Politics or Poppycock

CNN

By Stephen Gandel and Paul J. Lim

Last Updated: October 9, 2008: 12:29 PM ET

If you’re watching the news and scratching your head wondering what bomb hit the economy, you’re certainly not alone. It’s rough out there. People are losing their jobs, retirement dreams are going up in smoke and personal wealth is plummeting. Here’s why it’s happening and what it all means.

How did we get here?

By now you likely know that the crisis in the financial markets is the culmination of years of reckless mortgage lending and Wall Street dealmaking. It’s the final gasp of the burst housing bubble. But how exactly did this happen?

To find the root cause of Wall Street’s woes, you have to go back to the collapse of a different bubble – tech. In 2001, after the dotcom craze ended and the bear market began, the Federal Reserve started aggressively slashing short-term interest rates to stave off recession. By eventually reducing rates to a historically low 1%, the Fed reinflated the economy. But this cheap money sparked a new wave of risk taking.

Homeowners, armed with easy credit, snapped up properties as if they were playing Monopoly. As prices soared, buyers were able to afford ever-larger properties only by taking out risky mortgages that lenders were happily approving with little documentation or money down.

At the same time, Wall Street investment banks got a brilliant idea: bundle the riskiest of these mortgages, then slice and dice these portfolios into tradable bonds to be sold to other banks and investors. Amazingly, bond-rating agencies slapped their highest ratings on the “best” of this debt.

This house of cards came down when subprime borrowers began defaulting on their mortgages. That sent housing prices tumbling, unleashing a domino effect on mortgage-backed securities. Banks and brokerages that had borrowed money to boost the impact of those investments had to race to raise capital.

Some, like Merrill Lynch, were forced to sell. Others, like Lehman Brothers, weren’t so lucky. “What we always tell investors is beware of too much leverage in a company,” says Brian Rogers, chairman and portfolio manager for T. Rowe Price. “Leverage is the enemy of the investor.”

Sure, everyone from former Fed chairman Alan Greenspan to your friends and neighbors played a role in stoking this casino culture. But troubled banks and brokerages can’t pass the blame. “These firms closed their eyes and made very bad bets on risky securities that they didn’t truly understand,” says Jeremy Siegel, finance professor at the University of Pennsylvania’s Wharton business school. “Investments that they did not have to make led to their demise.”

How bad could the economy get?

Before the meltdown, economists fell into two camps: those who thought the economy had already slipped into recession and those who thought a recession could still be avoided.

While forecasters still differ on the timing and severity of a downturn, “the consensus view is that we’re headed for recession and will be in one until next year,” says Mark Zandi, chief economist for Moody’s Economy.com.

Corporate profits are already on the verge of falling for a fifth straight quarter, according to Thomson Financial. The next shoe to drop will be consumer spending. “Two years ago, people were using their homes as ATMs, pumping out cash,” says Robert Arnott, chairman of the investment consulting firm Research Affiliates in Pasadena. “As banks continue to tighten their lending, that spending is disappearing.”

But softer profits and slower spending haven’t translated into widespread layoffs yet. “This is the strongest recessionary job market in 40 years,” says James Paulsen, chief investment strategist of Wells Capital Management. A jump in unemployment could still be coming, especially given bank and brokerage failures and mergers. But outside of finance and housing, much of the rest of the economy is strong, he says.

The weak dollar is boosting demand for our goods abroad, and lower gas prices are making Americans feel more flush. Add in the cash that the Fed has been hosing into the banking system and we are bound to see growth in 2009. “If all this stimulus has no effect on the economy, that would be a rarity indeed,” says Paulsen.

Standard & Poor’s chief economist David Wyss expects a mild recession that ends next spring. “Gradually we will regain confidence in the market. Lower oil prices and a falling trade deficit will help,” he says. “This is a financial panic, not an economic one.”

Of course, that could change if the financial panic doesn’t abate soon. If banks remain too scared or broke to lend, would-be home buyers will be frozen out of the market. If that happens, home values could fall even more, crimping confidence and putting the brakes on the economy’s greatest engine: the consumer.

Does all this mean I’ll pay higher taxes?

Yes. “Taxes will rise regardless of who wins the Presidency,” predicts Greg Valliere, chief political strategist for Stanford Group Co.

It’s impossible to say what the final bill for rescuing Wall Street will be. Even before the bill to buy $700 billion of unwanted mortgage-backed debt, the government had already signed on for nearly $365 billion in loan guarantees and other costs.

The eventual price tag will depend in part on the housing market. If it recovers by 2010, the value of mortgage-backed securities could rise, minimizing the tab for taxpayers, says Brian Bethune, chief U.S. financial economist for Global Insight.

“On the other hand,” Bethune adds, “if the economy continues to tank into a deeper recession, dragging the housing market along with it, then the costs to the taxpayers easily could escalate to several hundred billions of dollars.”

Under Treasury Secretary Henry Paulson’s original debt-buyback proposal, some economists predicted the federal deficit could soar to $900 billion in 2009. Even without a bailout, the federal budget was expected to hit $482 billion next year. If government aid pads that figure by $200 billion, the deficit will be back to where it stood in the 1980s – around 5% of GDP. At the very least, that will make it hard for a future President to keep tax-cut promises.

