by Rick Willeford, MBA, CPA, CFP
For more on this topic, go to www.dentaleconomics.com and search using the following key words: financial crisis, multiplier effect, mortgage debt, mortgage brokers, mortgage–backed investments, financial institutions, commercial paper, meltdown, Great Depression, Wall Street, AIG, bailout, Rick Willeford.
The good news is that the current financial crisis should have little long–term effect on your financial investments. If you have followed our advice to be broadly diversified in your investments (which most of you have), and if you have not invested in crazy "mortgage–backed derivatives" (which most of you have not), then your investments should be safe. The bad news is, if you were hoping to sell your home, refinance your debts, or take out new debt, then the short run may be sticky indeed ... especially if you do not have sterling credit!
In addition, you will certainly feel the impact if your patients suffer job losses, have difficulty getting credit, or have a tough time filling their gas tanks. Their real problems will be exacerbated by the emotional stress and angst brought on by uncertainty and the general turmoil. Needless to say, any discretionary dental wants are going to be delayed.
So, just what is all the financial crisis about? Let me start with a little refresher course in economics.
Economics 101 — The multiplier effect
You may not recall the "multiplier effect" that is at the heart of all economic systems. By that, I mean that spending $1 generates a ripple effect that may have the impact of spending $5. Suppose you have a company that sells lighting fixtures. You have a good year in sales, so you borrow money to buy a car. The car dealer makes a profit and has a good year, so he goes and buys a boat. The boat dealer makes a profit and has a good year, so he buys some new boat–building equipment. The equipment company has a good year, so the owner buys a new house. The new house needs lighting fixtures, and the whole cycle helps you sell more lighting fixtures. So the entire economy prospers, and by an amount far greater than the original car that was purchased.
As you can imagine, the whole cycle is energized even more when we are not limited just to the funds we have on hand. Instead, the process is supercharged when we can use credit. Credit is the lifeblood and lubrication that drives not only consumer spending, but also business spending in the same way. (Anyone bought a CEREC for cash recently?)
The amount of available credit is generally based on the amount of a bank's customer deposits, capital, and the quality of a bank's investments, which include its outstanding loans. (I am using the term "banks" loosely, but I am referring to any number of "financial institutions," including those in the recent headlines.) Many banks' investments are real estate–based, such as construction loans and mortgage–based assets. As the real estate bubble burst, those investment values dropped ... and so did the bank's ability to provide more credit to the community!
So, the sucking sound you are hearing in the economy is that of credit drying up. Just as the effect of injecting $1 into the system is multiplied many times over, withdrawing $1 is amplified many times over. Using debt — "leveraging," "other peoples' money," etc. — magnifies your profits ... when things are going up. It can be a millstone around your neck when things are going down. Hence, the cyclical nature of the economy.
So what went wrong?
Your last house purchase
Do you remember that, long ago, it was a given that you had to have about 20% down payment to buy a house? But laws and regulations changed, and in recent years, the lender was willing to make you a second loan to cover even the 20%! It seemed odd at the time, but who was going to complain about 95% or 100% financing?
It used to be that the banks and mortgage companies serviced your mortgage debt by accepting your monthly payments, handling property tax escrow, etc. But then you started sending your payments to strange folks you had never heard of. Your mortgage had been "sold," but that did not really affect you. It helped the bank, though, because it meant that the bank had fresh money to make more loans. But selling your mortgage also meant that the bank no longer had a responsibility to collect on the mortgage. So the bank became less concerned about the quality of the borrower.
At the same time, "mortgage brokers" came into existence. Rather than deal with the bank directly, you got your loan through this middle man, who collected a fee. He only got paid if the loan went through. He could care less about the quality of the borrower. Hence, a number of "subprime borrowers" were able to take advantage of easy money and easy lending standards. A scary pattern was beginning to emerge. But if the value of real estate kept going up, what difference did it make? The property was the collateral, not the borrower's ability to repay the loan.
