Economic Update: October 1, 2008
Our economy is in a crisis. This economic update is in response to numerous emails and phone calls I have recently received asking for my advice and perspective on the economy.
Let me begin by saying that I hope I am wrong. It will bring great joy to my life if in 2010 I look back and realize that I was wrong. As I write this article, I am more willing to take the risk of being criticized in the future (for being wrong) than to take the risk of knowing what I think is going to happen and not having the courage to tell anyone. I am also willing to take the risk of being labeled a pessimist. The fact is, I am a realist. A realist takes the facts and evaluates them.
I believe we are in the middle of a mortgage/housing financial storm that will not be clearing until mid or late 2009 at the earliest. (Just for your information I have been using this time line on radio interviews since October 2007.) This time-line estimates is how long it might take for the bad sub-prime mortgage and housing market to clear up. When the mortgage crisis began in July 2007, I thought it would take at least 24-36 months for the bad loans to work their way out of the system. I still hold firmly to that projection. However, we have other major financial storms on the horizon that I will document later.
How did we arrive at where we are today? The most recent crisis began several years ago when mortgage lenders began lending money to individuals who really could not afford to purchase a home. The “sub-prime” mortgage market as it has been labeled, was designed to lend money to individuals: (a) with poor credit scores; (b) had no money to put down on the purchase of a home (0% down); (c) were willing to pay a higher interest rate; (d) and were willing to accept an adjustable rate mortgage (ARM).
As the sub-prime mortgage problem began to hit the headlines, we found out that many sub-prime mortgage lenders were approving loan applications and were not even verifying that the person applying had a job or could actually afford to make the mortgage payments! The mortgage brokers and the initial lenders did not care because they knew the mortgages would be bundled together and sold to investors/banks /financial institutions.
Because millions of mortgages were being granted to people who in reality could not pay their mortgage, millions of homes began going into foreclosure. The results were: (a) investors were losing hundreds of billions of dollars because of bad mortgages; (b) house values began to decline due to the number of foreclosures and increase supply of homes for sale; (c) other areas of the economy began to be impacted (stock market, unemployment, retail sales).
With a surplus of homes on the market due to record foreclosures -- home prices will only continue to decline the next 12 months which will delay economic recovery. When home values began to decline, millions of home owners became what is called “upside down” on their mortgage. In other words, they owe more than the home is worth. Too many people were buying homes assuming they would continue to appreciate in value.
In recent years as homes appreciated in value, the home owner began tapping into their home equity by taking out a home equity line of credit. All they had to do was to write a check and use the home equity. For those who do not understand how a home equity line of credit works, let me explain. If the bank determines you are approved for a $50,000 home equity line of credit, they will simply give you a check book and when you want/need some money, you write a check. Millions of home owners simply began “writing checks on their home”. You always want to protect your home equity, not spend it on vacations, new cars, clothes, and computers.
Before the financial clouds can begin to clear, millions of bad sub-prime mortgages will need to be sold or taken off the books. If the government bailout is approved it will help, but millions of bad mortgages must be dealt with.
Consumers are very concerned therefore spending is down and will continue to be so until we see the financial clouds clear. Fewer purchases (appliances, clothes, cars, travel) turn into less being produced and sold which ultimately brings the economy down. Less being produced means less jobs and higher unemployment which leads to a down economy. It is a snowball effect, picking up more snow and speed as it rolls down the hill.
Inflation is up in recent months which will only create more problems for the economy. If it costs more to make a purchase, people will be spending less.
The economy is down. It is not common for the economy to be down and inflation to be up at the same time. When this does happens, it is called “stagflation.” This puts the Federal Reserve (who control interest rates) in a no-win position. When inflation is up, the Fed’s response is to raise interest rates to decrease the supply on money in order to “slow the economy down.” When the economy is down, the Fed’s response is to lower interest rates to free up more money that will “help the economy” expand.
Unemployment has been up for eight straight months and most expect the increase to continue for many months. We are currently at 6.1% - the highest in about five years. It is very possible we will be at 7% in early 2009.
Energy cost is high, but has recently decreased. Crude oil peaked at $145 a barrel and is currently hovering around $100 a barrel, which is still high. Higher energy costs translates into increased inflation/prices. When it costs more to deliver food, clothes, building materials, prices go up.
As a result of our current credit crisis (millions of bad mortgages), credit will be harder to obtain. In my opinion, this is very good! In the short term, many Americans will feel the pain as the availability of credit shrinks. It is unfortunate that Americans have become so dependent on using credit. We can trace this increased dependence of credit back to the mid 1970s. Before the 1970s who had ever heard of a pre-approved credit card? Who had ever heard of a person having 10 credit cards in their wallet? Who had every heard of being able to purchase a home with nothing (0%) down?
