The Federal Reserve and U.S. Treasury continue to fail in their attempts to stabilize the U.S. financial system. That is due to failure to grasp the nature of the problem, which concerns the parallel banking system. Rescue policy remains stuck in the past, focused on the traditional banking system while ignoring the parallel unregulated system that was permitted to develop over the past twenty-five years.
This parallel banking system financed vast amounts of real estate lending and consumer borrowing. The system (which included the likes of Thornburg Mortgage, Bear Stearns and Lehman Brothers) made loans but had no deposit base. Instead, it relied on roll-over funding obtained through money markets. Additionally, it operated with little capital and extremely high leverage ratios, which was critical to its tremendous profitability. Finally, loans were usually securitized and traded among financial firms.
This business model has now proven extremely fragile. First, the model created a fundamental maturity mismatch, whereby loans were of a long term nature but funding was short-term. That left firms vulnerable to disruptions of money market funding, as has now occurred.
Second, securitization converted loans into financial instruments that could be priced according to market conditions. That was fine when prices were rising, but when they started falling firms had to take large mark-to-market losses. Given their low capital ratios, those losses quickly wiped out firms’ capital bases, thereby freezing roll-over funding.
In effect, the parallel banking business model completely lacked shock absorbers, and it has now imploded in a vicious cycle. Lack of roll-over financing has compelled asset sales, which has driven down prices. That has further eroded capital, triggering margin calls that have caused more asset sales and even lower prices, making financing impossible for even the best firms.
My dad had a fundamental rule of economics, “When your outgo exceeds your income, your upkeep becomes your downfall.” Amazing how the titans of the financial world seem to have forgotten this.
What I do not understand – and if others do, please explain it to me – is if economists can figure why were in this financial crisis and what are the root causes, why oh why can’t the Federal Reserve, the US Treasury and the US Congress? Why must we endure half-baked plans that commit a lot of tax payer dollars and may or may not work. Maybe I’m missing something, but this humble commenter is very confused and rather annoyed that our country’s leaders are not doing a better job – not just political leaders but our financial leaders as well.
What’s does an average person have to do to create a nest egg? I know the answer to this, but my point is when Wall Street big time investors manipulate the market, day traders gamble on the market, smoke and mirror mortgages / securities evaporate in smoke (due to political favors, greed and people getting loans who have no business getting loans) and golden parachutes inflating for company executives, what chance do average people have? I mean really; it’s enough to make my head spin and my wallet cry.
BJ [#3]: You raise two important (though very different) questions.
1. Samuel Taylor Coleridge wrote, ” “If [we] could learn from history, what lessons it might teach us! But . . . the light which experience gives is a lantern on the stern, which shines only on the waves behind us.”
Our financial system has been changing rapidly, and there’s been much disagreement about what the changes mean and how to deal with them. How do you have effective, efficient financial regulation with four competing federal bank regulators, fifty state insurance regulators and bank regulators, a patchwork of other financial regulators, and fundamental political and ideological disagreement over whether and how to regulate the “parallel banking system” to which the author refers.
It’s hard to make controversial changes during good times. Defenders of the status quo chatter, “if it ain’t broke, don’t fix it”: i.e., you can’t make major reforms until it’s too late.
We have seen this pattern repeatedly during the course of American history. Congress rechartered a central bank in 1816 only after the government had defaulted on its debts during the War of 1812. The difficulties of financing the Civil War drove Congress to create national banks. The Panic of 1907 led Congress the create the Federal Reserve System. Wall Street excesses of the 1920s, followed by the Great Depression, gave rise to the securities laws and federal deposit insurance. The thrift debacle impelled Congress to bring savings-and-loan regulation up to the standards of bank regulation. We need a crisis or scandal to break the usual political deadlock or special-interest logjam.
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Now to your second question. Developing the right saving strategy depends on your age, your feelings about risk, and your other personal and financial circumstances.
But I’d urge you to consider investing in the stock market through a broad-based index fund like the Vangard Total Stock Market Index Fund. This fund is well managed, has low overhead, and mirrors the performance of the entire U.S. stock market. It does not seek to beat the market (which is hard to do) but to parallel the market. Thus if GE stock accounts for 1% of the value of all U.S. stocks, the fund keeps 1% of its assets in GE. You’d avoid putting yourself at the mercy of a commissioned stockbroker or other promoter. You’d also avoid putting many eggs in one basket. The market goes up and down, but over time it has generally done well.
