WSJ: Tips for 2009

The Wall Street Journal has some great advice for weathering tough economic times. On credit,

It's also a good idea to check your detailed credit reports at least once a year, which you can do free of charge at annualcreditreport.com.

And if you're beyond the credit maintenance point,

A good place to start looking for a nonprofit credit counseling agency is www.debtadvice.org, a Web site maintained by the National Foundation for Credit Counseling. The NFCC sets guidelines on fees that member agencies can charge consumers and requires agencies to provide services free of charge if a consumer can't afford to pay. To find NFCC member agencies, click on "find a counselor now."

On saving, WSJ recommends CDs if you are nervous about investing in the stock market:

Auction your cash to the highest bidder. At MoneyAisle.com, more than 100 small and midsize banks compete for consumer deposits through live auctions. When a customer comes to the site and asks for the terms of a CD or high-yield savings account, the banks bid against one another -- through automated auction software that runs on the Web site -- to win the deposit. The cost is free to consumers, and you don't have to commit to investing anything before you see the results of an auction. Participating banks, which are all FDIC-insured, are screened by an independent bank-rating agency to filter out the riskiest banks.

On student loans, WSJ points us to some private sources:

If you're maxed out on lower-interest federal loans, consider comparison shopping with SimpleTution.com or StudentLoanMonkey.com. The sites allow prospective students to shop around for student loans and avoid a hard inquiry on their credit reports. As the credit crunch has crimped student borrowing and increased interest rates on private loans, SimpleTuition and StudentLoanMonkey will show you available offers from a wide swath of lenders, not just ones that market heavily.

There are many more tips on saving, job searching, health insurance, and general life conveniences. Take a look at the article, you may be pleasantly surprised.

Impending Doom

60 Minutes warns:

...there are tough years to come because, just like the sub-primes, the Alt-A and option ARM mortgages were bundled into Wall Street securities and sold to investors.

Sean Egan, who runs a credit rating firm that analyzes corporate debt, says he expects 2009 to be miserable and 2010 also miserable and even worse.

Alt-A mortgages are not quite prime, but better than subprime. It stands for "alternative a-paper," a financial instrument that is rated just below the top credit rating. An option ARM is an adjustable rate mortgage that allows the borrower to select from a range of payment options, like varying levels of balloon payments.

Federal Reserve Chairman Ben Bernanke has lowered interest rates to the lowest level in the central bank's history, and Treasury Secretary Hank Paulson has committed to increasing credit availability. These measures are intended to eliminate a good amount of the toxic debt mentioned above by encouraging refinancing into traditional, safer fully-amortized mortgages, like a 30-year fixed rate mortgage.

Eighty years ago, before the great depression, the United States was locked in a housing and electrification boom. The balloon mortgage was the financing method of choice. Imagine a factory worker, James, wants to buy a home in 1925. He would save 20% of the value for a down-payment and finance the rest with a mortgage. Imagine the home costs $100,000 in 2009 dollars, he would put up $20,000 and the bank would lend the additional $80,000 as a balloon mortgage at an interest rate of 15 percent per year for five years. (I've added a zero to the cost of the home to make it easier to conceptualize.)

James now buys the home and only repays interest on the loan until the principal ($80,000) comes due in five years. His monthly payments are [$80,000 * (0.15 / 12)] = $1,000, and his total annual interest expense comes to ($80,000 * 0.15) = $12,000 per year. Therefore, over five years, he would have paid the bank a total interest of $60,000, and would still owe the $80,000 principal. In many situations, James and his 1925 cohorts would come short of the $80,000 and the bank would have to foreclose hoping to be able to sell the house for at least that much.

Unfortunately for the bank, they had to foreclose on James' home in 1930, only months after the 1929 stock market crash. That crash sent shivers through the entire financial system and no one is lending anymore. As a result, families that can afford a home cannot get a loan. Making matters worse is that mass layoffs are forcing more families to dip into their savings, their balloon payment, which forces more foreclosures. Therefore, even if a family can fully finance the purchase of a new home, there is no incentive to buy if that home will be worth less just months after buying. This creates a deflationary spiral, in which prices just keep falling with no end in sight.

