The credit crisis explained in a nut shell

Here is an excerpt from an email I mailed clients last week ahead of the historic actions taken by Congress. Keep in mind there is no easy way to explain what is going on in the financial system but my attempt is to put it in a nutshell. While many are angry, scared and have assessed blame, I fall down on the side that at this point it does not matter, we just to fix the problem and move on.

The Reason

When the home down the street from you sells for $50,000 less than what you paid for your house, you are not at risk of losing your house or filing bankruptcy. It does not feel good, but in the end, so long as you continue making your mortgage payment and pay your taxes, you can hold onto your house until the market recovers. However, this is the situation our banking industry finds itself in. Because of accounting rules that require banks to decrease the value of their assets (loans) based on the value the bank down the road sold a similar asset for, the bank now has less money to lend to customers and other banks. A bank's loans are it's assets and deposits are it's liabilities. Every night the banking system lends money to each other to make sure regulatory requirements are met and that each bank is solvent. It's a very good system. However, because of the asset value declines, Bank A looks at Bank B and says, "we're not lending to you because we're not sure if you will pay us back." Further complicating the situation are depositors walking out of the banks with all their money, further tightening the banks ability to lend. So banks have less money to lend because the loans are worth less and less money to lend because deposits are walking out the door. A bank needs both in order to lend and so the banking system becomes frozen.

Why does this affect you?

Our economy runs on credit. When you buy a car, most do not have $30,000 of cash laying around to do so. In fact, financially that may not make a whole of sense. Everything else being equal, if you can earn 8% on your money in the stock market and only have to pay 6% for a car loan, the financial answer is to finance the car at 6% and let your $30,000 grow at 8%. When banks are frozen and don't lend, that potentially stops you from getting that car loan. Which in turn does not allow the salesman to earn a commission, which in turn may affect his spending habits. See our economy is based on consumer spending, two thirds of our gross domestic product is the consumer buying goods and services. If that stalls, our economy suffers.

The Plan

Whether Congress' actions are termed "bailout" or "investment" or "credit stabilization" or if you think it is necessary or not, we do believe at this point, after all of the discussion, it is necessary for Congress to act in some fashion to alleviate the crisis of confidence. Perception is now reality and there is tremendous fear in America and in the world. The stock market had discounted some form of action at the end of last week. Since the Plan failed to pass in the House, the stock market is now lower as it awaits some sort of action. It is clear that if a Plan does not happen there could be significant pressure downward in the stock market. What a Plan does provide is Trust and that mitigates the fear that is so rabid in the financial system. When Trust returns, banks become stable and slowly, banks will begin lending to one another and to customers and then rapidly the economy will recover.

Outlook

We have faith that taxpayers, investors and the economy will be OK. It will get darker before it is pitch black but we have faith that given time we will be OK. We expect the Federal Reserve to lower interest rates in the near future after Congress acts. We expect at least a 0.25% cut in the Fed Funds rate but it could be as much as 0.50%. This will help consumers with home equity loans and potential lower mortgage rates to allow homeowners to refinance at lower rates. It will also help the small businesses that have credit lines. If the Plan passes, we expect the focus of the stock market to shift back to the fundamentals of the economy which are currently deteriorating. In our opinion, the economy will get worse before it gets better. We expect job loses to continue and consumer spending to all but halt expect for necessities. The unemployment rate is currently at 6.3% and we expect that to increase towards 8%. This would not be out of the ordinary based on prior recessions. Slowly, the economy will get better, it won't be next month but if it's six months or two years from now, it will get better. When it does the stock market will react and it will be just as violent going up as it has been going down. We call this the whiplash affect. Missing that turn can be devastating to long term growth. If you believe that we will eventually pull ourselves out of this, then now is not the time to jump off the ship. Now is the time, maybe a once in a generation opportunity, to take advantage of buying depressed assets just as the Treasury seeks to do.

Tom Taylor is a Certified Public Accountant and Financial Planner and can be contacted here. He is a member of NAPFA and the MACPA.