Wondering when the roller-coaster ride will end? Should you bail out now? Here are some answers to your questions about your stock portfolio in the current economy and what your next move should be.

When will stocks bounce back?

Don’t expect an immediate rebound. “Investors shouldn’t get overly enthusiastic,” says Jean-Marie Eveillard, portfolio manager for the First Eagle Funds. Why? Even if Washington gets its act together, the economy will remain a drag. “In a time of slow growth, profits will not be that great,” Eveillard says.

Remember too that a massive government rescue plan could have unintended consequences. If the budget deficit were to balloon – as many economists assume it would – that could further weaken the dollar, which would lead to another bout of inflation fears.

Rising inflation and a falling dollar, in turn, would likely boost market interest rates, since it will take a big carrot to entice foreign investors to buy U.S. bonds. When rates are on the rise, investors typically aren’t willing to pay up for stocks in the form of higher price/earnings ratios.

Economists are predicting that a recession could last through next spring or even the fall. Does this mean stocks will languish that entire time? No. Equities have a knack for rallying in anticipation of an eventual recovery. So a stock market rebound could take place sometime in the first half of 2009. Until then, don’t hold your breath.

If the outlook is so bad, why not dump stocks?

Selling stocks after they’ve sunk to a three-year low in hopes of buying them back after they’re trading at higher prices is a surefire recipe for losing your shirt.

While it’s understandable to want to flee, Bohemia, N.Y. financial planner Ronald Roge suggests taking a cue from Warren Buffett. “Here’s the smartest guy on the block, and his firm, Berkshire Hathaway, is down like most other stocks this year.” But instead of looking to sell, Buffett is buying. Recently he agreed to plow $5 billion into Goldman Sachs.

Still have the urge to purge your portfolio? Consider this: So far this year, fund investors have yanked more money out of their stock funds than they’ve put in, marking only the third time in recent memory this has happened. The other two times? In 2002, just before a five-year bull market, and 1988, the start of a 12-year bull.

“If you leave the market now entirely, you probably won’t make it back in time to enjoy the recovery,” says Torrance, Calif. financial planner Phillip Cook. According to Standard & Poor’s, equities typically recoup a third of what they lost in a bear market in the first 40 days of a new bull.

Are stocks still best for the long run?

If you’ve been a stock investor over the past decade, you probably feel like the mythical Sisyphus: You’ve been trying to roll your portfolio up the hill, only to see the market keep batting it back down. Stocks are trading lower than they were at the start of 2000. Even boring bonds have beaten equities during this time.

But disappointing performance doesn’t erase the case for stocks. Over the long term (meaning more than a decade), equities give you something fixed-income investments can’t: a share of growth. The benefit of owning a stake in a company – as the Treasury Department, no doubt, understands with the majority position it is taking in exchange for helping AIG – is that you get to share in the earnings of the firm. And because stock prices, over time, reflect corporate profit growth, you’re likely to far outpace the long-term rate of inflation.

If your faith in stocks is still wavering, consider the last time they performed so poorly: the 1930s. “What if you concluded then that stocks weren’t the best place to be?” says Alan Skrainka, chief market strategist for Edward Jones. “You’d have missed out on decades of bull markets.”

With banks falling like dominos, there’s a lot of worry about the solvency of financial institutions. Some people are pulling their cash out of the stock market and putting it into FDIC-insured accounts, while others are hiding theirs under their mattress. Before you make any drastic moves, read these answers to some common questions about your savings.

Are there any safe havens left?

It sure doesn’t feel like it. Even conservative investments – like ultrashort- term bond funds and a single money market fund – have lost value recently. But rest assured, your cash accounts are still extremely safe. To shore up confidence in money-market mutual funds after a prominent portfolio “broke the buck,” the Treasury Department launched an insurance plan to guarantee their value.

What’s more, bank money-market accounts and CDs are as protected as ever. While it’s certainly hard to tell which banks will eventually survive this financial meltdown, your accounts are FDIC-insured.

Finally, if you’re looking for a safe option within your 401(k), consider a stable value fund. These portfolios often invest in a diversified mix of short- to intermediate- term bonds that are backed by different insurers. Plus, they’ve been yielding around 4% lately.

Is my bank or brokerage going to disappear?

Even with the government stepping in to buy up the crummy mortgage-backed securities that are endangering the health of so many banks and brokers, this relief won’t be immediate. It may take weeks for the Treasury Department to put together a team to evaluate these bonds. In the meantime, more banks and brokers could go under or be forced to sell out to healthier firms.

Still, the tally of failed banks is unlikely to come close to the number we saw in the savings and loan crisis. Between 1986 and 1995, 1,043 thrifts went under (though many of them were tiny). So far this year, only 13 banks and savings and loans have failed, according to the Federal Deposit Insurance Corporation. That includes Washington Mutual, the nation’s largest S&L, which was shut down before its deposits were sold to J.P. Morgan Chase (JPM, Fortune 500).

