26 September 2008

Beware! There be Rocks Ahead!

I have been keeping tabs on what is happening in the US Financial markets as it does affect us here in far away Australia. The US economy affects China and India which purchase a lot of Australian resources. In our global economy, the financial chaos in the US affects every country.
The bailout is just the latest in a long series of government moves to become bigger and more involved in everyone's lives. It is not Republican vs Democrat as both seem to go for bigger governments in practice, even if they say otherwise.

Some background:
Loans have been made that normally should never been made. Typically banks and financiers made loans to people who couldn't pay, or on houses that were way overvalued. This was a combination of government policy and financier greed.

Now these loans were pretty dodgy. Although on the books they may be valued at $100, considering the risk of default, they may only be worth $50 to $60. (That is the open market value for them). To cover up this risky nature, many of the loans were bundled together into a group of loans called a CDO (Collateralized Debt Obligation - aka Bag of Bad Debts)
Now the CDO was presented as a AAA rating (That is, worth the full face value of the investment). The new $1000 CDO containing 10 dodgy loans was promoted as really being worth $1000. As these CDO's were often rolled up further and further, firms investing in them thought their money was safe as no-one could - or wanted to - discover what was really in those CDOs. They were "Asset Backed" so were as "safe as houses".
Problem is, the underlying loans were already starting to fall apart as those with the loans were defaulting and house values dropping.

If the banks with these dodgy loans tried selling them on the open market, they would have to record the loss. That would make them insolvent and the bank would go down. So they don't sell, hoping (futilely) that the loans will stay good. But the underlying house values are still dropping so the assets backing the defaulting loan don't even match what is owed. A loss in inevitable.

Imagine what would happen if many banks closed down. This is the current risk. If enough banks go down, the effect on others as interbank transfers start failing on the financial system is pretty dreadful. At the end of the day, the bailout will happen so that the financial system - worldwide - doesn't go into an equivalent of toxic shock.

Is the bailout a good idea? No, but I can't see the choice. All the decisions and government meddling over the last 10 years have been to artificially pump of the economy, and the banks and financiers have raked in the money knowing that the financial economy was all a stack of cards waiting to fall down. The laws requiring loans to be made to those that were never a good risk certainly didn't help. What a dumb idea. That deferred a recession but has only made it worse. Many of the decisions over the last few years is like you or I borrowing on credit cads to pay essentials or opening new credit cards with higher interest to pay off older ones.
Eventually the credit merry-go-round stops and the tears start.

The media reports this as a failure of free market capitalism.  The US market (and all financial markets) are not free market.  They are REGULATED free-ish markets.  It's just that the regulators in the US meddled way too much.

What can you do?
About the bailout? Nothing.
About your own situations? As always, follow Macawber's advice to young David Copperfield (paraphrased). 
Annual Income $20, Annual expenses $19.90 = Happiness. 
Annual Income $20, Annual Expenses $20.10 = misery.

There are two sides to getting into a better financial state - Offensive (getting income) and Defensive (not spending). Both are vital. As the Defensive side is mostly in the homemaker's area work at it the same way as the primary bread-winner works at the offensive. 
Cut unnecessary expenses like cable TV and many expensive activities. Encourage your children to provide services to locals such as car washing, mowing and house maintenance - for a fee. It is good for them and they can contribute to the family. Overall, operate as a combined family, not a set of individuals, and typically you will do well.

Also, remember that the economy always goes up and down. It has been quite a while since the last down cycle, and it is no surprise that this has come. Those who allowed themselves to be unwise with their money in good times will now have to relearn in the bad times. The best way to get through any bad times - whether war or disaster or economy - is strength of character. Integrity is your best defense.
Practice what you preach, remember God is in charge and ask him for help.


Anonymous said...

what a great and encouragain post - even if it is a little frightening to think we could be facing another depression

Dawnie said...

Thanks...this bailout stuff is making my brain hurt! Thanks for explaining it in a way I can actually understand!

We have no debt except for our house (praise God!) and plan to stay that way. It's much easier to make ends meet without credit card and car loan payments! And we can save money, too, now!