I believe the rapid growth in our economy that began in the 1980s can be traced back to the massive increase in the availability of credit to American consumers. If you have 10 credit cards you can buy more TVs, clothes, appliances, computers, and vacations. More sales result in an ever-expanding economy.
One problem is that Americans were learning to live beyond their financial means and the system was allowing and encouraging them to do so. They were expanding the American lifestyle while at the same time expanding the economy. Consumers loved it because they could spend more. Businesses loved it because it transferred into increased sales and profits, credit card companies loved it because of huge profits, and the government loved it because the economy was expanding and tax revenues were up due to the growth in the economy.
Before the mid 1970’s you had to earn the right to have a credit card. You had to prove to the credit card company that you had the income to justify a credit card.
Before the mid 1970s if you wanted to purchase a home, you had to have 10% or 20% for a down-payment. The home buyer actually had to have some money to put into the house. The banker/lender would carefully analyze your mortgage application and verify your employment, income, and any assets you listed. Many people who applied for a mortgage would be turned down – for the benefit of the bank/lender who did not want to lose money and for the benefit of the person applying for the mortgage. The lending industry played the role of protecting people from getting into financial trouble. And that was a good thing!
But, things began to change in the 70s and 80s. Lenders were no longer doing their job and credit cards and mortgages were too easy to obtain! And since the home buyer was not required to put any of his/her money into the home, it became easy just to turn in the key to the bank/lender and say, “I don’t want this house anymore.” See the logic? If you have none of your money invested in the house, what do you have to lose? However, if you have $10,000 or $40,000 invested in the house, you will do everything you can to keep your home and make the mortgage payments. That $10,000 or $40,000 you used for a down payment represented many hours/years of hard work and saving.
The expansion and availability of easy credit (credit cards, mortgages, home equity loans, home equity line of credit) helped our nation to build an economic house of cards. And the house of cards was almost blown over in mid-September 2008.
Our government continues to expand which is not good for the economy long term. Expansive government costs more to run, which translates into higher taxes to run the government. Expansive government will be a long term drain on the economy. You are kidding yourself if you expect the government to shrink in size. Name one government program or department that once established has ever gone away.
Health care costs are out of control. Medicare is already in deficit spending and unprecedented spending will drastically increase each year from this point forward. We will have a Medicare melt-down in the future and our political leaders fail to acknowledge Medicare is in a crisis. Why will they not address the crisis? One reason: re-election. Avoiding doing the right thing for fear of making too many people mad and losing the next election. In reality they are acting like what they are: professional politicians who are putting their own political and financial interest in front of what is best for the nation.
Politics as usual. Our political system has problems. All we have seen in the past few days is do-nothing professional politicians in both parties taking political cover and trying to look good on television. We should be outraged at how our elected officials are acting. They should stop being “professional politicians” and begin working on solutions for the real issues our nation is facing: (a) $10 trillion national debt; (b) record deficit spending; (c) Medicare Crisis; (d) Social Security crisis coming; (e) expanding federal government.
How many times have you heard in the last 14 months our leaders say, “Our economy is sound”? “All the fundamentals are in place.” If there is a fire in the house, you address the issue and don’t just keep saying, “We have a strong foundation, new appliances, and a good roof.”
The week of September 15th we learned just how fragile our economic system had become. We literally came close to a financial melt-down. The stress points in the walls and foundations had become visible and people were beginning to run. A category 5 hurricane mortgage crisis almost blew the house of cards down.
Our nation has weathered financial storms in the past. What is different this time? In our history we have never had so much happen at once. In past years we might have dealt with housing problems, or inflation. But we have never been hit at one time in so many areas: (mortgage crisis, housing devaluation, rising inflation, poor economy, rising energy costs, health care costs, lack of available credit crisis, national debt growing, record deficit spending, post 911 economy, wars, travel industry decreasing, auto sales down 20%, increasing unemployment, 80 million baby boomers retiring, and a declining stock market). It reminds me of the recent test of the levies in New Orleans. Everyone on TV was asking the question, “Will they hold or will this become another Katrina?” As category 5 financial hurricane winds pound our financial levy today, we are standing there looking and watching the TV and asking the question, “Will they hold?” In reality, since we are at the beginning or in the middle of the storm, we don’t know! All we can do is what millions of people did during a hurricane: pray that they will hold.
As I write this article Congress is debating a $700,000,000,000 mortgage bail-out. If it passes, our national debt over the next few months will increase by $700,000,000,000 (or over $2,000 for every man, woman, and child in America.
