For today’s post, I have agreed to join eight other bloggers and provide my thoughts on the following question:
"What is the single most important initiative that the next administration should undertake to improve the economic health of the U.S. middle class?"
At the end of this post, I have listed other sites that are also participating in this, so if this is something that is of interest to you, feel free to visit them for their prespective on this topic.
Introduction
As we saw from the turmoil in the financial markets on Monday, passage of the bailout bill was not enough to fix the crisis at hand. In order to restore confidence to the credit markets, the bill needs to be implemented; and this work will fall largely on the shoulders of the next administration.
The crisis is largely one of confidence; brought about by the way that the financial markets are set up. And unfortunately, if the government fails to restore this confidence, the potential downside will be felt by almost everyone. In the remainder of this article, I will provide basic explanations for some of the principle causes and will also discuss the potential risk if confidence is not restored.
The Causes
Leverage: As a rule of thumb, banks typically lend out about 12 times more than their capital base. So, for example, if a bank has $100k is assets, it might lend out $1.2 million. In practice, this works well. However, if a bank has to write off a bad loan, then leverage works against them. So a $10,000 write-off means that the bank has to either reduce their loan portfolio by $120k, or raise new capital to cover the loss. And with many bank stocks floundering at or near 52 week lows, raising new capital can either be expensive or impractical. As a result, some banks have turned to tightening up lending by canceling lines of credit or making it more difficult and costly to borrow.
Mark-to-Market Accounting: Simply described, this is an accounting rule that says that if you have an asset on your books, it has to be valued at the price that the market will pay for the asset at a given point in time. Firms can choose whether or not they use mark-to-market for their assets; and many banks chose to do so when housing and similar assets were rising in value, as it allowed them to recognize oversized profits. However, once a firm chooses to use mark-to-market, they cannot revert to a different method.
Toxic Mortgage Debt: Banks and other financial firms that are holding mortgages or mortgage related securities are finding they are worth a lot less than they expected, or that the secondary market for buying and selling mortgage-based products has effectively evaporated, because there are few, if any, buyers. As a result, the market value for these securities is either very low, or zero.
The combination of bad mortgage debt, along with mark-to-market accounting and leverage has created a perfect storm of sorts, where the losses that banks are being forced to recognize on their books are being amplified into much larger problems in the credit market.
The Risk
Given that our economy is largely driven by credit, the problems in the credit market can readily spillover into other areas of the economy. Tighter lending means that it can be more difficult and costly for consumers to obtain loans for large-ticket items such as homes and cars. More importantly, many large organizations depend upon loans of varying types to fund expansion activities, as well as short-term operational needs, such as payroll and inventory purchases. Already, McDonald’s has reported a delay in its plans to build coffee bars in its restaurants because franchisees were denied financing through Bank of America. And California is thinking about asking for an emergency loan from the government so it can keep operating.
Simply put, if the next administration fails to instill confidence in the banking system through a successful implementation of the bailout program, we may see a large set of issues pop-up that are all indicative of a worsening economy: Firms closing and associated job losses because they cannot cover payroll or buy inventory, auto and housing companies facing tough times because of fewer sales, and continued softness in the stock market. Issues which will hit Americans at every level, regardless of their income.
Other blogs covering this topic include:
Blunt Money at www.BluntMoney.com
Cash Money Life at http://cashmoneylife.com
Clever Dude at www.cleverdude.com
Finance Your Life at www.financeurlife.com
My Dollar Plan at www.mydollarplan.com
My Journey to Millions at www.myjourneytomillions.com
Student Scrooge at www.studentscrooge.com
Tough Money Love at http://toughmoneylove.com
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The bailout
Randy, thank you very much for your post today. I kept hearing the term mark-to-market on the TV all last week and this wek, however never knew what it meant. Thank you very much for clarifing this and the other bullet oints you brought up. I really appreciate your taking the time to post this.