend, only the most reliable businesses are going to get the credit they need.  Those who don't are forced to make some hard decisions: fold the business, reduce costs (through layoffs), or find some other cost savings measures.  It's not a free ride for those businesses that do receive their credit either, as they get much less than they had hoped for.  The net result here is what you see in the news every day: massive layoffs and corporate bankruptcy.  

So what's next?  Stage three (again, my own interpretation here) is a drastic reduction in purchasing, both at a personal and corporate level.  Sales predictions for every business are heading south because there is very little money available to buy any more than the bare necessities to get by.  All of the workers that went through layoffs are cutting every corner they can to get by until the next job comes along.  Businesses aren't investing in new equipment until their own sales improve.  It's a nasty downward cycle.

And here is where I get back to my wife's question: does the financial crisis really impact us?  To some extent, yes.  My company is very profitable, and we look to remain profitable throughout these tough times due to the nature of our products.  However, we do recognize that sales are going to be significantly less, so we've made some prudent cost cuts to help insure our safety.  One of those cost cuts includes my not receiving a salary increase this year.  This across the board measure will help save the company millions, and will help us to avoid any layoffs.  So in that sense, yes, the economic crisis has affected us, but only by three degrees of seperation from the root cause.  On the other hand, I have no concerns about losing my job, nor of not receiving my paycheck.  Although the news talks every day about personal spending cuts, our house can continue to live as we always have.  Part of this is due to job and financial security, and part of that is due to the way we live.  We have always chosen a lifestyle that means living well within our means.  We don't carry balances on credit cards, nor do we regularly depend on short term debts / credit.  Our only debts are a car loan and mortgage, and we've made sure those are well within our budget to pay each month.  We also were prudent savers, with four months salary in our cash reserves as well as healthy 401K, Roth IRA, and 529 savings plans.  This may come off as a bit boastful, but it is because of our conservative behavior that, for the most part, this economic crisis will not have a significant impact on our lifestyle.  In fact, this may be a time where our lifestyle improves due to the increased buying power of our dollar.  

So in answer to that original question, yes, we as a nation and as a world are in a very difficult economic time.  At a macro level, the economic crisis is real and great number of people are going to be affected by it.  The only way out of it is to find a way to recover from the bad debts that started this mess, prevent it from happening again, and make good credit available to those who can pay it back.  At the micro level, assuming that there are no further bombs to drop, our family will feel very little affect from this economic crisis.