Mortgage–backed investments
Who was buying up all the mortgages, and why? Let's jump to the end product, and then come back.
What if you could only get, say, a 5% to 6% return on CDs, but your financial advisor/salesperson told you that you could buy an investment paying 9% to 10%? What if you were also told that the investment was collateralized by mortgages and the underlying real estate? Sounds like a no brainer, doesn't it, especially since they are not making any more land, and who would default on a mortgage in the first place? Thus were born "collateralized debt obligations," or "CDOs," which are simply a bundle of mortgages packaged together. So, plain old mortgages ("debt") were bundled together ("securitized") and sold as "securities," along with stocks and bonds and other traditional securities.
The investment bankers and other financial institutions (Fannie Mae, Freddie Mac, Merrill Lynch, etc.) who created the CDOs were trying to be prudent by getting insurance from folks like AIG to protect against the risk of mortgage defaults. This was called a "credit default swap." The insurers presumed the risk of default was low, so they got aggressive to earn more fees, and they sold more "insurance" than they could cover.
Creative investment bankers began selling the credit default swaps themselves, along with other esoteric investments derived from the mortgage–backed business, or "derivatives." Fortunately, those investments were not sold to individuals like us. Instead, the big financial institutions were selling these back and forth to each other, to large private investors ... and to other countries.
The meltdown
As the value of real estate began to decline, the pervasive, yet unthinkable, meltdown began. The drop in values was exacerbated by the fact that the initial "teaser" interest rates were going up to true market rates. The subprime borrowers — and many others caught up in the 100% financing spree — simply could not afford the new payments, and they could not refinance with the values deteriorating. While the CDOs and other related investments were designed to handle traditional minor defaults, the current magnitude of the defaults was never envisioned. The party was over, and the hangover was about to begin in earnest.
We think nothing of accepting and using paper currency for everyday transactions because we have faith in the government standing behind that paper. A similar faith and trust pervade the entire financial system at the highest levels as it deals in unsecured "commercial paper" issued by the big institutions. As the system's financial strength deteriorated due to the bad real estate–based assets, these institutions lost the confidence of the market, whether deserved or not. It is as though the first big Wall Street name, Bear Stearns, was suddenly radioactive. The other institutions would not accept the company's paper or trust it with their deposits. Other big names soon had the same problem. On top if this, the big insurer, AIG, was not prepared to cover everything they had insured. (Just like State Farm would be in trouble if every house in the U.S. caught fire at the same time.)
The last shoe that hasn't fallen yet would be if the consumers lose faith in their banks and begin withdrawing their savings ("run on the bank"). Foreign investors could do the same if they dump all their Treasury bills and notes. In this scenario, credit tightens even further — or disappears — and the entire market goes into a tailspin, as happened in the Great Depression.
The proposed "big bailout" hopes to bolster confidence in the system at all levels. By buying up the bad investments from the banks, the banks once again have liquidity and can begin offering credit again. This may also provide a "floor" for falling real estate prices, so that the market can return to normal sooner, although that still may mean several years.
So, unless you are hoping to sell a home soon, or if you are retired and living off your investments, or if you are looking to borrow money without strong credit, then this turmoil should not affect you in the long run. Historically, we are a resilient nation, and we will not stand idly by as we search for solutions. Even though things should "technically" improve, the day–to–day economy and consumer spending will be a problem until consumer confidence is restored. And we can't legislate that!
Raymond "Rick" Willeford, MBA, CPA, CFP®, is president of The Willeford Group, CPA, PC, and Willeford CPA Wealth Advisors, LLC. As a fee–only advisor, he has specialized in providing financial, tax, and transition strategies for dentists since 1975. Willeford is the president of the Academy of Dental CPAs, a consultant member of AADPA, and is available as a speaker nationwide. Contact him by phone at (770) 552–8500 or by e–mail at [email protected].