To follow up with Irenaeus’s advice I also advise that — if you are looking for a sure return in a *short-term*, you not invest in the market.
Any competent financial advisor will say the same thing. The stock market is affected by a myriad different forces — almost none of which does the Federal Government have control over, which is another reason why their bailout package will do very very little to stave off the recession that is coming.
I also advise a spread of investments — don’t put all of your disposable money into the market, but spread it out over other investment possibilities, including “hard” investments like rental real estate investments.
And finally, as I learned from my Dad and many other wise advisors . . . . once the money goes into the stock market, say “goodbye, sweet money” and let it go. It should be *truly* disposable money.
To build a retirement nest egg:
Rule one: Avoid debt.
Rule two: Establish a regular plan of saving.
Rule three: If your employer has a 401(k) plan at least take advantage of the maximum employer match (that’s a tax free contribution).
Rule four: Never, ever take money out of an IRA or 401(k) before you retire — and then stick with the Minimum Required Distributions.
Rule five: Never, ever listen to a saleman — this includes insurance agents, money managers, fiancial consultants, etc. They are interested in their commission, not your retirement.
Rule five: Have at least six months of your income in a liquid asset (e.g., a bank savings account — 1 for each $100,000 of savings). P.S. the new $250,000 insured max expires after a year. The same applies to money you are likely to need soon (e.g., to make a down payment on a house, buy a car, pay the kid’s college tuition).
Rule six: Learn to read and understand a prospectus. Actually read the prospectus before investing.
Rule seven: Money you are not likely to need quickly in Treasuries or in some money market funds. Yes, some have “broken the dollar.” That’s one reason you need to read and understand the prospectus. You will discover that a fund like Vanguard Prime Money Market Fund is nearly all U.S. Treasuries. Others are riskier.
Rule eight: Put the retirement dollars in a mix of broad based *index* funds. This is like investing a few dollars in hundreds of different companies. Either put it in a “balanced index” fund, which is mixture of bond and stock funds (usually 40%/60%) or in a bond index and stock index fund. Most authorities recommend for young people mostly stock and for people near retirement mostly bond. There are also some “life index funds” which are similar to a balanced index fund except that the mix of bonds and stocks is varied by the managers depending on how long before you plan to retire.
Rule nine: Put your money into a good index fund. Do so on a regular basis (i.e., every payday) regardless of what is happening in the markets. Pretty much forget about it after you have put it in.
Rule ten: Do not attempt to time the markets. Above all, do not sell or move stock index investments just because the market is down (it will eventually go up) and do not buy stock index investments just because the market it up (it will inevitably go down). If you must try to time the markets, at least think “buy” when everyone else is selling and “sell” when everyone else is buying.
Some other advice. Don’t put your money under your mattress (where theives break in and steal…). If you put $1,000 under your mattress, a year later with only 3% annual inflation it will only buy $970 worth of goods. A bank savings account is better, but not by much; usually the interest rate will be close to the inflation rate — and you will pay your maximum tax rate on the interest. The idea of the savings account is to keep your money safe and quickly accessible in an emergency.
Generally avoid “managed mutual funds” because the fund managers’ salaries and expenses tend to be high. “Index mutual funds” typically have very low expenses.
Things to look at with funds: (1) commissions (at either end), (2) expense ratios, and (3) high turn over (i.e. they are doing a lot of buying and selling of stocks or bonds). You will find that information in the prospectus.
Irenaeus gave good advice. I have all of my retirement funds in various Vanguard funds (Balanced Index, Total Stock Index, Total International Stock Index and Prime Money Market). Yes, it is way down at the moment. The Money Market fund is stable and covered this year’s Minimum Required Distribution and will cover next year’s as well. I’m hoping that we will be recovering by 2010 when that has been exhausted.
There are some other outfits like Vanguard, such as Fidelity which offer similar “products.”
Thank you to all who responded. Excellent perspective and very helpful counsel.
Blessings –
BJ