If the $700 billion bail out DOES NOT pass -we will potentially have a major financial crisis. No one really knows for sure what is going to happen. I believe any of the following could be possible: (a) a significant drop in the stock market; (b) home values continue downward; (c) unemployment up; (d) recession. Of course this would be very hard for our nation, but it would purify our financial system - which long term would be a good thing. What do I mean by purify? The following would happen: (a) we would establish a new home value base – making homes more affordable; (b) stocks would be based more on value than on inflated prices; (c) availability of credit to “anyone for anything” would be eliminated; (d) justifiable credit would be available.
If the $700 billion bail out DOESpass – be assured this is only putting a band-aid over a wound that in reality needs to be cleaned and have stitches. Oh yes, short term the stock market will rejoice and see a significant increase, only to have another melt-down when the next financial crisis hits the headlines. Our economic system has major problems and unless addressed the economic house of cards will fall in the future. I am not exactly sure when, but it will fall. There is no other option but to fall - unless major changes take place and the sooner the better. As I have already mentioned, Medicare is already in a crisis, SS will be in a crisis, federal debt is out of control and reaching the point of no return, government deficit spending will only increase. In addition, as the government raises taxes (out of necessity) to pay for increasing expenses (see list above), this will only cause the economy to decline - creating more problems.
There is a third option: a partial bail-out. We do not have to have an all-or-nothing bail out. It is possible that we can move forward with a smaller, partial mortgage bail-out.
The solution to our economic problem is not a $700 billion bail-out resulting in $700 billion in more debt. What our nation needs is less debt (government, business, and private). You cannot borrow your way out of a financial crisis.
For years I have believed that the role of government is to establish rules and regulations – and not to intervene in “financial markets.” Let the financial markets work out their own problems. This has been one of my core values. You keep your core values in the good times and in the middle of a crisis.
The #1 question I have been asked is, “What should I do concerning my investments? Should I get out of stocks/mutual funds or should I ride out the storm?”
If I were a prophet and knew the future that would be an easy question for me to answer. Here is what I would recommend you do. Take a look at the financial horizon (6-12 months) and develop your own conclusion. Do you think the economy (which drives the price of stocks) will be better or worse in the next 6-12 months? Now you look at the list and decide:
- Millions of bad mortgages
- Housing devaluation
- Inflation rising
- Economy slowing
- Energy costs rising
- Health care costs out of control
- Lack of available credit crisis
- National debt growing ($10 trillion)
- Record deficit spending
- Post 911 economy
- Wars (Iraq and Afghanistan)
- Travel industry decreasing
- Auto sales down 20%
- Unemployment on rise (6.1%)
- 80 million baby boomers retiring
- Declining stock market
- Expanding federal government
- Lack of leadership in Congress
I trust you agree that we have a perfect financial storm.
Can things get worse in the months to come? I personally believe they can and will.
Some see the current circumstances as a tremendous buying opportunity. I think the tremendous buying opportunity is yet to come. And when it arrives, many investors will have the cash to take advantage of the opportunity.
If you get out of the market, and in the future it begins to rise, you can always get back in. You might miss the first 8% to 12% rise, but you can still get back in once the economy begins to stabilize and recover.
We are blazing a new economic path. We have never walked down this economic road before. We have never been so close to an economic melt-down before. It is my opinion that these are not the days for “cute investment” sayings. These are days to begin using the brain God has given to you and to make decisions based upon what you believe will be happening in the future.
I love this nation and have no desire to live anywhere else in the world. I would rather be paying taxes in the United States than anywhere else in the world.
Let us be careful as a nation that we not allow pride and financial arrogance to destroy us. We cannot walk around saying and thinking, “We are the United States of America. We are too powerful and strong for anything to happen to us.” The Bible has something to say about that kind of thinking, “Pride comes before the fall.” Proverbs 16:18. Let us not be arrogant, but let us remember our nation’s motto, “In God We Trust.”
In 2005, I said in my book on Social Security, “America is losing her financial conscience. America is quickly losing her financial alertness. America is charting a path of unsustainable spending, increasing entitlements, escalating debt, and greater-than-ever taxation.” (p. 15)
We are on an unsustainable fiscal course!
This is far more true today in 2008 that it was in 2005!
I feel compelled to repeat what I said at the beginning of this article. I sincerely hope that I am wrong. It would bring great joy to my life if in 2010 I look back and realize that I was wrong. However, as I write this article, I am willing to take the risk of being criticized in the future (for being wrong) rather than taking the risk of knowing what I think is going to happen and not having the courage to tell anyone.
Ethan Pope
Ethan Pope is the president of Foundations For Living and lives in Dallas, TX. He is the author of six financial books and has been a guest on over 200 national radio programs.
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