I digress... that is for another post. Following the Great Depression -- into the great society reforms of the 1950s and 60s -- the fully-amortized mortgage replaced balloon mortgages as the standard offered by the Federal National Mortgage Association (Fannie Mae) and insured by the Federal Housing Administration (FHA). Fully-amortized mortgages calculate all the interest for the life of the loan, add it to the principal, and give the homeowner a single payment obligation for the life of the loan.

Using the example above, James would owe the bank $80,000 + $60,000 = $140,000 over the entire life of the loan, principal plus interest, respectively. The bank would ask him to repay the loan with payments of [$140,000 / (12 * 5)] = $2,333.34 each month. Even though this more than doubles the monthly cost of the home compared to the balloon example, neither James nor the bank have to worry about the balloon payment.

This is a very simplistic example, but it is intended to illustrate that we need to continually look toward history for examples of when, where, and how to use credit responsibly. Balloon loans are powerful tools, especially for governments and corporations that have access to huge investment pools. Individuals cannot refinance as easily as these entities, though, so conservative loans often make more sense. Most consumer loan products today are based on this principle, e.g. student loans, xx-year fixed mortgages, auto loans, etc.

Credit card debt, however, is a balloon loan, and Business Week warns:

...the subprime threat is also greater in credit-card land. Risky borrowers with low credit scores account for roughly 30% of outstanding credit-card debt, compared with 11% of mortgage debt.

There may be impending doom in credit cards, alt-a, and option ARM loan products, but federal regulators are extremely sensitive to these problems. That is one of the main differences between the Great Depression and today's economic situation. I will address some other issues raised above in other posts.

Emerging Market Watch

Nouriel Roubini writes:

There is now also the beginning of a hard landing in emerging markets as the recession in advanced economies, falling commodity prices, and capital flight take their toll on growth. Indeed, the world should expect a near recession in Russia and Brazil in 2009, owing to low commodity prices, and a sharp slowdown in China and India that will be the equivalent of a hard landing - growth well below potential - for these countries.

Professor Roubini correctly identified the potential of a structural crisis in the banking industry. Today, he is pointing to emerging economies as experiencing a bigger challenge.

Emerging economies do not have the political or financial infrastructure to weather a storm of this magnitude. For this reason, the International Monetary Fund (IMF) is critical to maintaining stability in those countries. Former IMF chief economist Simon Johnson thinks the Fund is ill-prepared to handle this crisis, as Bloomberg reported in October:

...the fund has the option to tap an additional $35 billion to $50 billion from rich countries. The IMF may need to go beyond that total to meet the demand for loans, he said.

"If we are really facing the problem I think we are, you need about $1 trillion," Johnson said.

Demand for the fund's loans -- which had dried up over the past five years as developing nations boomed -- is now soaring. Hungary, Ukraine, Belarus, Iceland and Pakistan have all announced this month that they are seeking financial support from the IMF.

Political stability of the emerging market should be of major concerns to policymakers in advanced economies, like the United States and Europe. Financial crises are fertile ground for fascism and irrational dictators. The IMF and World Bank were created to act as a lender of last resort to help young democracies avoid political revolution. We should hope our domestic policymakers recognize the importance of ensuring stability in emerging economies.

Recovery from Our Core

Peggy Noonan writes:

[Former Secretary of State George] Shultz laid out some particulars of his own optimism. There is "the ingenuity, the flexibility, the strengths of the national economy." The labor force: "We are so blessed with human talent and resources." And the American people themselves. "They have intelligence, integrity and honor."

The United States has been under a microscope for some time as a safe investment, a land of opportunity, and a place where ideology is challenged but never silenced. Today, we are under the microscope again for the purpose of fixing the many ills that emerged from complacency of the wealthy.

Economically, the damage is done. The Federal Reserve, Treasury, and thousands of independent businesses are working together and separately to ensure a better future. The challenge for students and early labor market entrants is to fully understand the obstacles we face. Secretary Schultz makes the point that, above all else, the American worker has a core set of values that makes the United States the best investment, still. It is up to us to identify those values and reinforce them in our nation's youth.

Welcome

Welcome to the Graduate Rich blog.

The purpose of this blog is to provide current commentary and perspective on the Graduate Rich principles. It will look at economics, goal setting, budgeting, credit, employment, and money. I will try to update it at least twice a week with articles of interest, links to other bloggers, and other daily musings. My ultimate goal is for this site to be accessible to all that subscribe.

Please enjoy and feel free to drop me a line with any comments/suggestions.

John