Regardless of what the final tally is, it’s important to keep in mind that your bank deposits are for the most part safe. Deposits up to $250,000 per person per institution and $500,000 for joint accounts will be protected by the FDIC (The FDIC temporarily raised the limits from $100,000 and $200,000 respectively through December 30, 2009.). Some retirement accounts are covered up to $250,000.

Investment banks and brokerages have also come under pressure. Here too you are mostly protected. Unlike commercial banks, which use your deposits to lend to other customers, brokerages are supposed to segregate your assets from theirs. So if you own 1,000 shares of General Electric and your brokerage collapses, your 1,000 shares of GE should still be there and will most likely be transferred to another broker on your behalf.

If for any reason your failed broker can’t locate your securities, up to $500,000 of your assets per account is covered by the Securities Investor Protection Corporation, a nonprofit funded by member firms. With a few exceptions, SIPC limits its safety net to SEC-registered investments. So while your stocks, bonds and mutual funds will be covered, foreign currency, precious metals and commodity futures contracts won’t be.

When AIG had to be rescued by the U.S. government, holders of annuities and home insurance policies everywhere got spooked. If AIG could be vulnerable, couldn’t anybody? To find out what could happen to your policy in the event of catastrophic failure, read on.

What would happen if my insurer went under?

You may have wondered that very thing before the federal government stepped in with an $85 billion loan guarantee to save American International Group from bankruptcy. Since then no other large insurance company appears to be in similar peril. That’s because few insure mortgage bonds, the business that contributed to AIG’s problems.

In the event that your insurer goes belly up, you have protections. If you have an outstanding claim when your insurer fails, a state guaranty fund will cover it. The rules vary, but funds typically pay up to $300,000 in claims on most policies.

In nearly all states, disability payouts have no caps. With a variable annuity, you are completely protected because you’re investing in mutual-fund-like separate accounts held in your name, and insurance companies can’t touch those assets when they liquidate.

If you have yet to collect on your insurance policy, will you face any coverage gaps? With life insurance, you shouldn’t lose coverage: In past failures, regulators have moved policies of failed insurers to healthy ones. For most other types of insurance, you’ll have 30 days to find another insurer. And if you have paid in advance for, say, a year’s worth of homeowners insurance, you can apply for a refund from your state insurance fund.

The global contagion has spread, but the source of the crisis is still bleeding. From struggling homeowners who can’t make their payments to would-be buyers, almost everyone is wondering where home prices are heading next. Here’s some insight.

Is there any hope for home prices?

The burst real estate bubble that kicked off this crisis is unlikely to reinflate quickly. “I don’t see the slump in housing prices ending anytime soon,” says Dean Baker, co-director of the Center for Economic Policy and Research. The government takeover of Fannie Mae and Freddie Mac lowered mortgage rates briefly (which helps buyers afford your home).

But the bankruptcy of Lehman Brothers, the failure of Washington Mutual and the sale of Wachovia, as well as the stock market sell-off, have made investors nervous about everything, mortgage bonds included. And that has pushed home-loan rates right back up.

The proposed government bailout could help home prices if the banks that get relief turn around and make new loans, but it’s not clear that they will. More important, housing prices are not just a factor of mortgage rates. Foreclosures and slow sales have left 4-million-plus homes on the market, nearly half a million more than two years ago. That could get worse before it gets better if rising unemployment translates to fewer buyers to work off that fat inventory.

“In the long run none of what we’re doing now is going to matter that much to real estate,” says Wellesley economics professor Karl Case. “Home prices have to do with the scarcity of land and perception of that scarcity.”

Until homes for sale are again scarce, it will continue to be better to be a buyer than a seller. Most economists expect another 10% drop in housing prices nationally over the next year. Some, like Nouriel Roubini of New York University, say a 15% to 20% drop is more likely.

In today’s world, most of us need to borrow to buy a home or a car, go to school or start a business. But the credit crisis has banks too scared to lend. Is it really as bad as they say? Here’s what it takes to get funding in today’s tough market.

How tough is it really to get a loan today?

For months you’ve likely been hearing about (or even experiencing) tight credit: frozen home-equity lines of credit, lower credit-card limits, tougher loan standards. That could be just the beginning. One reason regulators have been so anxious to step in during this crisis is the fear that consumer and business borrowing will be shut off altogether.

For now, though, many people are still able to get loans. “If you have good credit, job stability and low debt, there is a good likelihood that you will get a mortgage,” says Marc Savitt, president of the National Association of Mortgage Brokers.

In general you’ll need a 660 credit score and a 10% down payment to qualify for a loan. Another important criterion is how much of your monthly income goes to repaying all your debts. Today lenders want you to cap that at 41% of your income.

Getting a small business loan is similarly tough. But if you can borrow and have the itch to strike out on your own, small business experts say economic downturns can be a good time to start a venture. In bad times, you may find better deals on, say, advertising and office space. And some of the land mines are more apparent.

“When existing companies are stumbling, it’s more obvious what mistakes are to be avoided,” says Bob Chalfin, a Metuchen, N.J. small business adviser and a lecturer at the Wharton business school. “When there is change, there is opportunity.”