How to Cope in a Scary Economy

The dollar is down! Unemployment is up! The housing market is collapsing! The stock market is in the tank! Nobody can get a loan! We’re bailing out brokerage firms!

Who Wouldn’t Be Nervous?

I was teaching a Securities Analysis class at UCLA when nearby Orange County declared bankruptcy. A student asked me to explain why. Another student quipped, “It’s too complicated.”

I explained it within ten minutes, and not one student failed to understand it. The one who thought it would be too complicated said, “It that it?”

Yes. This stuff is easy to understand when it’s explained in English.

The Dollar

The value of the dollar is down. The value is measured against other currencies, though. That’s good news and bad news. Good news is other countries can buy more of our stuff. It used to be that a Euro was worth about a dollar. Now one Euro buys about $1.50. The stuff we sell overseas is half off. Winner? US companies who sell a lot of stuff overseas.

Bad news is we have to spend more of our dollars to buy their stuff. Like oil. You might have noticed that oil’s gone up. I can bore you to death with a myriad of other causes, but one very big one is that our dollar is worth less. We have to spend more of them to buy imported stuff. Winner? Overseas companies who sell us a lot of stuff.

Unemployment

Unemployment is up. This statistic is as important as whether you have a job. If you do, it’s just a signal of a slowing economy. If you don’t, it’s the end of the world. Either way, the question is, why have businesses let people go? The answer is maddening.

If you own a business, and everybody is saying that people have stopped spending, you are unlikely to expand your business. The data say that spending is holding, though. We may be buying at WalMart rather than Macy’s, but spending is not down. It’s a fear thing – everybody’s talking about bad times, so we act like times are bad. That includes business owners, who decide whether to hire or not.

Housing Market

The housing market situation is a correction. Housing prices, like stocks, gold, cars and taxes, go up and down. These corrections happen about every decade or so. Some are mild – sometimes prices are just stagnant for a few years, then begin normal appreciation. Some are severe. This one’s severe.

The severity was caused by lenders making “zero down” and “no doc” loans. Zero down means what it sounds like. No money down. Well, if housing prices go down at all, people who put no money down will owe more that the property is worth. No doc loans are loans that require no documentation to prove things like how much you make and how much you’ve saved.

If housing prices always go up, there’s no problem. There will be equity in the price appreciation. But nothing always goes up. Some of these zero down people now owe more than their property is worth. And there are lots of them.

They probably wouldn’t have qualified for a conventional (20% down, 30 year mortgage, with payment no more that 30% of gross income) loan. Now we know why.

So, they lose their homes, and a lot of these homes go on the market. When there are more sellers than buyers, sellers lower prices until buyers start buying. That happened to internet stocks and now it’s happening, to a much lesser degree, to houses. The last time it happened in housing was the early 1990’s. We lived through that, and we’ll live through this, too. By 2012, this will be forgotten by all except those who lost their homes.

Stock Market

In a normal (20%) correction. Companies that get most of their income from overseas (see Dollar) are doing best. Housing stocks and housing lenders (see Housing) are doing worst.

The reason no one knows for sure whether we’re in a correction, is that a correction is two consecutive quarters of contraction (negative growth). We won’t know until July whether that’s true.

We do know that people feel less rich because they don’t have oodles of equity in their house, and while spending is not Decreasing, it’s not likely to go up a lot. And consumer spending is 2/3 of US Gross Domestic Product.

Corrections happen about every ten years or so, and the last one was in 2001. Since the stock market tends to ‘discount’ prices six months in the future, most of the smarter people I listen to think that the economy will improve in the second half of this year, so the stock market is probably about finished correcting.

Nobody Can Get a Loan

Banks have to keep a percentage of their assets (which are loans) in cash. That is called capitalization.

When loans are bad, an extra amount, called ‘reserves’ is put aside to cover people who don’t pay them back. Right now, a lot of people aren’t paying back mortgages (see Housing).

Because banks have to put this extra amount aside, they don’t have as much to lend out. So, they only lend to people with really good credit and lots of assets. If you’re not one of those people, banks don’t want to lend to you right now. They have enough problem loans.

If your credit is good and you have lots of assets, you’ll have no problem getting a loan.

Bailing Out Brokerages

J.P Morgan bought Bear Stearns for a song. Sort of.

Bear put lots of investors in mortgages. Not regular mortgages, but little slices of mortgages. Here’s how it works.

Banks make home loans and bundle them into packages. Here are a bunch of loans, sliced into pieces – some with only the interest part of the mortgage payments, some with only the principal part. Because mortgages were very highly rated by bond insurers, little old ladies bought them for income.

Some of these loans, though, were ‘no down’ and ‘no doc’ loans. Some weren’t. When these loans started to be problems, they weren’t owned by the banks that made them. They were owned by hedge funds, mutual funds, and lots of little old ladies who bought little pieces of them from brokers.

Bear had a lot of these things. No one knows how many, or what they’re worth.

Before they were bought by J.P Morgan, Bear’s book value (my favorite way of valuing a financial company) was about $74/share. On the following Monday, there stock was selling for $2 and change/share. That’s because nobody, not the Fed, not J.P. Morgan, not Bear, nobody knew how many of these things were on their books. They just knew there were a lot.

The Fed knows how nervous people are, and didn’t want to have a brokerage failure, with people panicking about their money market accounts and thinking their accounts were worthless. So they were very, very persuasive with J.P. Morgan about buying Bear. They made lots of promises to help if things went wrong, because they thought it would be cheaper than a panic.

The Sky is Not Falling

This is a rough patch. In the next president’s mid-term, these stories won’t make the first five pages of the paper.